For venture capital-backed startups, we are now entering a new phase of financings. Many will be down-round financings – i.e., financings at valuations that are significantly below those of prior financing rounds and will therefore cause dilution of the stakes held by pre-existing investors, especially holders of common stock which typically lack any rights to protect against dilution. Others may not be down-rounds, but will result in accumulations of meaningful control for the lead VC investors as they continue to invest more privately because the liquidity events of an IPO or M&A exit are being postponed until an indefinitely later date. Causes of this new era of down-rounds and investments triggered by postponed liquidity events are not only the result of the COVID-19 macro-downturn, but also the sudden external and internal challenges being faced by the most active and largest source of venture capital in history, the Softbank Vision Funds and the aftershocks of recent high-profile IPO postponements, the ugly performance of Casper’s 2020 flotation, and the volatility of the trading prices of some of the leading members of the 2019 IPO class.
We’ve been through periods of down-round financings and financings necessitated by postponements of liquidity events in the past, but this time the atmosphere in the board rooms of start-ups will be different. In the not-too-long-ago “old days”, pre-IPO ventures had founders who held both economic and voting control and the other shareholders were a relatively tight and manageable group. Those in the boardroom – the founder and the lead VC fund investors – used to represent pretty much everybody that mattered. Moreover, the amounts invested pre-IPO were relatively small compared to the last few Vision Fund-fueled years. Under these circumstances, the demands of accountability to shareholders were accordingly relatively easy to manage even in the midst of down-rounds.
But now, as a result of changes in SEC rules (that permit companies to remain private despite having very large numbers of shareholders), the availability of private secondary markets, the magnitude of late stage financing, and the use of innovative arrangements that permit companies to provide employees with liquidity, companies have remained private longer and developed broader and more diverse shareholder profiles. Family offices, former employees and angel investors with cousins who are plaintiffs’ lawyers ¬– as well as traditional funds like T. Rowe Price and Fidelity – are regularly at the bottom of the capital table of start-ups these days and they are not types who like to get the short end of the stick. Indeed, they are relying on the boards – which still generally consist of only the founders and the point persons from the largest VC fund investors – to look out for their interests. This can be especially challenging when the governance arrangements at these companies provide the major VC fund investors with lots of special rights to impede future financings that, in turn, can make it hard to market-test the fairness of the valuations and other terms for financings.
What to do? One recommendation is for these companies to start adding truly independent directors who are unaffiliated with any holder of preferred stock and have the backbone to look out for the common stockholders and to engage serious advisers to help with process and valuation analysis. While this recommendation should be acceptable for some of the more well-endowed start-ups, for others, their cash burn rates and revenue challenges make it hard to attract outside directors or to justify paying for top-tier advisers.
Another important recommendation is to conduct more upfront work on the long-term plan and on investor and stakeholder communications of that plan. Too many start-ups rely literally on “back of the envelope” analyses. Investors deserve better. More work is needed on sufficiently detailed forecasts and assumptions, the use of metrics that are well-understood, spelling out of the risks and specific probabilities that apply to the forecasts, clarity as to the stage of development (and what next steps are needed) for implementation of each initiative that comprises the underlying plan, and explanations of the main alternatives to that plan and why these alternatives are being rejected. In other words, these companies have to start acting more like their publicly traded peers, especially those who have upped their games to ward off campaigns by activist investors. This can be a difficult challenge as many ventures simultaneously have both “through the roof” internal forecasts and strong indicia of foreseeable insolvency. Supporting a reasonable basis for the company’s valuation does not require the board to abandon its strategic plan to conquer the world. It just requires the board, for purposes of assessing the valuation of a financing round, to separate out internal forecasts that are aspirational and subject to lots of uncertainties and hypothetical initiatives from a reasonable projection of what is most likely going to occur under current circumstances.
Finally, some internal homework will be necessary to figure out how to respect the rights of the existing major investors, such as the Vision Fund, and maintain constructive relationships with them, while concurrently not permitting these rights and relationships to get in the way of obtaining financings and taking other strategic steps that would be in the best interests of the stockholders generally. Resolution of this tension requires attention both to the details of the existing investment arrangements and to creative ways to do right by the shareholders generally. Financing sources other than the company’s existing major VC fund investors represented in the board room may need to become important parts of the equation for maximizing shareholder value.
The pressure is on to be good gatekeepers on behalf of all investors. Will start-up boards be up to the challenge?