Situation Room #11: A closer look at deal terms pre-and-post the big C-19

What impact is the ongoing situation having on the terms that VCs offer to founders? Is the climate souring, and are we going to see less of the “founder friendliness” having become so ubiquitous lately?Governments around the world are offering up relief packages to salvage their economies. Are they hitting the mark, and will they save the early-stage startups with the potential to improve the world we live in and create new jobs?

Julie Høi-Nielsen and Frederik Hasling of Mazanti is constantly tracking the changes on the Danish venture market, whereas Kevin Rooney of Cooley is an expert in international law with a particular focus on foreign companies entering the U.S.

Read the below summary or tune in to the recording to catch up on the episode.

A situation report

Kevin Rooney, Cooley (Bay Area, US)

“The Situation has been surprising…”

• Surprisingly continue to see lots of new deals (both early/late-stage companies)
• C-19 produced some favourable results for some companies — companies supporting remote working, cloud infrastructure, security, collaboration & project management software in the cloud
• For others…not so much — for companies in the retail & tourism space, the hit has been devastating
• An identified challenge is access to bandwidth at the funds — deal meetings now need to fit between special board meetings, restructuring discussions, employee discussions etc.
• What’s to be expected in the next few months in the US? We are going to see a decrease in the deal count increasingly difficult to get deals done in this contactless environment, as offices are expected to remain shut until at least the end of the summer

Julie Høi-Nielsen and Frederik Hasling, Mazanti (Copenhagen, Denmark)

“Good news is, we don’t expect a repeat of the 2008 financial crisis”

• Good news — we have not seen a lot of impact from the C-19 on the venture market;
• The fundamentals are still there — new funds are still established, we still have capital to deploy
• Bad news — some startups are of course in trouble and have difficulties coping with the new normal and are facing a hard time
• Broader perspective — approaching the pandemic as a ‘bump on the road’
• there are some corrections on the market both on the valuations of terms
• we don’t see any significant impacts in VC going into Q3 & Q4

VCs current behaviour in relation to term deals

• Pending deals break into two groups: 1.) New financing — company raising a new round & 2.) the extension or bridge rounds — the existing investors who are focusing on revising their portfolio companies to make sure they are prepared to weather the storm
• Bridge rounds are likely to influence the current deal count — people are doing preemptive inside rounds — this is where the terms may get trickier

1. New rounds:

• There has been very little change (on the West Coast at least)
• We haven’t seen really opportunistic behaviour
• Early-stage deals — we’re seeing the deal size be a little smaller but preferences are still very much pari-passu among the investors all in the same group. People are quicker to accept terms as they’re not negotiating as hard. So the deals are smaller the pricing around series A has dropped a bit in aggregate on the data.
• Later stage deals — we’re seeing a bit more structuring where the new money’s coming in on top of the old money. We’re seeing some down rounds, we’re seeing some pay to plays be introduced.
• West vs East Coast — the impact on the West Coast is relatively little, it’s not dramatic. On the East Coast we’re seeing more of the funds definitely getting structuring and in some cases, putting more favourable liquidation preferences on the deals.

2. Inside rounds:

• Lots of internal discussions on portfolio companies having a difficult time coping and on whether or not investors will follow the last round within the same valuation (down round vs bridge round?) and what the terms for these investments look like
• Some investors might be opportunistic within the insider nature of such deals — this is where lawyers have to legally think about the process to ensure the board doesn’t get into trouble for doing some form of insider round when things turn around — other investors in the company might have the basis for a claim against that board especially those investors that are taking the opportunity to favour their positions
• Legal is spending more time counselling clients through deals, structures, doing more rights offerings to make sure of stockholders can participate on the same terms

Signals from investors and startups

“ What drives the terms is the investor behaviour”

1. Investors

• We see investors slowing down their activities and rather obtain a ‘wait and see’ approach to see what will happen post the pandemic
• We see some investors focus on their own portfolio companies to get them to survive their business plans to fit in the new normal after COVID-19.
• We see funds being reluctant to invest in new companies because they want to save that ‘powder’ for the winners in the existing portfolio
• We see investors being more risk-averse

2. Startups

• Demands for startups for getting new money has increased as investors have raised the bar — the need for investors to invest is getting smaller
• Consequently, we see less competition for term sheets which leads to lower valuations and deal terms — which is not a bad thing. We see it as going from being more founder-friendly to being more ‘middle of the road’.
• We see more staggered deals and smaller rounds
• We see some changes in the participating — In Denmark we are going away from one x non-participating to participating preference rights again
• We are going towards having some anti-dilution in the term sheets
• In general, we don’t see investors trying to ‘overplay their cards’ in Denmark — if someone does since the Danish market is so small, those VC’s will be remembered by the founders
• What we see is that some funds say no to investors if it’s not the right deal instead tweaking the terms

Have you seen any type of signs on your end that m&a activities are starting to pick up here or is it actually unusually quiet?

US

• We’ve seen m&a decreased — which can be due to the combination of people resetting to where the markets are heading and the uncertainty
• One key challenge for a foreign buyer is just the ability to execute having people out of the office
• So we’re the VCs, but they’re spending time on this, right? They’ve got limited capacity as well and they’re otherwise busy focusing on their companies and on the acquirer side, they’re replanting, forecasting, spending time on all those activities, and to tackle an m&a project can be a challenge. So we’ve seen deals die.

DK

• We saw strong m&a market going into the Corona crisis. And right now we’re seeing that stagnated market.
• I am quite optimistic, though, in terms of q3 and q4. We still have a lot of buyout funds, private equity funds ready to shoot to buy companies, they have available capital, we have good companies in particular within tech and biotech, ready for exits.
• I think that we will see some quite Have the evaluation gaps and there are some glitches to be made there.
• But my general the general feeling or sense here is that the market will start opening up in q3 the, as far as we the sales processes have been paused until September, but that they’re the financing tanks they expect to go up in again from September onwards
• we believe that that in q3 and q4 we will be back to the same level as before the crisis to a more normalised level

What changes are you specifically seeing in terms of expectations to founders and companies from VCs?

• we see an effect in the investment processes for new investments
• VC funds are doing more thorough investment processes, more critical to the business case, looking at whether the potential business can sustain a new world crisis, e.g. another pandemic or financial crisis or something different
• We will probably see fewer term sheets because we expect to see a decrease in the so-called ‘FOMO deals’ and an increase in what is seen as ‘the profit business cases’
• So before, we saw a big focus on the growth cases of VC companies where now we will see a lot more focus on profitability
• We will see pre-investment processes being more strict than we have before.
• In terms of existing portfolio companies, when we do internal financing rounds, it might very well be that the risk mitigation will be affected or seen in, in the deal. So maybe some liquidation preferences, but also maybe an extension of the catalogue. It could also be more expectations to founders, how they perform and etc.

On ‘Future Proofness’ — are you seeing a change in focus towards sustainability impact and climate change?

DK

• Before COVID-19, there was no doubt that easily driven companies were hyped, and we saw successful founders tapping into the ESD driven companies and a lot of good business cases.
• We also saw from a regulatory perspective, there were an increase in initiatives as well new ESG disclosure requirements for VC funds, forcing funds to consider the ESG impacts.
• We saw VC investors starting to set their own requirements that go beyond what is required by law. Germany is an example where we saw large VC funds join forces to develop this sustainability class with the leaders for climate action.
• So this was very heavy, pre-COVID-19 and then COVID-19 heads and then we started to see companies going into a survival mode. So temporarily focusing more on imminent challenges, adapting their business case, strategies, etc into the new normal, rather than allocating a lot of resources to ESG strategies.
• We already now see again that the ESG focus is back on track. And in the VC market, there has been a discussion on whether there is a business case for ESG. But then the stock market has shown during the crisis, that investments in companies with a high ESG score actually performed better than companies with low ESG score.

US

• We have — So we’ve got a sort of vertical, what we call a practice vertical in the space.
• I’ve had a number of my companies converting to public benefit companies or B corporations.
• I think the sentiment around that is that it’s an additive or an accelerant on an otherwise good company to build a position. So I think it’s been a bit positive. I haven’t heard on my investor side of my practice. I haven’t heard folks sort of say they’re seeking it out as they might have otherwise.
• So I think today, I mean, it is Back to Basics of the people are maybe as quick to react on investment opportunities or seeking to fill out areas of their portfolio that they’d otherwise like to. I think they’re looking for strong businesses in whatever form

Two disadvantages of doing deals remotely — or perhaps advantages?

• As we’re sitting on the screen and chatting with the founders, it’s very difficult to really get a general understanding and feel for them vs. when you simply feel some energy in the room when you’re together with a founder, and you can feel that passion.
• As a result, we become much more focused on metrics and many other things because we cannot really stand out and shake the founder and get a good feel around that.
• On the other side, this can be kind of an advantage where you cut all the bullsh*t and you actually go to the real value-adding activities and metrics

2.

• We spend a lot more time negotiating on fairly trivial things that in a normal environment where we would sit around the table, we would have come eye to eye and said, hey, let’s not make this a big issue. Let’s just get this deal done and move on. But instead, we go back and forth on some calls and it gets tedious.
• Eventually, we can lose the ‘human touch’ in all this conversation, as it becomes just negotiations for the purpose of negotiations. And certain deals would not have been broken if we had been together, sitting alongside and eventually laughed about things. But because we were sitting remote and we never met, it can feel more like strangers talking to each other and telling each other what to say.
• On the other hand, in 5 or 10 years time we might get used to using the state of mind that we have right now as a result of remote work instead of feeling like we need to be together and feel each other — I think that will change.

As we’re seeing a much more blurred setup, can you as a founder in Norway or Sweden breakthrough and actually be successful in the US market How can you help them on that journey from the early stages to where eventually they may end up?

• I don’t think it’s clear cut. And unfortunately, probably the data I’m getting is certainly biased because I’m here and so I’m meeting companies that have either decided or exploring, usually what we call flipping so they reincorporate that they put a US parent company on top of their existing European company.

And are you seeing like, are you, in general, seeing more flips than not?

• So at the beginning of the year, I did a few. I think the trend will probably decrease over time as it did in Canada, for example, there were some tax reasons but in Canada now, it would be very uncommon for a company to flip and most us VCs are increasing number have experience investing directly can as it is in Israel, for example, a very popular model.
• I think over time, we’re going to see less of it. I think there are more and more great capital funds available in Europe. I think as startups are being democratised to a degree and they exist everywhere. Talent is everywhere, I think there’s a lot of challenges in the US in terms of costs and recruiting and retaining talent. And now in this environment, before, people might be a little more eager to at least explore it or do a flip, because they thought they could access this great pool of capital. But that requires them to come here and break in and network. And I think that at this time this is much more difficult.

Have you been looking at alternatives to equity financing? Are you seeing any trends there in relation to COVID-19? Or people looking more into debt financing? Are there any other movements or trends that you’ve noticed?

DK

• Some startup are trying to extend their runway right now & extend their next equity round until Q2. So we see an increase in the intern pitch rounds.
• We do see also startups looking for other alternatives. That could be venture debt that could be revenue-based financing and other measures where you could sort of without getting dilution, you could get or you could extend the runway so that you can, you know, go to the market for your Big round, big exit equity round when the market is more normal than it is right now.

US

• There was the big incentive through the government-backed ‘Small Business Association’ loan which were made available under what’s called the cares act — there was a huge run on this grant basically grant money where banks would lend this out guaranteed and there’d be anticipated forgiveness. And it came out in instalments, it was a huge activity here, we set up a task force to help our clients with it.
• It’s a loan, but it’s a loan that the lenders are extending based on guarantees from the government, and which has the potential based on the framework to be forgiven. As long as you spend those loans on payroll, basically, the intent was to preserve employee employees at companies.
• If you happen to be in the US and applied for a loan or have the loan, then you’re probably dealing with it. If you haven’t, then I wouldn’t worry about it.
• It’s still an evolving process. It’s been a big issue, in that the applicability to Ark types of clients, companies that are venture-backed that have other sources of liquidity. It’s had limited application, at least for those that are not been severely hit by the impacts of COVID. So the focus has been on private funds.

DK

• We’ve seen that exactly the same in Denmark with the relief packages that was disclosed just around Easter.
• We had some early relief packages that didn’t really help startups, and then they would try to do more but very specific towards the startup ecosystem.
• We have now four different loan types provided by the Danish Growth Fund. And I think they’ve worked out really, really well.

Up next…

We are rounding off the season next week before the summer with our final episode of the Situation Room, where we will be talking to Lars Thinggaard, recently stepped down CEO of Milestones Systems and Thomas Madsen-Mygdal, co-founder of Techfestival and a number of startups, most recently the video marketing platform TwentyThree.

Both members of our byFounders Collective, we’ll talk to these guys about Lars’ newly published book “Tech For Life”, addressing the trust issues in tech and its leaders — encouraging opinion leaders in our community to take back control and use their immense influence in the world for good.

Don’t miss out on this one — head over to our page to sign up! ✍️