Prior to the onset of the COVID-19 pandemic, the Canadian venture capital (VC) marketplace experienced consistent growth and record VC fundraising, with total Canadian VC investment increasing from $2.3B in 2015 to $6.2B in 2019, according to the Canadian Venture Capital & Private Equity Association (CVCA). However, more recent deal studies are showing the impact COVID-19 has had on the Canadian VC market. In its Venture Capital Canadian Market Overview for H1 2020, the CVCA recorded a 45% quarter-over-quarter decline in Canadian VC activity in Q1 2020, followed by a 102% quarter-over-quarter increase in Q2 2020. This bounce back in Q2 2020 was largely driven by a disproportionate number of investments in later-stage companies.
The data for the Greater Toronto Area (GTA) is consistent with this trend and in some cases more worrying. Hockeystick reports a 61% drop in funding in the GTA over the last three quarters. The funding for Q2 2020 was less than half of the funding in Q2 2019 with half as many deals occurring in Q2 2020 than in Q2 2019. Hockeystick's data also reveals a positive trend-deal volumes during COVID increased by 15% quarter-over-quarter. More concerning is Hockeystick's data which points to a slowdown of later stage deals in Toronto for two quarters in a row, even though Series A activity is healthy1.
If earlier-stage Canadian companies continue to struggle to attract VC investment, and if market volatility continues, we may begin to see new trends in deal terms and dynamics. In this article, we discuss potential changes to investors' approach to negotiating future VC financing rounds and the impact this may have on VC deal terms.
Regardless of the economic climate, the most promising startups tend to attract VC funding. The COVID-19 pandemic, however, has made identifying the best startups and determining an appropriate valuation more challenging. This has led VCs across the globe to take a more defensive approach, shifting focus to existing portfolio companies and applying a more risk-averse strategy to investment decisions.
Further, Canadian startups may be disproportionately impacted by COVID-19 compared to the global VC marketplace. A recent report shows that foreign VC investors, particularly U.S. investors, make up a significant source of funding in Canadian VC deals2. In its survey of 257 Series A investments by VCs in 76 Canadian companies, the report found that only 18% of those rounds were financed solely by Canadian VCs, compared to 29% of rounds with no Canadian VC participation at all. Any longstanding restrictions on cross-border travel or a reluctance of VCs to travel to Canada due to COVID-19 may result in a reduced ability for international investors to develop relationships with Canadian founders and may lead to disproportionately less international participation in funding rounds for Canadian companies.
The impact of Canadian startups competing for a smaller pool of VC dollars will not affect all companies equally. Unsurprisingly, we have seen companies in the biotech, remote working technology, e-learning and telemedicine sectors attract a greater share of VC interest. Companies in industries more greatly impacted by COVID-19, on the other hand, such as travel, food and beverage, hospitality and events, may experience greater difficulty in raising capital and generally, during these times, have a weaker bargaining position with investors. This disparity in leverage may lead to a greater prevalence of deals containing terms that would otherwise be considered "off-market" in the pre-COVID era. Some changes to investment terms may include:
VC investors often negotiate to receive proceeds in priority to common shareholders in the event of a liquidation of the company. In a "normal" investment cycle, this is typically equal to the amount they have invested in the company (i.e., a 1X liquidation preference). However, investors that are concerned about limiting their downside risk may demand enhanced liquidation rights. This may take the form of liquidation preferences exceeding 1X (effectively guaranteeing a certain return on their investment before other shareholders are paid), or they may insist on their liquidation preference taking priority over existing classes of preferred shares (ranking senior, rather than the more typical pari passu treatment of preferred holders)-or both.
In the alternative scenario, where the liquidation preference of the company's preferred shares starts to approach the company's current valuation, the new VC investor may require that existing preferred shareholders convert all their existing preferred shares to common shares in connection with the new investment, wiping out the liquidation preference of the existing shareholders.
Typically, Canadian VCs invest in non-participating preferred shares, meaning that the investor has a choice between the better of: a) receiving their negotiated liquidation preference; and b) converting their preferred shares into common shares and participating, alongside all the other common shareholders, in the residual value of the company. In the post-COVID financing environment, some VCs may insist on participation rights that allow the investor to receive both: a) its negotiated liquidation preference; and b) its pro rata share of the residual value of the company, as if it had been converted to common shares (often referred to as "double-dipping"). This participation right can be highly dilutive to founders and other common shareholders, and would be even more dilutive if a participation right were coupled with a multiple liquidation preference.
Antidilution protection rights are a common provision in VC deals that provide investors with price protection if the company issues additional shares in a future financing round at a lower price (i.e., a down-round)3. When this provision is triggered, the ratio at which preferred shares convert into common shares is adjusted to provide for the issuance of a greater number of common shares and thus partially protecting the investor against the dilution of such future round. The new ratio is normally calculated on a broad-based weighted average basis, which reflects the price per share and amount of money raised in both the previous round and the subsequent down-round. This weighted average formulation helps ensure that in a scenario where there is an earlier large financing round followed by a smaller down-round, the earlier investors are not provided with a disproportionate level of adjustment to their original conversion price.
Market uncertainty may lead to an increased gap in valuation expectations between founders and investors. Investors might get comfortable with a higher valuation, on the condition that they receive "full-ratchet" antidilution protection, instead of the standard broad-based weighted average approach. Under this formulation, the investor would receive full share price protection regardless of the amount raised in the future round, with the effect being that if the company has been significantly over valued in the financing round, the valuation that the investor paid will get reset to the next round price in a future down-round. This provides significant protection to the investor but can be highly dilutive to the existing shareholders. A company that has a much more positive outlook on its valuation than the investor may be willing to accept a more aggressive antidilution provision if it believes that there is little chance of a future down-round.
In connection with a "Qualified IPO", all preferred shares of VC-backed companies automatically convert into common shares. In negotiating a financing round, investors may seek to negotiate the definition of a "Qualified IPO" to reflect a minimum price per share that results in the investor achieving a multiple of the original price paid for their preferred shares. This, in effect, provides the investor with a guaranteed return before they exit their investment in an IPO. Investors looking for further downside protection in the post-COVID investment ecosystem may seek additional antidilution protections if an IPO constitutes a "down-round" and receive additional common shares under the antidilution provisions described above.
Preferred dividends are typically granted at the discretion of the board and are not usually a key term in VC financing negotiations. In successful investment scenarios, where the VC returns may be multiples of their initial investment, the additional dividends would only represent a very small portion of their returns.
However, in a downside scenario where the VC is receiving their liquidation preference and there is minimal residual value in the company to be split amongst the common shareholders, a preferred dividend could make a material difference to the founders and the other common shareholders (which residual value would be further reduced to the extent that the investors negotiate for a cumulative dividend). VCs that are cautiously modelling upside and downside scenarios may consider requesting preferred dividends in their negotiations.
Veto rights, protective provisions and information rights
VC investors seeking to minimize risk may push for additional control rights with respect to their investment. This could take the form of vetoes or protective provisions that attach to their shares or board seats. The actions over which an investor might seek a veto range from routine operational matters (e.g., entering strategic relationships) to more fundamental corporate actions (e.g., raising capital or selling the company).
Further, VC investors may request greater "information rights", such as more frequent financial reporting, in order to more closely monitor their investment. These provisions are often bespoke to the individual transaction, the investors and the appetite for control by all parties involved.
Prior to the COVID-19 outbreak, many of the above provisions would be seen as off-market in the Canadian VC ecosystem. While the full effect of COVID-19 on market practices for VC financings in Canada remains to be seen, companies looking to raise money may need to be prepared to deviate from standard deal terms to secure financing and accept one or more of the above terms. Negotiating parties should understand the impact of these terms and be mindful that off-market terms accepted in a current financing round may put the company in a worse negotiating position vis-à-vis future investors requesting similar terms in subsequent financing rounds. Investors should also keep in mind that although enhanced terms may be beneficial to the investor in the current round (e.g., requesting that the current preferred security receive a senior ranking), the same term may adversely impact their current investment in a future financing round if new investors request the same rights. With these considerations in mind, parties can effectively negotiate a deal that benefits investors, founders and the company.
3 For further discussion of issues founders and investors should consider in a down round, see our previous publication on the topic: "COVID-19 may increase down round financings: what companies need to know".
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.