Notwithstanding recent radical changes to the world around us, growth equity investments into mid- to late-stage private companies are marching on. While at first glance, the overall shape of these transactions today in many ways resembles that of peak economic times, there has been a noticeable shift in certain aspects of these deals over the past three months, particularly around key economic protections for investors. In the current environment, growth equity funds, while continuing to make new investments, are also having to look at their existing portfolios and decide where they are going to double down, where they are going to invest their pro rata or where they are going to hold back on infusing more capital. Those funds that are willing to move forward—be it through new or follow-on investments—can and must negotiate for increasingly favorable terms for investors. Against this background, this Goodwin Insight is an overview of five emerging trends that we are seeing in the course of our representation as investor-side counsel in growth equity transactions today.
1. Valuation – Rise of the Down Round
- One straightforward way to get comfortable with investing during these uncertain times is by placing a lower valuation on a company than that of its last financing round. Unless waived by existing stockholders, doing so will trigger anti-dilution for any series of preferred stock that has anti-dilution rights and was priced above the new round price. This approach allows companies to keep investment terms generally consistent with past rounds, which can help keep negotiation to a minimum and facilitate short closing timelines, but it can also send a negative signal to the market.
2. Structured Debt is the New Equity and Other Variations on the Theme
- Where before, a straight convertible preferred security was commonplace, there has been an increase in highly-structured convertible note rounds and the issuance of quasi-debt securities, both of which can include features such as the ability of an investor to require that a company repurchase its shares in the future or to force a sale of the company after a certain number of years (and rights that kick in if the company cannot complete such repurchase or sale, such as the right of the investor to control the board of directors), accruing interest, warrant coverage and more.
- In addition, investors are now sometimes resisting transactions where proceeds are used to provide liquidity for existing stockholders including management, founders and/or the broader employee base, instead requiring that the proceeds be used and retained for working capital. This is a growing shift from prior times when secondary liquidity for equity holders was nearly ubiquitous in primary financing rounds.
- Rather than proceed with funding a full investment at one time, some deals today are being structured to allow a portion of the investment to be made now with an option to increase the investment or fully acquire the company at a later time. There are a range of approaches to how to value the future investment or acquisition in these “toehold” investments—including setting it at the current valuation, having the investor’s option be at a higher valuation and giving the company the right to call an investment at a lower valuation. Creativity with the cadence of investment allows for an infusion of some capital now for the benefit of the company while also giving the parties time to understand and respond to how the market is evolving.
3. Restacking the Stack – New Approaches to Liquidation Preference
- For companies that have raised multiple financing rounds with institutional late-stage investors, preferred securities often all ranked equally (at their applicable initial purchase price) for purposes of returning capital on a sale or other exit event. In the current environment, investors are shifting away from the “pari passu” approach and instead negotiating for senior liquidation preferences, entitling them to be paid before other classes of stock on exit, either at one times their investment or, to further increase the likelihood of earning a return, a higher multiple thereof.
- As noted above, it was also often the case that the security issued to preferred investors was a straight convertible preferred, entitling the investor to receive the greater of its investment amount or the amount it would receive on an as-converted-to-common-stock basis. For additional downside protection and sometimes in lieu of proposing a lower valuation, a “participating preferred” security is being implemented where the investors in the round are entitled to get their respective investment amounts back but also share in any remaining proceeds—either wholesale or, often, up to a cap—that would have gone only to the holders of common stock if the security had been a straight convertible preferred.
4. The Ratchet Racket
- Companies and investors are agreeing on future performance metrics of the company and upward adjustments to preferred conversion prices in the event those metrics are not met. This does not require immediate reconsideration of the valuation upon investment (and thus it helps to avoid the potential negative signal to the market noted above) but does provide protection in these times when future performance is difficult to predict.
- In respect of a potential exit event being a public listing, investors are negotiating for price protection through a right to receive a true-up issuance of shares or a higher conversion price on an initial public offering or direct listing where the price to the public is lower than the price per share (or a multiple thereof) of the current financing round. Similar to the performance ratchet described in the prior paragraph, this “down-round IPO” mechanism provides time for the actual valuation to play out and delays a determination of whether an economic adjustment for investors will be needed. It can also be an alternate approach to the right of an investor to block an IPO thus allowing a company more flexibility in the future to go forward with a public offering or a direct listing while still providing downside protection.
5. Voting Rights – New Series Getting Serious
- An attendant right to the protections described above is ensuring that the new series of preferred equity controls any amendments to and waivers of those protections and, in some instances, that the new series of preferred have its own consent rights over certain company actions, such as exit events, as opposed to the ability of a specified percentage of all preferred stockholders voting as a single class to be able to approve amendments and waivers and take actions on behalf of all of the preferred. While there has always been a focus on having series-specific voting rights over economic protections, it is even more important now in order to safeguard the enhanced terms for which new investors have negotiated. In addition, there is a broader potential misalignment among stockholders when there is a participating preferred security (particularly where other preferred securities are only convertible) and when other rights like those described in this Goodwin Insight have been layered in, which in turn requires a more nuanced and thoughtful identification of where those misalignments lie so they can be addressed in the voting and governance rights.
Only time will tell whether these terms are a temporary blip or a more permanent shift in what is “market,” but for the time being, these trends seem to be the new normal.
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