As adviser to a number of respected technology-focussed venture capital institutions ("VCs") and investee companies, we are well placed to observe trends in the VC market generally, and particularly in relation to the terms on which VC investments are concluded. Over the past six months we have seen a marked reduction in the number of new VC investments, and coupled with the drying up of the availability of debt, it is becoming increasingly difficult for growing technology companies to obtain investment. There are a number of factors responsible for the slowdown in new VC investments, but perhaps most important is the fact that the growth prospects for any early stage business are uncertain at present, and a number of VCs are waiting in the expectation that valuations will come down further. Many VCs are also preoccupied with supporting their existing portfolio companies through difficult times (or alternatively managing their withdrawal from those companies whose survival is doubtful).
We have also noticed that VCs are imposing increasingly tough terms as a condition of their investment, some of which we have summarised below.
Convertible loan stock
Investment in convertible loan stock instead of shares is becoming increasingly prevalent. This is partly because VCs are struggling to build strong investment syndicates in the current climate, and it also avoids the need for protracted negotiations with founders over the valuation which should be applied to the company. Although the use of convertible loan stock is generally less attractive for investee companies (not least because of its impact on its balance sheet) it does have a number of advantages for investors:
- It provides flexibility, since the VC can either (i) (theoretically) seek repayment of its loan (often with a redemption premium of 2 or 3 times the principal amount of the loan where repayment occurs on an exit), or (ii) convert its loan into preference shares on the next equity fundraising, usually at a discounted price;
- Convertible loan stock can be secured against the assets of the company, guaranteeing the VC a priority return over both shareholders and unsecured creditors;
- It is usually quicker and cheaper to conclude an investment in loan stock than shares, and consequently loan stock is often used to "bridge" cash-strapped companies until the next equity fundraising or other milestone.
The use of anti-dilution provisions (which entitle a VC to receive more shares on a new fundraising at a lower price) is becoming more common, and there is a general shift away from the more balanced "weighted-average" anti-dilution provisions towards the more draconian "full ratchet" formulation.
VCs are looking increasingly carefully at "drag-along" and similar provisions which allow them to force a sale of the company. In the current climate VCs are more likely to contemplate a sale of poorer performing portfolio companies at a low valuation to recover their investment and free up precious cash. Such exits may return little or nothing to ordinary shareholders, and so VCs will want to be sure that they can force ordinary shareholders to participate in a sale if necessary.
We are starting to see pressure from VCs to require a multiple return on their investment on a return of capital on a sale or other exit, although in our view we are unlikely to see a return to the multiples of five times or more seen during the dot-com boom.