VC financial engineering fuelling tech bubble?

As the hunt for $1bn-plus "unicorns" amid VC-backed startups has intensified among investors in recent years, more stories of billion-dollar valuations propped up by aggressive term sheets have emerged.

Later-stage and pre-IPO funding rounds running into hundreds of millions have become increasingly commonplace, driving the multi-billion-dollar valuations and success stories investors crave in the age of not just unicorns, but of the awkwardly named $10bn-plus "decacorn".

However, questions are being asked about terms such as liquidation preferences in the term sheets of some of the mega funding rounds, and whether the downside protection they offer is also being used as a type of financial engineering to artificially inflate valuations. Liquidation preferences will protect investors if a company does not achieve the valuation at which an investor invested when a liquidity event happens – or in some cases when the company has a down-round. In such a situation, investors with downside protections will be paid first, minimising their losses.

"For the majority of investments, we arrived back at the beginning of 2010 in a far better position than 10 years before and with a lot of recognition of the need to make sure that terms were clearly defined in term sheets, and for the most part – liquidation preference rights, anti-dilution – it is pretty straightforward," says Simon Walker, a partner in law firm Taylor Wessing's corporate technology group.

"The biggest change has been the financial engineering that has been used to justify these extraordinary valuations," says Walker. "It is, to a certain extent, more akin to the financial engineering in private equity than anything in the venture world. That is a significant change over the last four or five years."

Walker also says the term sheets in later funding rounds offer more aggressive protections when US investors participate, though European and US terms are similar in early-stage rounds.

Bunch of Squares
The IPO of fintech company Square on the New York Stock Exchange in late 2015 sharpened focus on investor downside protection. Participants in Square's last fundraising round before the flotation were reportedly offered terms that would see them paid back in full if the company did not achieve a certain value in a liquidity event. With its final pre-IPO round valuing Square at $15 per share, its $9 share price at listing naturally triggered the liquidation clauses for some later-stage investors, adding fuel to the debate over inflated tech company valuations.

Daniel Blomquist, a partner at Swedish VC Creandum, says that while investors in early-stage rounds now have fewer protections than in the immediate aftermath of the dotcom bubble bursting, most later-stage rounds have so-called "non-participation liquidation preferences", which allow investors to convert preference shares into ordinary shares in the event of an exit that favours ordinary shareholders.

"In the last 6-12 months, there has been this mismatch between everyone going for the billion-dollar valuation and exits not happening. Of course, the later-stage investors have partly left that financing, or are at least making sure they have ways to get returns," says Blomquist.

In Fidelity
Part of the debate over investor protections and inflated valuations has also centred on asset management company Fidelity, which publishes monthly valuations of its portfolio, including VC-backed companies it has invested in. Since the end of last year, Fidelity has slashed its valuations of several high-profile tech companies substantially – some by around half – despite many of the startups raising capital at far higher valuations mere months before.

Fidelity does not make public its valuation methods and has received a fair amount of criticism as a result, including from fellow investors, VCs and founders. On the other hand, there is an argument to be made that investors such as Fidelity are comfortable to participate in funding rounds they see as over-valuing the company, because they are offered liquidation preferences that will protect them if the company has not exceeded its last private valuation come exit, or in the case of a down round.

"I think it's a way to accept inflated valuations, so you can argue it's a way to inflate the valuations," says Blomquist. "Investors have accepted ponying up because everyone wants to have the billion-dollar valuation and that has created an adjusted structure to cope with it."

Maybe in this unicorn hype, entrepreneurs and companies have been neglecting terms a little bit in favour of valuations. It has been such a craze for getting that status that maybe some companies have accepted terms which, if things don't go well, can backfire" – Daniel Blomquist, Creandum

"In a way, every early-stage company is overvalued, because you have to put a valuation on it that doesn't dilute ownership too much, but many companies in these spaces may not even have revenues, so it's very difficult," he says, noting the large information deficit in favour of the entrepreneurs when it comes to financial information.

He suggests founders have been more focused on valuations than the terms that come with them, and that some will pay the price as a result: "I think maybe in this unicorn hype, entrepreneurs and companies have been neglecting terms a little bit in favour of valuations. It has been such a craze for getting that status that maybe some companies have accepted terms which, if things don't go well, can backfire."

Given some of the large funding rounds raised in the past two years at top valuations, some parts of the venture industry are predicting an increase in down rounds. In January, US-based wearables maker Jawbone raised a $165m funding round, which several media outlets reported had dropped the valuation of the company to half that of its previous round. Blomquist says a down round is troublesome in and of itself and that a liquidation preference aggravates the issue of not being able to live up to a previous valuation.

Entrepreneur upside
Though liquidation preferences and similar investor protections may be controversial in the eyes of some, they are not necessarily the draconian devices forced on unwitting entrepreneurs they are sometimes made out to be.

Liquidation preferences do provide, often substantial, downside protections to investors, but they are also a way for founders to protect their life's work and capture as much upside as possible.

The driver for founders to accept liquidation preferences when raising capital is that it prevents over-dilution of their share capital. This is a motivator for getting as high a valuation as possible for the capital being invested, rather than taking a more conservative valuation where the founders give up a larger stake to the external investors.

A lower valuation may be less risky for founders and more achievable to surpass at exit, but will also stunt the possibility of a big payout if the company reaches its full potential and is sold at top dollar. As such, it is also a symptom of founders' optimism and belief that they can build world-beating organisations.

The key is always to get the investors to actually spell out what they want and what they mean. One person's standard terms is another person's outrageous request" – Simon Walker, Taylor Wessing

"Accepting liquidation preferences has been the approach for founders to achieve their billion-dollar valuation and not have to go through the full dilution they would on a lower one, but with the flipside that if they don't perform, the latest investors in are compensated rather than the founders," Blomquist says. "It's not only affecting the company and the entrepreneurs, it's also affecting the early-stage investors who may not have the same sort of protections."

Playing chicken
Whether aggressive term sheets are a symptom or source of rising tech valuations is a chicken-and-egg question. Looking ahead, entrepreneurs may face harsher terms when raising capital, as talk of a bubble has caused some non-VC investors to withdraw from venture investing while those that remain require further protections to invest, as startups continuously push for higher valuations.

It remains to be seen how the balance between investor downside protections and the drive for high valuations will be struck, but both sides of the table are better equipped to negotiate from a position of knowledge than at any previous time. Investors are more likely to know exactly what protections they should be achieving and entrepreneurs are equally savvy to what terms they can expect.

"The key is always to get the investors to actually spell out what they want and what they mean," says Walker. "One person's standard terms is another person's outrageous request."

Similarly, Blomquist says that, compared to a decade ago, entrepreneurs have access to a wealth of resources to keep them in the know about terms and conditions. "There's so much material being published and entrepreneurs' networks are much stronger, so they're much more aware of these things. It's healthy that both sides know what they're getting into."

Further reading

• Early-stage

Unicorns blessed with big-buck fundings

• 23 Jul 2015

• UK / Ireland

Frothy tech venture market echoes dotcom bubble

• 29 Oct 2015

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