Expensive money and aggressive terms: how the game has turned for startups in the search for capital
- July 21, 2022
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There is a saying that the devil lives in the details. In the venture capital market, however, the cramullion lies in the term sheetsa pre-investment agreement document, in which the entrepreneur and the investor sign, as a “letter of intent”.
In the boom moment of the last two years, when the valuation were stretched and liquidity was high, the clauses that protect investors became looser. Now, the tables have turned and the pendulum has become more favorable to funds that contribute resources to startups.
O NeoFeed heard several reports from entrepreneurs and investors that show that negotiations are not only difficult on the issue of valuation (still the main factor for a round not to go out), but also in the clauses that avoid dilution of investors and, consequently, increase the dilution of the entrepreneur.
These are clauses like liquidation preferencesuper pro rata, anti-dilution or “cap” in future rounds, terms that are not common in the glamorous news of investments in startups, but which can have a great impact on entrepreneurs if the expected growth does not happen after a round or even when the company is liquidated.
“The rounds are more negotiated, even for companies in early stage, and are less one-sided. Before it was almost an adhesion contract that was happening from some term sheet of a leading investor”, says a venture capital investor to NeoFeed.
Another investor corroborates this view, which shows that the conversations to close a round are longer and terms are negotiated word for word. “When the market was hot, the entrepreneur looked like he was doing me a favor by putting me in a spin. Now, that’s over.”
Take the example of Dolado, a startup that operates as a marketplace aimed at small merchants. Founder and CEO Guilherme Freire raised BRL 53 million in a round led by Valor Capital Group and which also included the participation of Flourish, GFC, Clocktower Ventures, IDB and Endeavor, announced in April this year.
During the negotiations, carried out last year with several venture capital funds, Freire managed to capture what he expected. But the conversations were not easy. He heard questions from at least two of them about the revenue of the business, which was taking its first steps.
In his presentations, Freire focused on customer retention and contribution margins, indices that can indicate the financial health of the business in the future, according to him. “I prepared detailed presentations and listened to the investor: ‘I don’t want to waste time, I want to know about revenue’. It’s no use growing revenue and having zero margin”, says Freire. “Some funds only looked at revenue, without questioning whether the business would have a chance of being profitable.”
The immediate impact of this tougher game on both sides is that many entrepreneurs, when they can, are leaving the negotiating table and postponing contributions to a time when the arm wrestling is more balanced.
“The terms that are coming for entrepreneurs are heavier and go beyond the valuation depreciated”, says João Pedro Resende, CEO and founder of Hotmart, about what he has heard in the market from other entrepreneurs who are looking for contributions to their companies.
On the investors’ side, the bar is higher at the time of writing the check and the new scenario is a natural correction after years of boom. “The excesses committed in recent years are being corrected”, says Patrick O’Grady, partner and one of the founders of Vectis Partners, a capital manager that has already invested in companies such as Avenue, which recently had 35% of its business purchased by Itaú Unibanco .
The short-term result of this tug of war between entrepreneurs and investors is that investments in startups in Brazil are falling. In the first half of this year, contributions reached US$ 2.9 billion, a reduction of 44% compared to the same period last year, according to the District.
Terms like liquidation preference, super pro rata, antidiluation or “cap” in future rounds are part of the vocabulary of entrepreneurs looking to invest in their startups. Before, they were not an obstacle to moving forward during the capture process.
Now, according to reports heard by the NeoFeed on the part of entrepreneurs who do not want to be identified so as not to expose a fundraising failure, these clauses have become tougher at the negotiation table. “These clauses are common in any term sheet, but they have limits,” says a venture capital investor. “Today, these limits are more favorable to the investor.”
THE liquidation preference, for example, guarantees the preference in liquidation of an asset by the investor before the entrepreneur. In practice, what currently happens is that investors are boosting this term with multiples to guarantee a return even if the company has its market value decreased in subsequent funding. “It hasn’t changed from water to wine, but it’s harder for the entrepreneur,” says Daniel Ibri, partner at Mindset Ventures.
Super pro rata is the right to have a larger share than yours in a new round. Imagine that in Series A, the investor got a 10% stake in the startup. In a B, he could buy more than his pro rata.
The “cap” in future rounds is a negotiation of valuation for one round future. An example is a fund investing 10% for a value of R$ 100 million and negotiating that, the next time it raises, the startup is worth R$ 300 million. If another fund invests at a valuation greater than, for example, R$ 500 million, he has the right to keep his percentage, but for the amount previously negotiated. Result: buy more shares for a lower price.
The anti-dilution clause, in turn, guarantees the right of an investor to keep his share in the event of a down round, when the startup is valued below the previous round. In the case of fintech Klarna, which saw its value drop from US$46 billion to US$6.7 billion during a new fundraising, previous investors protect their stakes.
The negotiations also do not focus only on the issue of dilution. It is easier to get more seats on boards and some contracts impose limits on debt and deprive the manager of administrative liberties such as the approval of extrabudgetary expenses.
“There is a much stronger bargaining power than before. The fund can tie the company with rules and clauses that limit the entrepreneur”, says Daniel Abbud, from 7Stars Ventures, a Brazilian manager that has 18 startups in its portfolio. “The entrepreneur (if he wants to capture) may have to submit to these conditions.”
The venture debt market is also not being an option to resort to, in case of need for capital. According to one entrepreneur, conditions are even more aggressive than in venture capital.
“Terms are bad and everyone is choosing to do nothing,” says this entrepreneur. “It’s a bet that if you grow a lot, the dilution will be reasonable. But if it grows little, the dilution is gigantic.”
In the venture debt market, which is a structured debt, operations include a part in debt and another in equity. In the first case, the principal loan is paid in cash. O equity is converted in a future round.
“But the value in equity order is very high”, says this entrepreneur. “That’s why a lot of people are choosing to fire and hold on to the cash instead of doing a new round or borrowing money.”