VC terms — Return of the Barbarians.

I hate complex terms in venture investments. Value is created by backing exceptional companies that return your fund, not by word-smithing aggressive legal agreements. In the last decade, we’ve seen cleaner and simpler terms become the norm, which has been great for everyone and created more alignment.

However…

Founders beware. OG venture capitalists like myself remember vividly the days of full ratchet wiping out entire cap tables and leaving founders with nothing.

As we’re entering a new ice age, I’m hearing that paring knives are being sharpened and old weapons might get taken out of storage. I’m hoping I’m wrong and VCs will keep their term-sheets clean, but in case they don’t, here’s a detailed look at the arsenal that these barbarian investors can draw from.

So saddle up, grab you shield and get familiar with the subtleties of Participating Preferred’s, Full Ratchet Anti-Dilution, Pay-to-Plays and more by reading further. As Andy Grove would say, only the paranoid survive.

Deep gratitude to my contributors for this post, who are also my two favourite transaction lawyers in London, Robert Glass at Withers and Aaron Archer at Cooley. I love them both, and they both rock.

Here we go.

Share terms

Participating Preferred & Multiple Liquidation Preferences

There are ordinary shares, which simply pay out pro-rata and pref shares, which offer a “preference” of some kind to investors on exit or liquidation. This was designed so that founders couldn’t take, say, $2M for 20% and then immediately sell the business for $5M, leaving their investors with half their money back and pocketing $4M in the process.

The market norm has been for a while that liquidation preferences are simple (1x multiple and non-participating), whereby the investors get their money out first until such time as the pro-rata amount they own is greater than the value of the cash they put in.

This preference is just downside protection; but it can be used to enhance returns as well, with either participating preferred (i.e. the investors get their money back and then share in the rest of the proceeds pro-rata with all other equity shareholders, so called “double dipping”) and/or multiples being applied to the preference (i.e. instead of 1x money back first, they may get 2x or 3x).

So in addition to getting a higher percentage of the company through a lower valuation, the investors may take more than their pro-rata share of any proceeds in a sale transaction. As purse strings tighten, and investors are less confident in a positive outcome, they might seek additional protection for putting capital at risk.

“It’s easy to see how one round like this can be tough for founders, but it gets really grim when you consider the standard it sets. If each subsequent round asks for the same style of preference, the stacking effect can totally bury founders (as well as earlier preferred investors)”

Down Rounds & Anti-Dilution

Clearly, company valuations tend to fall as the fundraising climate becomes more challenging (doh!). The direct impact of a lower valuation is obvious, but startups should keep in mind the additional impact of any anti-dilution provisions. Anti-dilution rights essentially give investors free shares in the event that the next financing is a down round to (partially) compensate them for the reduced valuation in a subsequent financing round. The dilution is borne by the founders and their team, and any shareholders who are not receiving anti-dilution shares (such as EIS investors and lower-priced prior rounds).

For a while now broad-based weighted-average (BBWA) has been deemed a fair / market approach to anti-dilution based on a blended pricing between the two rounds. Smaller rounds trigger a smaller anti-dilution adjustment and larger rounds trigger a greater adjustment.

It’s possible that we see a return of the dreaded full ratchet. Full Ratchet is designed to completely negate the down round’s dilutive impact on the existing investor, by giving them the number of shares which they would have held had their original investment been made at the lower price of the new round.

If you’re raising at a pre-money valuation equal to the cash previouslyraised, your equity mathematically goes down to … zero.

In cases where founders and team suffer too much dilution, additional share options will be issued to keep everyone incentivised to stick around and continue to build; no such luck for your angels and very early investors.

A variation of the anti-dilution theme comes in the form of warrants that trigger on a down round; different flavour, similar outcome.

For a detailed breakdown of the math, head over to this great post from Tom Wilson of Seedcamp.

Pre-emption and its sidekicks: Pay-to-Play and Super Pro Rata

Pre-emption is always a key term for investors, as it gives them the right to continue to invest in the company, thereby maintaining their percentage of ownership. Normally, the only real qualifier is that an investor majority or special resolution can waive the right for all investors.

Pay-to-play

Pay-to-play doesn’t come up much when the market is going strong, but will definitely be talked about in the coming months. Pay-to-play punishes investors who don’t invest again and, implicitly, reward those that do. It’s arguably a more balanced approach than changes to the preference or anti-dilution as the axe falls on investors rather than founders.

The simple version is a “use it or lose it” approach, where an investor loses their participation right the first time that they decline to use it. Additionally, you could include that other rights or protections (ex. anti-dilution) are forfeited as well.

The more extreme version provides that if an investor doesn’t participate, their shares are converted into ordinary / common and they lose all preferred share rights and protections forever.

Radical pay-to-play recapitalisation is common in the US but far tougher to achieve in the UK given shareholder protections enshrined in law; but it can be done by giving investors the right to buy shares at a discounted price for a period of time. It is theoretically possible to wipe and rebuild the whole capital structure at close to a low pre-money value based on who participates, followed by a large ESOP to re-incentivise the go-forward team. I don’t have a philosophical problem with those as it’s a way to give companies a second chance, but I’ve never seen one done in the UK.

Super Pro Rata

Separately, investors might ask for a super pro rata right, which would be a pre-emptive right in excess of their pro rata holdings. Super pro-rata’s bake in a really valuable call option for investors; I really dislike them as I feel investors have to earn their seat at the table and if not taken up they create real signalling risk.

Milestone-based tranched equity rounds

“I will give you the money if you do what you said you’d do”. Logical on the surface, these round types present two challenges:

• They’re pretty anxiety-inducing for founders. Should I invest in my business when I’m not sure that second tranche will materialise?
• In an environment as fast moving as the one we are in, setting objective milestones that aren’t dependent on external factors and do’t limit the ability of the company to evolve its strategy can be really tough.

I personally much prefer to take more risk with a bigger check than to introduce tranches as a forcing function, but they are often used in internal rounds despite their limitations.

Higher Discounts/Lower Conversion Price Caps on Convertible Notes/ASAs

A 20% discount to the price being paid on the funding round into which notes/ASAs convert has more often than not been the norm. In a market in downturn, we may start seeing not only higher discounts (and maybe even stepped time-based increases) but also multiple repayments (analogous to the multiple liquidation preferences described above) on a sale. Higher discounts or lower conversion price caps mean more dilution is suffered by founders and existing shareholders on conversion, but also means an increased risk of triggering anti-dilution adjustment — even where the funding round into which the notes are converting is a flat or up-round to the last round. Valuation caps may also become more prevalent for bridging note rounds, even though traditionally valuation caps were really only used as protection for investors in the potential soaring of a company’s value prior to its first priced round.

Founder terms

Vesting / Reverse Vesting

It’s hard to say what “market” is on vesting in the UK — both in terms of time period and consequences for leaving. However, four years with a one year cliff where a good leaver keeps vested shares and a bad leaver loses all shares, is pretty typical.

For founders who own actual equity, investors will look at implementing “reverse vesting”. I actually like those because they act as an insurance policy amongst founders, where if one leaves early, he or she doesn’t walk away with all their shares, which isn’t fair to the other founding members. Typically, we’ll say 25–30% or so is vested upfront and the rest vest over 2 to 4 years. Watch out though for clauses that force departing founders to sell vested shares at low prices.

Bad Leaver

It is typical in the UK that shares held by founders (and sometimes management) are subject to both vesting and good/bad leaver provisions that determine the portion of a founder’s shares that they get to retain when they leave the company. The concept of bad leaver isn’t used in the US and is not something we endorse but it can be pretty narrowly tailored.

In most cases, a bad leaver will result in the forfeiture of all of a founder’s shares, so the definition of this is extremely important. Bad leaver is typically defined to include some or all of the following: (i) true wrongdoing, such as the commission of an offence, fraud or gross misconduct; (ii) voluntary resignation; and/or (iii) lawful or fair dismissal. In particular in the case of (iii), the concern here for founders is that poor performance, or not adequately ‘steering the ship’, may bring about termination. It is really unusual for poor performance to bring about termination without the usual formalities being followed, but in a difficult market there may be a different view taken on this by the board, even for founders employed for more than two years and where the main employment protections would be in place. It may be that the drafting leaves founders technically at risk of losing all of their shares, whether this was the intention or not.

Control

The most effective way to control outcomes is to control the board or to enshrine your rights through investor consents. I’ve found the UK early stage scene to be particularly bad when it comes to board and investor consents, trying to control way too many small decisions that are best left to management or quick informal board decisions, so we’re not starting from a great place here. This reflects a misplaced notion that investing in startups is about controlling risk. Well, I’ve got news for you, you don’t control shit anyway. Keep the consents to the essentials and you’ll build a more efficient business.

Board

Giving away a board seat to the lead investor on each round is pretty standard, though they add up, particularly if you have more financing rounds than planned. Remember: the board’s #1 job is to decide who runs the company.

You often have a list of board consent matters which tend to be a bit more operational than the consent matters and often veer into the intrusive. We might see these get heavier in the coming months.

My most read post deal with precisely this issue: Tiny Startups Need Tiny Boards.

Consent Matters

consent matters, or reserved matters, are the list of company actions that an investor majority needs to approve. Ideally, this list is limited to significant actions that could have a serious impact on the value of the Company and, therefore, the investors’ position. Ideally, the investors trust the founders with running the business and day-to-day operational matters stay off the list.

In a rougher market we might see (a) consent lists which are more invasive or (b) lead investors asking for solo vetoes over exits in order to protect their downside risk further.

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