On this episode of Ropes & Gray's podcast series, The Sponsor's Edge: Insights on Growth and Venture Investing, asset management counsel Catherine Skulan hosts the second of a two-part conversation between Brad Flint, partner and co-lead of Ropes & Gray's venture investing & emerging companies practice, and Raj Banerjee, a senior associate in that practice. Brad and Raj cover some traditional means of bridging valuation gaps before discussing the emergence of additional terms and investor protection mechanisms recently taking root in the market.
Transcript:
Catherine Skulan: Hello, and thank you for joining us today. My name is Catherine Skulan, and I am counsel in Ropes & Gray's asset management practice group based in the San Francisco office. I'm here again today with my colleagues, Brad Flint, partner and co-lead of Ropes & Gray's venture investing and emerging company practice, and Raj Banerjee, a senior associate in that same group. Both Brad and Raj are based in our Boston office.
Today's discussion is part of a series of podcasts hosted by a cross-practice group of Ropes attorneys, where we look at the near-term challenges faced by growth equity and venture fund sponsors, together with long-term opportunities that we see for them. In our last episode, Brad and Raj discussed the challenges faced by companies and sponsors in the current deal market, speaking to down rounds and their alternatives. In today's podcast, they'll circle back to some more traditional means of bridging valuation gaps before discussing some evolving terms and investor protection mechanisms coming up more frequently these days.
Raj, could you talk a bit about some more traditional means of bridging valuation gaps?
Raj Banerjee: Happy to, Catherine. When it comes to raising funds and bridging valuation gaps, traditional bridge notes and convertible notes have played a significant role, but it's important to recognize that these instruments have their limitations in terms of the amount of funds they can attract. While convertible notes offer the advantage of a discount to the future round, as more funds are stacked into these notes, the discount results in significant additional dilution relative to the company valuation at the preferred stock financing round in connection with which the notes would convert into equity.
Brad Flint: Right. Convertible notes serve as a suitable alternative for short-term bridges, allowing companies to secure at least a modest amount of interim funding while delaying the valuation conversation until a full-priced preferred stock round at a later date. Six to 18 months ago, many VC-backed companies were hopeful that the market and valuations would have improved significantly by now, which led to a surge in bridge notes around that time. But there is a limit to how much can be done with convertible notes alone, and now, we are seeing more companies forced to have the valuation conversation in the context of many more flat or down price rounds of preferred stock financing.
Raj Banerjee: Another thing to mention about convertible notes—and also SAFEs (Simple Agreements for Future Equity), which are similar to more traditional convertible notes—is that although they may provide a path to avoid a valuation conversation, valuation caps have become typical features of these securities in recent years. A valuation cap limits the valuation—and therefore, the conversion price—at which a convertible note will convert, regardless of the company valuation at the preferred stock financing round in connection with which they'd convert into equity. This means that conversations surrounding any such valuation caps—which tend to be related to actual perceptions of current and near-term company valuation—would still be necessary.
Brad Flint: Let's now turn to the emergence of other terms and investor protection mechanisms that do not have the effect of modifying the up-front investment price. Many of these examples were relatively uncommon just a few years ago but have become more common in the recent, higher-risk investment climate. Although such terms do not directly impact the effective price paid by investors, they have become another means of bridging valuation gaps and convincing investors to complete investments that are now perceived to be higher risk than they would have been just a few years ago by providing an enhanced level of investor protection and oversight.
One such development is the rise in prevalence of full ratchet anti-dilution adjustment mechanisms, which differ from the more traditional weighted-average anti-dilution formulation. Unlike the more modest adjustment resulting from a customary weighted-average formulation, a full ratchet adjustment would have the effect of completely repricing an investment as if that investment was originally made at the price of the new down round, regardless of the amount raised in that new down round. It is thus quite a harsh mechanism—and somewhat arbitrary—compared to the more typical weighted-average formulation. Full ratchet anti-dilution protection can be applied for a specific period, often one or two years following an investment. Since full ratchet anti-dilution protection essentially provides full anti-dilution protection to investors, it gives them much more comfort and risk mitigation with respect to any future down rounds, except in the case of a total failure or recapitalization of a company.
Raj Banerjee: Additionally, enhanced investor consent rights have become a more significant consideration given the potential misalignment of interests between existing and new down round investors. New investors are seeking increased governance, oversight, and control in their investment agreements. While a core list of customary consent rights—or "protective provisions" — is typically voted on by the full syndicate of investors across all financing rounds, new investors often seek a broader list of consents that are voted on by investors in their new round alone.
We've also seen much more conversation regarding, and some implementation of, liquidation preferences in excess of the customary 1x level, reaching 1.5x, 2x, or even 3x, ensuring that investors have not only protection for their original investment in an exit below their round valuation, but also some level of built-in gain on any exit in which the sale proceeds are enough to cover such preferences—before the founders, the other common stockholders and earlier investors are entitled to any of such proceeds.
Brad Flint: Another term that comes up a lot more in this climate is participating preferred liquidation preference, often with a capped structure. Participating preferred stock provides both (1) a preferential liquidation preference, and (2) the right to participate in the distribution of any remaining exit proceeds after liquidation preferences have been satisfied, unlike a more customary convertible preferred that only entitles the holder to the greater of those two things. Capped participation rights allow such dual-track return up to a specified total return multiple, often 2-3x, above which point the liquidation preference reverts to the customary convertible structure. Although participating preferred was not very common a few years ago, more investors are certainly demanding it now.
Anything else, Raj?
Raj Banerjee: I would also add that the concept of tranching investments has become more typical. Tranching involves tying investment disbursements to specific milestones, and that reduces risk relative to making an investment in one up-front lump sum and provides reassurance that the company is making progress to justify the cash infusion. Tranching was always common in the context of VC-backed life sciences companies, but now, we're seeing it more across tech and a wider variety of industries.
We're also witnessing an increased prevalence of full recapitalizations (or recaps) in which all existing preferred stock is converted to common stock and a company effectively starts fresh with a new highly dilutive preferred stock financing, a new option pool to reward current management, and a highly diminished ownership position for other existing stockholders. Recaps are often accompanied by a pay-to-play mechanism or a pull-through mechanism. Pay-to-play provisions incentivize investors to maintain their pro rata investment in future rounds to avoid penalties, while pull-through mechanisms allow investors who participate in the pro rata investment to convert their existing series into a new series with senior liquidation preference or into a junior series, effectively preserving some or all of their ownership and rights relative to non-participating investors. Investors who choose not to participate would typically be left behind and highly diluted naturally, or in the context of a pay-to-play mechanism, have their shares converted into common stock at a punitive multiple of 5:1 or 10:1, resulting in a reset of the cap table that rewards investors who are continuing to support the company and punishes investors who are not.
Brad Flint: These evolving provisions, including full ratchet anti-dilution protection, enhanced consent rights, participating preferred liquidation preference, tranching, full recaps, and pay-to-play and pull-through mechanisms, are certainly a reflection of the evolving dynamics of today's VC and growth equity investment market. They are a response to concerns of investors regarding broad economic risk and the general perception that such investments, in particular, are now higher risk than they were just a few years ago—and the desire to mitigate such risk and obtain more assurance of favorable outcomes in an ever-changing investment landscape.
Catherine Skulan: Thanks, Brad and Raj. You've provided some really great insights into the terms and provisions that you're seeing evolve as companies and sponsors respond to this challenging venture investing environment. We hope our listeners have found this discussion helpful.
For more information on these topics or other topics of interest covered by Ropes attorneys in the growth and venture space, including growth and venture fund fundraising, transactions and regulatory issues impacting growth and venture fund sponsors, please visit our website at www.ropesgray.com. If you have any questions regarding today's topics, please don't hesitate to reach out to us. If you've enjoyed today's discussion, please subscribe and listen on Apple, Google, Spotify or your preferred podcast service. Thank you again for listening.
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