When it comes to investment, the market is still open, transactions are still happening and companies still have options. But with the impact of the pandemic still playing out, founders need to be aware of several factors impacting the landscape — and a recent change in the approach to terms when fundraising.
Here’s what you need to know about the new world of growth equity terms.
An evolving investor landscape
A changed macroeconomic environment, greater uncertainty and an evolving investor landscape have all had an impact on fundraising terms, says Mike Turner, a partner in the emerging companies practice at law firm Latham & Watkins.
“It started with the private equity world appreciating they were missing out on growth tech investing,” he says. “These were buyout firms, not traditional minority equity investment funds. And they almost collectively, all at the same time, changed their view and said, ‘We need to come into these growth companies earlier.’”
As a result, Turner says, these firms — as well as sovereign wealth funds, another relatively new entrant into the growth investment market — have brought their traditional financial discipline: “They definitely brought a private equity focus to these terms.”
Shing Lo, another partner at Latham & Watkins, agrees that sovereign wealth funds have brought a different approach to traditional venture capitalists — investing for the long term and wanting more involvement and greater governance protections.
“They look at [investing] from a different perspective,” she says. “They are good validation capital and it is useful for companies to have these type of investors on their cap tables.”
Another factor shifting market dynamics is the pandemic; the effects of which are still being felt.
“Fundraising overall is probably more difficult, and conditions are materially changed [from a couple of years ago],” says Broor Spahr van der Hoek, a partner at financial advisory firm Arma Partners.
Turner agrees. “At the end of 2021 and into 2022, we saw companies having all the leverage in the negotiations. There were very competitive rounds and deals were incredibly quick,” he says. “Now, the competitive tension is gone, deals are taking a little bit longer, and the negotiating power has moved to the investor side.”
Part of this is down to fast-changing consumer behaviour, says Spahr van der Hoek.
“When Covid struck, after the first shock, it effectively created a push to digital because people were suddenly way more digitally oriented,” he says, adding this led to high valuations in the digital tech space, meaning “some of these companies probably need to prove still that they are worth that money to a certain extent.”
As a result, Turner says investors across the board today are offering lower valuations than might have been achieved two years ago.
“This has encouraged companies to think much harder about what a particular investor might be able to do for them beyond writing a cheque,” he says. “How good will that particular investor be for the potential growth of the company? How much value will they add beyond the cash?”
What to do as a founder
While valuation is one thing — and terms another — Spahr van der Hoek says picking the right partner should remain a top priority for companies.
“Yes, price is one element and terms will be another one, but if you run a competitive process then you can bring the price and terms [of all bidders] quite close. The thing is, if your partner is not the right one, and you find that out down the line, then you have a bit of an issue,” he says.
Turner adds that the market will shift in 2024, with investors needing to find outlets for the cash they’re sitting on — but more conservative terms are likely to remain a feature of the market.
“Deal terms will get only a little bit easier; I think we've set new standards now. But I do think we're going to see a lot more capital needing to be deployed and investors actually writing the cheques again,” he predicts.
Despite having an upper hand in negotiations, says Lo, investors should pause and consider the precedent they are setting with the terms they offer.
“It benefits them at that point in time, but they should be careful about what they've asked for. Because those terms, if the company raises another round, will be the base level terms for the next round,” she says.
“A 1.5x senior ranking preference share, for example, might be beneficial for that investor at the time of the round, but if the company were to do another raise, the new investor is very likely to ask for preference shares which rank above the last round investors with at least 1.5x liquidation preference,” she adds. “The prior round investors will get pushed further down the stack.”
While founders face a potentially more challenging environment, raising cash is still possible, according to Lo. She advises choosing bankers, lawyers or other advisors who know the terrain.
“It’s important to work with people who can help navigate these complex terms and who understand where you can and can’t push in negotiations.”