Surely the CVC industry has a standard set of deal terms set out in a consistent term sheet which everyone uses? This is a question that arises over and over when we are putting together term sheets and negotiating deal terms. The answer is no, CVC terms differ from deal to deal. However, best practice is developing and a more standardised set of policies and philosophies are emerging.
Term sheets for CVC transactions can look similar on first glance, covering the same broad topics in most cases, but the detail can be crucial. CVCs differ more than VC funds because CVCs invest predominantly for strategic and not financial purposes and each corporation’s strategic objectives differ. This often leaks through into the term sheet. As we will see below, the terms sought can also vary depending on the jurisdiction of the parties and their respective appetites for risk.
At the Global Corporate Venturing Symposium in May 2017, Neil Foster chaired a panel on the subject of deal terms and best practice. The outcome of this discussion is explored below.
Effect of differing strategies on deal terms
As has been well documented, the investment strategy of CVCs is often markedly different from those of their VC counterparts. Unlike VCs, the vast majority of CVCs are less driven by financial returns and more by strategic objectives. As a result CVCs are not necessarily seeking quick exits to make a return. However, while all strategies are different, deal terms can still be aligned. As Keith Gillard, general partner of Pangaea Ventures, whose limited partners in its funds are all corporates, said:
“I think the essence of the terms, beyond the process of the negotiation, is alignment. All of us are trying to maximise the success of this company and for me that is the essence of setting the terms. If we co-invest with strategics, which we frequently do, usually we ask that any strategic rights be in a separate side letter. It is a different agreement, it is separate from the investment and it should be treated as such but entered into at the same time.
“If you want to make sure that this management team will work hard, they have got to be happy and they have got to be able to get a reward out of this, they have to see a path to an exit. If the strategic partnership terms are such that it will negatively impact the possibility of an outstanding exit, not only will the management team be disincentivised, but you are going to have a hell of a time raising your next round of capital.”
While investors may need to tailor terms to specific deals, most have a standard set of terms they seek to impose across their portfolio. When a CVC leads an investment round it will have its own preferred term sheet, which often remains consistent across geographies, stage and product, and a certain degree of control to impose its terms. However, where CVCs are following on a round or they otherwise invest alongside other CVCs and/or VCs, this can cause various competing interests to collide.
Where deal terms are specific to a particular CVC, such as publicity rights and information rights where a corporate is publicly listed, a CVC can either provide for these in the main deal terms or negotiate its own standalone agreement specific to those rights.
How the maturity of a CVC unit affects deal terms
Corporate venturing is booming, with more than three-quarters of the Fortune 100 companies being active in corporate venturing. More than 200 new CVC units or corporate-backed captive VCs opened in 2016 alone. With so many new players to the market, how do the newer CVC units approach their terms of investment compared with their more established counterparts?
The approach that CVCs take to an investment can clearly be influenced by their experience. Funds that have been active for a short time sometimes treat investments as though they are joint ventures or, worse, mergers and acquisitions. This can cause a number of issues with a portfolio company’s development and can inhibit future funding rounds. As Gillard said:
“I have seen a lot of newbie mistakes. Often they are just naive, I would not say that they were malicious at all, but where the strategic investor, who does not have a lot of experience, is asking for a right of first refusal on an exit, sometimes they are insisting on it because it is something that they have done in other types of business relationships, but it is completely inappropriate for a venture investment.”
Avoid smothering your young
It could be argued that, compared with CVCs, VCs are more predictable – they will never want to do a strategic deal, they are never a buyer on exit but always a seller, they will never want to enter into a joint development agreement or be a channel partner. As such, portfolio companies may be concerned that where there is a close strategic relationship between the company and the CVC, the company may feel it is little more than a subsidiary of the CVC. If that is the impression given to the market, realistically on exit only the parent of the CVC unit will be interested in an acquisition and this will affect the price enormously. This is particularly true where overly aggressive exclusivity arrangements are sought by a CVC to ward off other potential suitors. Gillard said:
“The best way to avoid this is to make sure that you have two or more strategic investors in the deal so there is a natural healthy tension present. Also this delivers very clear optics to other potential acquirers that, if we have done the deal together with, say, Henkel, then Henkel does not already de facto own the company. We try to avoid exclusivities, or if there are exclusivities, they are for periods of time that are unlikely to interfere with the exit – one or two years, depending on where the company has reached with commercialisation or to grant exclusives that are for particular geographies or applications of the technology outside of the core that the company is focused on.”
However, since CVCs are the acquirer of their portfolio businesses in only a minority of cases, it is crucial to ensure that such companies are standalone and can become successful independently. Nothing should be agreed which could prevent a successful exit to a third-party acquirer. The best entrepreneurs are likely to have various options when raising capital, and if a CVC insists on a deal term which precludes the entrepreneur from exiting or otherwise seeks to impose an unwanted commercial agreement, such entrepreneurs will seek capital elsewhere. That would leave the CVC just with deals that others do not want.
European deal terms versus US deal terms
CVCs may wish to maintain uniformity of terms across their portfolio companies but often this could be compromised where a CVC is investing across sectors and across jurisdictions. Europe is more risk averse and so deal terms are often more aggressive than their US counterparts.
In particular, the European CVC market traditionally sees an abundance of heavy structuring in deals, through aggressive liquidation preferences. Furthermore, CVCs in Europe are more likely to tranche their investments, so the entrepreneur has to meet certain milestones before the second or third tranche is invested. Arguably this pursuit of risk mitigation in term sheets could be quite damaging to the company and consequently lead to lower valuations and less deal syndication in Europe compared with the US.
While some attribute this to the lower maturity of the European venture market, more capital is now being raised in Europe and therefore the funding gap between Europe and the US is likely to diminish, although there is still a way to go. Gillard elaborated further:
“I think that supply and demand is a big part of what is going on there. In fact, if you look at the trends of valuations across all rounds of companies it depends on the supply of capital in the area. As the supply of capital goes up the competition to get deals goes up. We have seen over the last 10 years in the US, across most stages of investment, a three-fold increase in the median valuation. Now in the last two years we have seen a downturn in the amount of capital coming into the system and so, as a result, just in the last year or so, we have seen about a 50% reduction in the median valuation at series D level. So we can expect to see more of that. I think that this, together with cultural issues, is at the heart of why European deals tend to be valued so much lower than North American deals. There just is not as much capital at play here in Europe.”
Liquidation preferences and anti-dilution ratchets
The perceived risk of any investment and the supply of capital are therefore linked to the deal terms, most noticeably with respect to terms such as liquidation preferences and anti-dilution ratchets.
A liquidation preference is a contractual provision setting out which shareholders get paid first and how much they get paid in the event of a liquidation event – not just a liquidation but also on the sale of the company, the sale of the company’s business or the company’s intial public offering (IPO). Liquidation preferences can be divided into two categories:
• A “participating liquidation preference” whereby certain investors will be paid an agreed multiple of their investment – usually one-times – before any other shareholder receives any sum. Any remaining balance of funds are then divided pro rata among all shareholders, including the holder of the preferred class. This could mean that, on a low valuation exit, shareholders without a liquidation preference or who are not near the top of the order of preference, such as founders, get crammed down.
• A “non-participating liquidation preference” usually provides the investor with a choice. Either they receive their subscription back – usually at one-times plus any accrued dividends – or they convert into ordinary or common shares so that all exit proceeds are simply divided pro rata among all shareholders. This is therefore seen as less aggressive than a participating liquidation preference.
The use of participating and non-participating liquidation preferences can be driven by a number of factors including the attractiveness of the company at the time of investment and also the relevant jurisdictions involved. As Gillard said:
“Non-participating preferred stock is present in 80% of deals in North America right now where the preferred are treated pari passu [at the same rate or on an equal footing] with the common. We all get our profits at the end of the day at the same time. But with participating preferred shares, 15% have 1-times and then about 5% have 2-times or more. It is a bit like skimming the cream off the top first and still participating along with common stock. It creates a misalignment of interest with the common stock. The preferred are going to make all their money back and then they are going to participate at the same level as common as well. We tend to see this only in North America in down rounds and distress situations, but I understand it is more common here in Europe.”
In the UK, the standard form constitutional documents published by trade body the British Private Equity & Venture Capital Association contain a 1-times participating liquidation preference and this is usually held as being the industry norm by UK VCs. and sometimes UK CVCs, when negotiating. However, this differs markedly from the standard terms of US trade body the National Venture Capital Association. European terms are more aggressive in this regard.
It could be argued that too much time is spent trying to protect against any downside risk and this does not reflect the commercial reality of making investments. Since venture investment ultimately makes its biggest returns from those rare outliers who can return an entire fund in one go, aggressive downside protection is not relevant in such circumstances. As such, some commentators have seen an increasing willingness by CVCs to invest in common stock to achieve complete alignment of interests among the various stakeholders.
Similar differences arise with anti-dilution clauses, which are complex mathematical formulae used to protect an investor from its equity investment being diluted by future funding rounds at a lower price than the investor injected its capital. Broadly speaking, such clauses can be split into “full ratchet anti-dilution” – generally seen as aggressive – and “weighted average anti-dilution” – seen as “market”. While anti-dilution ratchets are sometimes seen as a key point of negotiation, depending on an investor’s appetite for risk, the overwhelming prevalence of broad based weighted average ratchets means this is something that can often be quickly agreed. In fact their inclusion is often not required at all, argued Keith Gillard:
“88% of deals right now are being done with a broad-based weighted average methodology. Only 2% are full ratchets and, let’s be honest, in the situation where anti-dilution really comes into effect is when it is a down round and you really have no negotiating power. Frankly, the anti-dilution provisions tend to go away because the new lead will reset the terms, maybe recapitalising the company at a dramatically lower level, and they just say the existing investors must waive their anti-dilution provisions or no deal. Then you have no choice. You don’t want the entrepreneur getting completely crushed and getting only a fraction of what they should because then again alignment of incentives is a problem.”
Keep it simple stupid
It is commonly assumed that investors need a preferred class of shares and significantly enhanced rights to the other shareholders to protect their investment. However, this is not always the case. There are compelling reasons for moving away from this stance and for CVCs to seek swift execution, as Keith Gillard said:
“For our earliest-stage investments, we use very simple terms. It is very straightforward. Absolutely no downside protection. We have nothing to draw back on. We cannot even do an intellectual property sale if it fails. But we are talking about something that is very early stage that does not have many assets anyway. It would be a rounding error. So let’s keep it simple.”
Noting that fundraising can be a time consuming process for entrepreneurs and that they also have a business to run, he continues:
“It is about quick execution and capital efficiency so that these very early-stage companies can focus on derisking. Let’s get to that first milestone and see if this is something that we can rapidly commercialise or not.”
Conclusion
There are clear differences between the deal terms sought by CVCs but, as we have seen above, best practice is emerging, driven by the following factors – the investors and founders should be suitably aligned and the CVC should be motivated by long-term value growth. While attitudes to risk and certain accompanying deal terms show marked divergence on each side of the Atlantic, it can sometimes be counterproductive or even unnecessary to take an aggressive stance when negotiating the term sheet. The long-term strategy should always be kept in mind.
Neil Foster is part of the Global Corporate Venturing Academy faculty where he presents on deal terms and execution.