Are we reliving the past? Term sheet déjà vu

To negotiate attractive financial terms, startups must leverage lessons learned from previous financial events, including the dotcom bubble and 2008 global crisis

Yael Benjamin and Nimrod Vromen 09:4030.05.21
Covid-19 came and went, at least in Israel, and there's a sense of rejuvenation in the air. Let's discuss this initial sense of rejuvenation, or "reboot" for that matter, in the context of the one thing that is most crucial to startup success… capital.


New Startup Snapshot research found that in today’s uncertain market dynamics, investors are seeking more control and oversight when negotiating early stage startup investments. 36% of startups stated that they had restrictive veto rights and special liquidation rights in their latest term sheets, strict terms that were less common in the pre-Covid years.


Will this shift to more aggressive investor protection and control mechanisms continue in the coming months? Or will the trend disappear as quickly as it came, when additional signs of recovery arrive?


Yael Benjamin (right) and Nimrod Vromen. Photo: Courtesy Yael Benjamin (right) and Nimrod Vromen. Photo: Courtesy


As is many times the case, insight into future dynamics may be found in the past. The effect of a global financial crisis on a startup’s relationship with its investors is surprisingly cyclical. While the 2020 crisis was triggered by a global pandemic and therefore behaves slightly different than previous financial events, its effects on investor capital and term sheets are similar to the events of the dotcom bubble and the 2008 global crisis, enabling startup founders to apply such lessons to their negotiations with investors.


Let's explore three types of financial terms that investors include in the term sheet and analyze how their prevalence is affected by the general state of the economy.


1. The Liquidation Preference: Protection from a Future Event


First, let's look at the main right that VCs take when investing in startups: the "liquidation preference" right. This is essentially the investors' right to receive their money back first in the event of an exit or liquidation, before founders and employees.


Looking back historically, we can see that systematically the liquidation preference becomes more aggressive towards founders right after a crisis, as investors are facing uncertain market dynamics and looking for more control from future downside scenarios. But as time goes by, VCs begin to compete more heavily on startup deals, and the liquidation preference slowly becomes more founder-friendly.


A great example is after the dotcom bubble in 2000, when investors were extremely wary of startups that had previously "sold them" on high growth internet fantasies. To continue investing, while ensuring some minimal return that fits their VC structure, investors demanded the harshest forms of liquidation preference: a participating liquidation preference, securing the return of a minimal multiple of their investment together with a compounded annual interest rate of 8%. In addition to that, they would then “double dip” into whatever was left for the ordinary shareholders. Yet, as all cycles go, the tech boom returned between 2001-2008 and with it, investor confidence, with VCs slowly improving the liquidation preference terms for founders.

Following the COVID crisis and the return of the aggressive liquidation preference, what can we expect to happen in 2021? Well, perhaps the return of some form of compounded interest on the principal (to the tune of 4-6%).


2. Anti-Dilution Rights: Protection from Down Rounds


Unlike the liquidation preference, the strict anti-dilution protection rights start showing up in term sheets right before a crisis begins, as valuations reach their peak potential. The goal is to protect investors from a future drop in valuation.


The anti-dilution rights have morphed significantly over the past couple of cycles, and, similarly to the liquidation preference right, are at their most founder-friendly form yet. Right before the dotcom bubble burst, valuations were so high that investors included super aggressive "full ratchet" rights in their term sheets. In a down round, the first investor (who paid a higher price) would get their price corrected all the way down to the price of the down-round investor.


From 2009 until today, over 90% of deals globally are done with a broad-based average, which is the best "arrangement" for the non-investor shareholders. However, just before COVID, as valuations were at their peak, Y Combinator brought forward a special investment instrument that basically resurrected full ratchet anti-dilution protection for early stage investments.


3. Veto rights: Providing investors with control


The veto rights are also cyclical in nature. Right after every financial crisis, investors learn from the harsh reality and add new types of veto rights to their term sheets, increasing control in their portfolio companies.


For example, after the dotcom bubble, investors introduced more concepts of board membership and information rights, forcing their portfolio companies to report expenses and avoid the embarrassment of companies using investment money to take skipper courses. Fast forward to 2018, investors assumed a veto over crypto ICOs when companies were abusing that loophole to raise non-dilutive money as part of an overall "iffy" trend.


Today, we can see the same trend in Israel, as companies report stricter veto rights compared to pre-COVID. With pandemic related worries plaguing investors, they are looking to take more veto rights over day-to-day managerial matters, such as budget management, executive salary negation and loan taking (i.e. PPP).


The road ahead


The good news for startups, is that while a crisis causes a "jolt" in the way VC financings are negotiated, whatever the effects of the crisis are, they are typically slowly mitigated over time, during periods of growth, in which VCs end up competing on good companies more than companies are anxious to raise from them. Meaning, the crisis, which normally lasts one year, is a friction point where VCs have far more leverage, and then slowly over the next 7-10 years, the playing field levels out, until the next bubble bursts and a reset occurs.


Yael Benjamin is the founder of Y.Benjamin Strategic Marketing and Startup Snapshot, a data-sharing platform working to increase transparency in the venture ecosystem.


Nimrod Vromen is a partner at Yigal Arnon’s tech department, as well as the CEO of Consiglieri.