Taking a "dirty" term sheet to preserve headline valuation: short-term gain for long-term pain?
To avoid a down round, some founders may consider a structured financing to maintain recent valuation. Is this a silver bullet or simply kicking the can down the road?
Last week, I published my SaaS predictions for 2023. One of the predictions is that we may see an uptick in flat or down rounds through the first half of the coming year. A few days ago, Morgan Stanley even declared that it would be the “Year of The Downround”, noting that flat and down rounds now account for a majority of funding announcements and that “the pressure is likely to mount during 1H23 if the momentum continues”:
Historically, down rounds have been a taboo topic within the startup community. Complicating this, down rounds may be even more difficult to swallow in today’s paradigm because stakeholders have anchored palpable sentiments on the outlier sky-high valuations of the 2020-2021 period, driving angst at the very thought of a reset.
While 2023 may herald an increase in flat/down rounds, I ultimately predict that less stigma will be associated with such markdowns as there is increasing recognition that many of these valuation resets represent a correction of 2021’s peak frenzy mispricing and overhang, rather than a reflection of core business performance.
Enter the “dirty” term sheet
In some cases, in their efforts to avoid the risks and perceptions associated with a down round, some founders may consider a structured financing in order to maintain the most recent valuation. Through structured term sheets, an investor can meet a particular valuation ask as deal “sweeteners” have been embedded, typically through provisions that improve economics on the upside and/or guarantees for a minimum return or downside protection. Such term sheets are often called “dirty” as non-standard or highly complicated features have been added, versus a “clean” straightforward term sheet with typical clauses.
“Sweeteners” could vary across any number and combination of provisions from multiple liquidation preferences to warrant coverage to aggressive ratchet protections to veto rights... Here are some resources on common deal language and what might be considered atypical:
A Standard and Clean Series A Term Sheet (Y Combinator)
The VC Barbarians Are Coming (Fred Destin of Stride.VC)
A more bitter medicine?
Conducting a structured financing to circumvent a valuation reset may not be the silver bullet that it is perceived to be. This week, Fred Wilson of Union Square Ventures asserted in his “What Will Happen In 2023” essay that:
“This new normal will lead to many flat rounds, down rounds, inside rounds, and rounds with a lot of structure on them. None of that is good, but the worst of those options is rounds with a lot of structure. I believe founders and CEOS and Boards should take the pain of a new valuation (flat, down, whatever) over structure.”
Bill Gurley of Benchmark had shared similar (and stronger) sentiments years ago in his post “On the Road to Recap” from 2016:
“Terms are the true Godzilla that should scare you to death. A down round is nothing. Get over it and move on… If you cannot handle a down valuation you should seriously consider abandoning the CEO position. Being a great leader means leading in good times as well as tough times. Taking a dirty deal is jeopardizing the future of your company, solely because you are afraid to lead through difficult news.”
While no one is advocating for a down round if unnecessary, I’m aligned with the view that if a startup absolutely needs to raise and is stuck between the devil and the deep blue sea of accepting a “clean” round at a lower valuation or a “dirty” term sheet to keep a cover valuation, the former may be more preferable.
Of course, every situation is unique and there is no prescriptive approach. Founders have different considerations to balance and ultimately know what the most compelling terms are for their business. There are examples of companies such as DoorDash, Kayak, and AirBnB, that have emerged triumphant from either situation, and in some cases even from a down round scenario WITH structure.
It is thus perhaps more important for founders to be armed with different perspectives in order to make prudent decisions. With this in mind, and after receiving a request to double click specifically on the reasons to accept a flat/down round over incurring structure to preserve headline valuation, I put forth three points in support of this perspective:
Implications of asymmetric risk allocation
Complications to future financings
Valuation appearances from structure could ultimately be fleeting
I. Implications of asymmetric risk allocation
The terms an investor insists on can reveal a lot about the investor’s perceived risks and perceptions on how such risk should be allocated. As a result of “sweeteners” in structured term sheets, returns can be generated for an investor not from cover valuation but from aggressive legal clauses. A divergence of incentives and stakeholder misalignment could arise from such a distortion. For instance, as highlighted by Y Combinator:
“These are all ways of adding structure to reduce typical venture risk, either directly by boosting the investor’s downside economics, or indirectly by juicing the upside outcomes. The investor is essentially saying, “I’m sort of afraid of losing my money.” It can also foreshadow how they might behave when things aren’t going well, such as pushing you to sell when you don’t want to, or dial back risk when it’s important to take it. Good investors would rather address economic risks by negotiating valuation, and are otherwise happy to give standard terms because they know that the real money in venture is not made with structure, but by building long-term value, which they are confident in their ability to help you do.”
How can this manifest? Brad Feld of Foundry (another proponent of doing a clean reset over taking on structure) identified the phenomenon of “flat spots” where as a result of structure, an investor is indifferent across a range of exit values as they receive the same amount, leading to misalignment on the ultimate outcome across different stakeholders.
Mark Suster of Upfront Ventures noted a real life example of this:
“I’ve actually seen situations where some investors prefer a $30 million exit to a $50 million exit because they earn the exact same amount due to the flat spot and they think they have a higher probability of selling the company at $30 million… Can you imagine a scenario where you’re trying to sell your company for the highest price and one of your investors is privately signaling to the buyer that they’re fine at $30m? Happens.”
A different anecdote from Heidi Roizen of Threshold Ventures:
“It’s hard enough to be an entrepreneur when all your investors are aligned. It is way harder when they are not! In the aftermath of the dotcom bust, I saw some financings that resulted in cap tables with stacked preferences where those on the top had senior guaranteed 3–5x multiples! When the going got rough, many of those investors were happy to push for any deal that would allow them to bank their 3–5x — even a fire sale that left nothing for anyone else. I don’t know about you, but I never want to go there again!”
As Heidi highlights, such structure could be severely punishing, with new money reaping rewards at the direct cost of unprotected or early shareholders. In extreme cases, some founders did not even see a dime.
II. Complications to future financings
Current terms set the foundation for future rounds and incurring structure may have enduring ripple effects:
Subsequent investors may demand the same structured privileges as previous investors
Existing investors may refuse to unwind burdensome terms that future investors consider non-starters or want removed as a prerequisite to investing
Complex cap tables and non-straightforward terms take time to unpack, adding friction to the diligence or closing process
Structure could compound over time and more onerous terms could appear
Bill Gurley of Benchmark even goes so far as to declare that accepting a “dirty” term sheet is akin to “the clock on a time bomb” as it “could render future financings all but impossible”:
“Any investor asked to follow a dirty offering will look at the complexity of the previous offering and likely opt out. This severely heightens the risk of either running out of money or a complete recapitalization that wipes out previous shareholders (founder, employees, and investors alike). So, while it may seem innocuous to take such a round, and while it will solve your short term emotional biases and concerns, you may be putting your whole company in a much riskier position without even knowing it.”
III. Valuation appearances from structure could ultimately be fleeting
There is acute awareness from market participants that structure could be masking a discounted fair valuation, and this may eventually come to light in a very unwelcome manner, most prominently when private startups exit in the public market.
No one is being fooled, as Yoav Leitersdorf of YL Ventures notes in an interview from Pitchbook:
"[Companies] save face in terms of PR… but in the legal docs, you'd find terms that essentially make the flat- or up-valuation irrelevant because the economics of any future distribution favor the new investors as if the round was a down round."
Increased cognizance of this was catalyzed in the mid-2010s during the high-profile IPOs of several tech companies that had previously raised late-stage rounds with structure. These companies, such as Box, Chegg, and Square, had agreed to ratchet clauses that were subsequently triggered when they went public, sparking debate around how private post-money valuations involving structure were in effect overstated since all classes of securities were valued in the same manner despite having different rights.
This consequently raised questions around IPO mispricing and stakeholder misalignment. As Professor John C. Coffee Jr. of Columbia Law School notes:
“Effectively, such provisions create a moral hazard problem, as the investor is guaranteed a minimum return based on the price it paid in the final equity round. This investor faces no downside, and, as a result, this type of transaction should encourage mispricing in IPOs. Put simply, some will rationally overpay in the final private round in the hopes of inflating the IPO price, knowing that the economic risk of a “down round” falls mainly on the IPO investors who are diluted. The harm for the public investor is not just dilution, but the risk that the IPO will be overpriced, only to fall in the aftermarket when securities analysts catch up with it.”
Some members of the press have even gone the extreme, making sweeping warnings to avoid IPO offerings of companies that have been burdened with atypical ratchets.
The precedent set by these companies led to better understanding across the industry that the prevailing rhetoric of post-money valuation fails to account for heterogeneity in share characteristics of startups, which could result in systematic overvaluation when structure is involved. Recognizing this, Stanford Graduate School of Business Professor Ilya Strebulaev and University of British Columbia Assistant Professor of Finance Will Gornall proposed a new model to quantify the premium that should be attributed to structured securities, and corresponding discount factor to be applied to share archetypes containing less generous provisions.
In their seminal paper, they found that reported unicorn post-money valuations averaged 50% above fair value. Their model yielded lower fair value assessments “because most unicorns gave recent investors major protections such as IPO return guarantees (14%), vetoes over down-IPOs (24%), or seniority to all other investors (32%)” which should have discounted other share classes, but reported valuations still assumed all shares were of equal worth. Below is a visualization of their model output for SpaceX, showing how divergence between headline value and fair value can occur when structure is employed:
[Side note: The professors have since publicly launched valuation.vc that provides a calculation of share and option fair value using their model]
Intrinsic value is not created from convoluted legal provisions
A new baseline could be established in the industry if “dirty” term sheets become more prevalent. In the last decade, during bull-market conditions, the norm has been for investors to offer cleaner and simpler terms, rather than structured deals. The chart below illustrates an example of this with regards to term sheets containing “dirty” participating preferred clauses. But with the evolving economic and fundraising conditions, some VCs caution that this might be changing. In fact, just yesterday, Netskope announced a convertible debt round which is considered to be a structured financing.
I’m generally of the view that value creation is maximized in situations where transparency and stakeholder alignment is promoted, and this may come into conflict through the use of complex legal instruments. Structure is not innately good or bad, but it is my hope that founders understand the key trade-offs of different financing options and are able to navigate conditions with eyes wide open in this new fundraising climate.
There are many schools of thought on this topic. Please leave a comment below as I would love to hear where you stand on this debate!
Great article! Most founders (and investors) have not had to encounter such a sharp valuation multiples re-set and have not concerned themselves sufficiently about what these "dirty" term sheets can mean for them in a few years, good outcome or bad.
Hopefully, more companies just accept clean down rounds and others are motivated to do the same.
My guess is that the companies that aren't doing great will want to keep headline valuations and accept dirty term sheets to continue to promote a false image.