Companies that rely on venture capital financing have experienced challenging fundraising conditions in the last 6 months in stark contrast to the height of the VC market in late 2021. We are seeing VC investors taking longer to complete their VC investments and often demanding more favourable financing terms in this market.
This article discusses recent trends in VC financing, including the increasing prominence of bridging rounds (through the issue of convertible notes) and additional investor protections that are being sought by certain VC investors.
Convertible notes
We have observed increasing use of convertible notes for VC financings instead of traditional ‘equity rounds’ where ordinary shares or convertible preference shares are issued at an agreed valuation. While convertible notes often do not require an amendment to the Company’s constitution or shareholders agreement (which is typically required for an equity round and can be time consuming), they also allow the company seeking funding to avoid difficult valuation discussions with investors, such as a possible ‘down round’ where the company is valued less than at the time of its last fundraising.
Convertible notes offer benefits to both the company and incoming investors, however these benefits often come at the expense of existing investors through increased dilution of their shareholding. Generally speaking, notes will convert into the class of shares issued at the company’s next capital raising at a discount to the issue price for that capital raising. This discount is often 15%, but we have recently seen discounts as high as 30%.
It is also common for any interest charged on convertible notes to be capitalised, which compounds and further increases the dilution for existing investors when the notes are converted into shares. Finally. we are seeing some investors demand warrants (options to acquire additional shares at the current valuation) in addition to convertible notes, which give a greater potential equity return to these investors and don’t provide any funding to the company until the warrants are exercised.
Investor-friendly terms
The changing fundraising environment has resulted in investors being able to negotiate more favourable investment terms that have not been seen regularly since the last VC market downturn. Set out below is a summary of some of these investor friendly terms.
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Term
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Commentary
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Example
uses 2
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A.
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Liquidation preferences |
Up to 2x liquidation preferences (instead of a 1x liquidation preference), which guarantee investors a return of double their original investment ahead of existing investors in either an exit or liquidation of the company. |
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B.
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Conversion terms (for convertible notes) |
A conversion discount of up to 30% to the issue price of a subsequent qualifying financing round (instead of a more usual 15% discount). |
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C.
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Business restrictions |
Additional undertakings from the company are commonly being sought, which restrict how the business is conducted without investor consent. |
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D.
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Interest |
Either cash interest or payment-in-kind (PIK) interest, which is capitalised and compounds. |
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E.
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Warrants |
Warrants (ie options) to receive additional shares at the current valuation, which are only likely to be exercised in the future when the company’s valuation is higher and a liquidity event is likely. |
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Outlook from here?
Domestic and international VC investors still have significant amounts of capital to deploy, so we expect quality businesses with demonstrated revenue and product/service offerings will continue to have access to VC funding. We believe companies holding sufficient capital for a runway of 12 months or more will delay capital raising activity in this softer market, while companies in need of capital in the nearer term will be strategic by raising the minimum amount required to fund their next stage of growth and using bridging round structures, such as convertible notes to avoid difficult valuation discussions with investors.
