Everyone seems to know that VC financing in the current environment has dried up to a material extent.  The statistics demonstrating this fact, as set forth in the current issue of Economist magazine, are startling in confirmation, with the greatest impact on the largest deals; seems that seed capital is less impaired, and indeed robust in AI, albeit on tougher terms.

Yesterday’s Webinar presented by the Boston Bar Association, featuring VC lawyers in US and the West Coast (often somewhat disparate markets), explored the numerous practical ramifications of the current environment on actual deal terms for those companies lucky enough to get an actual proposal to invest.  Too numerous to list all, nonetheless below are some of the highlights (or for the company, lowlights).

Pre-money valuations are down of course, that comes with the territory by definition.  Larger equity deals may feature milestone release of funds based on progress of the company, redemption rights for investors, payment of cumulative dividends and even grant of security interests in assets for convertible notes (making them more like real notes), super-preferred returns for preferred classes (eg rather than having a distribution preference equal to cost, the preference before the common participates might be two times cost).

Deals also may provide for full-ratchet repricing of conversion rates to common rather than the typical (and statistically fairer) repricing over the total outstanding shares (the latter actually adjusts properly for the financial harm suffered by the earlier higher-priced preferred).

With convertible notes, aside from now looking like real notes, investors are insisting on receiving warrant coverage in greater amounts, particularly if milestones are not hit.

Investors in all deals are bargaining for greater corporate control: class votes on a broader list of corporate actions, more negative covenants, more board power.

When investors in prior rounds participate in a subsequent round which is a down round (eg the pre- money valuation is less), investors are sometimes insisting on recapping the entire company and repricing their prior investments to the lower valuation.  As a practical matter, also, prior investors are less likely today to waive the anti-dilution protections they obtained in their prior investment (which was often done because the company really needed new money or prior investments were imperiled).

Recapitalizations driven by investors, particularly those who already held an investment, raise fiduciary issues for directors, particularly nominees of the prior VCs and management holding common; recaps help new money investors and the price to be paid is paid by prior classes of stock.  (These fiduciary issues are not herein addressed.)  As to substantive deal terms, recaps often include addition of pay-to-play provisions, forced conversion of prior preferred to common, rights offerings, resetting preferred valuation of prior preferred.

Not addressed in the program was the prior practice in early rounds of requiring management holding large amounts of common to enter into forfeiture agreements whereby outstanding common shares are forfeited back to the company if the employee leaves or is terminated–  a somewhat draconian provision, but with persuasive investor logic behind it; and, incredulity expressed by founders in early rounds, particularly by founders who have not only sweat equity but also cash in the deal.  Empowered investors these days will be more likely to be  aggressive as to this practice.

One can speculate that seed and early stage companies may turn to more self-financing and to non-dilutive funding and joint venture models, in the face of the aggregate dilutive pressure these realities suggest.  Or– just wait it out, though the trough in VC financing in the early 2000s lasted, if I recall correctly, several years.