Has Silicon Valley finally got its groove back? Venture capital investment in start-up companies rose to $35 million in the third quarter, up 36% on the previous three months. M&A activity is also rising. And talk of a $20 billion initial public offering by Google is generating the kind of buzz last experienced in 1999.
But among long-term Silicon Valley insiders, the most telling sign of improvement may be the steady return to more traditional terms in venture capital financings, the life blood of the thousands of emerging growth companies that litter the landscape from Berkeley to San Jose.
Hard times raising cash It has been difficult for Silicon Valley entrepreneurs to raise capital in the wake of the high-tech meltdown. Venture capital firms and other strategic investors have not only become more selective with their money, they have also been demanding new and increasingly aggressive financing terms.
Multiple or super liquidation preferences, for example, have been appearing in over a half of all venture financings. These preferences give late-stage investors the right to receive as much as four or five times the amount invested in a company if there is a sale or merger, before any other shareholder gets anything.
Investors have also been insisting on mandatory cumulative dividends and “drag-along” rights, allowing even non-majority investors to force the sale of a company. Even once rarely-used pay-to-play provisions, requiring investors to keep reinvesting in each financing round or have their preferred shares converted into common stock, have become commonplace.
Arguably the least attractive trend, however, has been the increased inclusion of full-ratchet anti-dilution mechanisms in financings. Anti-dilution rights are used to protect a company’s existing investors from having their stakes washed out by a down round, where a company is forced to raise capital at a lower share price than in previous financing rounds.
Before the stock market bubble burst, most financings used what is known as a weighted average anti-dilution mechanism to compensate existing investors in a down round, taking into account the size of the price decrease and the number of lower-priced shares being issued to adjust the conversion price of their preferred shares.
By contrast, full ratchets allow existing investors to convert all their preferred shares to the lower share price, regardless of the number of cheaper shares being issued. For example, if a company sells just 10,000 preferred shares to a new investor at $1 after selling 1 million in earlier rounds at $2, a full ratchet would entitle the existing investors to 2 million common shares at $1.
Judging from the latest data, however, Silicon Valley entrepreneurs might finally be able to breathe a little easier. In a recent survey of 85 venture financings in the Bay Area by Palo Alto-based law firm Fenwick & West, ratchets were seen in only 8% of deals, down from a high of 29% in the first quarter of 2002. Multiple liquidation preferences, too, are rapidly falling out of favour, being seen in just 21% of the financings versus 58% in the first quarter of 2002.
“We’re still in a clean-up stage for some of the companies that were funded during the bubble,” says Mike Danaher, a partner at the Palo Alto office of Wilson Sonsini Goodrich & Rosati. “Once that’s over, you will see a lot of these types of terms will be phased out.”
Beyond the numbers, many venture lawyers and investors are reporting increased confidence in the market, both in terms of the valuations being given to technology companies and the likelihood of reaching a positive exit event, such as an in-the-money acquisition or even an initial public offering.
To be sure, the market is still far from booming. Venture capital investment in Silicon Valley is hovering around $1.4 billion a quarter. Though that is still one-third of the national total, it is far short of the $9 billion-plus invested in each quarter during much of 2000.
And some of the tougher terms, particularly pay-to-plays and drag-along rights, are expected to remain in circulation, especially in later financing rounds.
Targeted payment At the same time, a larger group of venture investors are experimenting with more novel strategies for protecting their investments, such as milestone funding. This type of financing links at least part of an investment in a company to the attainment of set objectives. For example, instead of giving a start-up software company $10 million in one go, the investor will divide the money into two tranches, releasing $5 million at the outset and the remaining $5 million when the company meets specified goals, such as releasing the beta version of its software or hitting a revenue target.
Bay Area venture investors are also beginning to incorporate extensive protective provisions into their financing documents, obliging companies to get the preferred shareholders’ approval for a much more exhaustive list of management decisions.
How these types of terms will affect the recovery of the Silicon Valley technology industry remains to be seen. Overall, most local venture investors and lawyers agree that the tougher terms were a necessary, if painful, response to market conditions. But for companies with a proven business model and exceptional intellectual property, the environment is markedly better now than it was as recently as last spring. And for long-suffering Silicon Valley start-ups, any good news is long overdue.
