Dec 072010
 
The Start-up Stage
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It shouldn’t come as a surprise to anyone that VCs have, over the past few quarters, been reluctant to put term sheets down on new investments. Most venture folks have instead been preoccupied with tending to their portfolio companies, either ensuring that their most promising companies have enough capital and resources to weather the downturn, or trying to sell off the others.

The statistics bear this out. U.S. venture-backed companies raised $9.28 billion in the first half of 2009, according to VentureSource. That’s 44 percent less than the $16.47 billion raised during the same period in 2008.

It may be too soon to pop the champagne, but the mood in the venture community appears to be slowly improving.

The market is up (the Dow has climbed back to above 9000); cracks are emerging in the tech IPO deep-freeze (with Open Table and Solar Winds having had successful IPOs, and a number of other venture-backed technology companies announcing plans to go public in the near term); and VCs are starting to do deals at an increasing rate (VentureSource cites that the amount of capital invested in the U.S in Q2 2009 rose by 32 percent as compared to Q1 2009).

What is most noteworthy about the recent increase in funding activity is the structural change occurring in the market for early stage investments. In the early part of this decade (after the dotcom boom and subsequent bust), when VCs recommitted to investing in early stage startups, most simply dusted off their Series A term sheets and recommenced investing in the “Series A mold.” Series A deals can vary dramatically, but they often look something like this:

  • VCs invest $3-5 million of capital for a 33-50 percent post-money ownership stake in the company.
  • Investors receive a senior liquidation preference on an M&A exit, and will often “participate” with the holders of common stock on the distribution of proceeds beyond their preference, either until all proceeds get distributed or up to some negotiated cap based on a return multiple (e.g., 2x-3x the VC’s initial investment).
  • Investors enjoy control features such as special voting “block” rights on important corporate actions such as financings and M&A transactions, as well as on operational activities like hiring executives or entering commercial or strategic transactions.
  • Investors control the Board or at least negotiate for board neutrality (where neither the founders nor the VCs control board voting).
  • Attendant to the investment are a panoply of additional rights including demand registration rights to compel a company IPO after a period of time, first refusal rights on founder stock transfers and “drag-along” rights (which force founders to vote for a sale of the company under certain circumstances).

As investors dip their toes back into the early stage deal pool following the most recent downturn, however, many are opting for “seed” financings instead of the typical Series A described above.

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