Written by Dylan Kennet

Valuations of double digit multiples are often no surprise when it comes to technology companies, whether in Silicon Valley or here in the UK. Commonly known as “unicorns,” they are often defined as private companies valued at over $1bn. There are currently 169 unicorns globally with a cumulative valuation of $609bn and whilst they remain a somewhat exclusive club, they are frequently associated with technology startups – and by extension, deep pocketed investors. This is not another article about unicorns and the ‘inevitable’ pop of the tech bubble, rather, how some tech investors in the private markets in 2016 are showing discipline and proposing ‘downside’ legal protections in deals.

Investor appetite is evolving and the bar has risen for quality. Over the course of the last year deal volume has dropped significantly and funds invested have reduced rather modestly. Global economic and political uncertainties partly explain the change (and it is currently unclear how the UK’s recent vote for to leave Europe will impact VC activity, both in the UK and in the US), but our experience shows a theme of disciplined and more measured approach to investing. The money remains out there and despite investors deploying their capital into fewer deals, the initial view on 1H 2016 is that we are going to be seeing some big valuations and large sums of money invested, especially at the Series C and D rounds.

Evolution

Where investors previously valued tech companies that championed, in the words of venture capitalist Bill Gurley, ‘growth at all costs’ to take market share, this ethos may not have necessarily delivered the companies they had hoped in the longer term. Having watched growth vectors maturing among the big tech stars, or having felt the impact directly through portfolio write-downs, we are seeing investors in both the US, UK and Europe becoming more reserved and seeking greater downside protections attached to their money.  Adding to the mix, we are seeing strategic corporate venturers and non-traditional tech investors (so-called ‘crossover investors’) such as sovereign wealth funds and mutual funds, who perhaps have less risk appetite and therefore also assign more demands to their money, contribute to this environment.

Lofty private valuations are therefore at greater risk , as complex legal protections in shareholders’ agreements aim to ground them in reality. This is not necessarily a bad thing, as it focuses the mind of the investee company’s main decision makers – the board, as well as its shareholders – about what they truly value.

Conceivably many late stage tech companies are remaining private for much longer, possibly in fear of the IPO (and its heightened legal and financial scrutiny) lifting the veil and thus acting as an unfortunate down-round.

The rise of investor protection mechanisms

Although more common in the US, similar protections are becoming the norm in British venture deals, especially at the late stage, as investors with deep pockets arrive later to the party.

The legal toolbox available for investors varies; here, we offer a non-exhaustive list of some common terms that are often found in tech deals:

• senior liquidation preference: this protects investors when a company goes bust, as it essentially provides a means of ensuring the latest investors’ money comes out first;
• preferential, guaranteed or exponential returns for the investor on exit events (such as a trade sale);
• veto/blocking rights over when the company can IPO may be introduced into a shareholders’ agreement or
• a ratchet: a type of downside protection mechanism that ensures that certain shareholders – usually, the latest investor are protected from a fall in valuation on an initial raise. This may come at the expense of the earlier round investors.

As companies go deeper and deeper into private rounds of funding and delay the once inevitable IPO, these mechanisms become increasingly commonplace and necessary to attract new rounds. They are serving as a means to protect investors, by asking serious questions of the company and its current shareholders.

Understanding how to manage the deal 

There are a number of practical ways in which all parties can manage the legal agreements, to deal with the realities described above. First and foremost, understanding what is making the investor tick is crucial – what are their motives for investing?  This will dictate the type of deal terms they may want to focus on.  It is important for the parties to be clear if the investor is looking purely for economic returns or, say, if they’re a corporate venturer and their modus operandi is strategic partnering with the investee company.  The corporate venturer may allow push back on potentially onerous liquidation preferences, if they’re guaranteed locked-in exclusivity period on product or a right of first refusal.  Depending on their reason for investing, a path to control may be more in focus to a corporate venturer at the entry point than the actual exit price.

Understanding how a waterfall works is also imperative. If there are many classes of shares due to the late stage nature of the company (i.e – Ordinary (UK)/Common(US), A Preference, B Preference, etc.), most likely the investors who invested last, will get their money out first on: a) an exit event; or b) a liquidation of the company.   How it is proposed that the money is returned among investors in triggered situations and in what proportions, helps better understand the investor.  This same principle applies to any readjustments granted to an investor on an IPO, as highlighted above.  If the price per share valuation in the financing round is arbitrarily high, this will have a diluting effect for all shareholders other than the last round investors who will be effectively issued free shares on a listing, should the company list lower than the last round.

Issues around class consents also play an important part in negotiating later stage deals. If there is a varied group of investors, some may have a different pre-conceived path to liquidity compared to their counterparts.  Managing competing interests to strike a proper balance among the parties is a difficult task (one we lawyers are always up for!), especially when the late round investors are bringing big cheques.  The Seed or Series A investor may have already waited many years (not to mention the early stage employees), but the new investor is may require a veto on any IPO until some years have passed, post-investment.  A possible work-through is agreeing that a certain proportion of each class (or overall percentage of investors) must vote to approve an IPO, thus creating a situation in the future which the views of the investors align with that of the best interest of the company and a majority of investors.  Also, the fresh funding round may present an opportunity for employees and early investors, who have been with the company from the beginning, to take money off the table, rather than locking them in even longer.  Be mindful of these early champions of the late stage tech company: data suggests the average time to reach a liquidity event in Europe ranges anywhere from 6-10 years.

Natural change

Perhaps unsurprisingly following the performance (and dearth) of tech company floatations in recent months, companies continue to stay private for longer. However, this doesn’t mean that they have completely fallen out of favour.

Investors are focusing on companies with strong balance sheets or business models that show a robust plan to achieve profitability. It is becoming less about growing market share at all costs and taking advantage of short-term peak valuations and more about the long-term return that these investments offer.   To wit:  recent tech IPOs on NYSE, NASDAQ and elsewhere perhaps have investors and late stage companies  breathing a sigh of relief with the normal path to realizing their investments shooting up green sprouts.

Nonetheless, greater investor demands, such as some of the protections mentioned above, while casting a more detailed eye over the financials and assessing the long term prospects of companies is ultimately a positive for the future of the tech industry.

The future of tech

The US has encouraged a new way to approach tech investments, embedding different legal concepts to UK investors. Silicon Valley is now a global phenomenon, and its markets reach well beyond the 101 and the 280. We believe fast-growing companies should expect to see a more disciplined and measured approach from the investment community in 2016, wherever they may be.

Dylan Kennett is an Associate at DLA Piper & Louis Lehot is a Partner at DLA Piper