European corporate venture capital teams should reflect on their rights in light of falling valuations, revised exit expectations, and other challenges.
By Richard Butterwick, Beatrice Lo, Shing Yuin Lo, Mike Turner, Jon Fox, and Catherine Campbell
This year has been challenging for venture capital (VC). Valuations of VC-backed companies listed on the public markets dropped by 74.2% in the first half of 2022, and evidence indicates private valuations are also declining. While the downturn underlines growing challenges for early and late-stage emerging companies, it also presents risks and opportunities for large corporates, who have significantly increased their presence in VC deals in recent years — with participation growing by 462.5% in the decade to 2021. In Q4 2021, corporate VC participated in 2,858 deals with an aggregate value of US$98.7 billion, a record high.
Given the significant increase in the number of corporates participating in the VC and growth equity space, many corporate VC teams will be dealing with a downturn for the first time. In our view, corporate VC teams should proactively seek to understand any downside protections they benefit from in order to position themselves to manage risk and maximise prospective opportunities.
Dilution and Valuation
Investors in private fundraising rounds in the European VC market typically benefit from anti-dilution protection on “down” rounds, entitling them to be issued additional shares as compensation for the decline in a company’s valuation. With down rounds becoming increasingly common, corporate VCs need to consider how their anti-dilution protection will work in practice, for example, whether it could be waived by other investors, and what types of share issuances are not caught.
Pre-emption rights are also in focus. Most investors will benefit from a pre-emption right upon a new issue of securities, and corporate VCs should consider whether they are likely to have the funding available and the corporate appetite to exercise this right during the prescribed period. If not, they should consider the dilutive effect of the new round.
Dilution is not just an investor concern; corporate VCs need to be mindful of the impact of anti-dilution protection on founders and management teams. As early-stage companies tend to incentivise management with shares or options rather than cash-based incentives, some of this equity may now be subject to valuation hurdles that are no longer realistic. Investors will need to work with founders and management teams to review the impact of lower valuations and the dilutive impact on employees.
For portfolio companies in need of funds, corporate VCs should note the availability of funding from alternative sources, e.g., growth debt or revenue-based financing. These forms of financing have become more appealing since they avoid crystallising a lower valuation. Not all companies will be willing or able to service additional debt funding. However, for the right company, additional debt may be more attractive than unfavourably valued equity.
Many early-stage companies are looking to exit rather than raise new funding. Corporates may be familiar with carve-out sales and asset disposals, but most will be used to having control of the timing and terms of such sales/disposals — whereas sales of early-stage companies are typically founder-led. Corporate VCs with strong views on the direction of a portfolio company are unlikely to have legal rights to enforce their vision — they will need founder support and should seek to coordinate with other investors.
Corporate VCs invested in companies seeking exit opportunities should review whether their shares have a liquidation preference attached (on a non-participating basis, an option for holders to have their money back in priority to the ordinary share return), whether shares have tag rights (the ability to join a sale being pursued by other shareholders), and whether the corporate could be dragged into selling by other shareholders, or dragged into a new purchaser entity (and forced to accept shares in an acquiring company).
The last scenario is expected to become increasingly common in the current market and poses a risk to corporate VCs, particularly those with strategic investments on behalf of parent groups. In such cases, a portfolio company being dragged into a new purchasing entity or sold to a competitor could compromise initial investment objectives.
Direction and Evolving Dynamics
Alignment with fellow shareholders is important to discuss at the outset of an investment, including differing investment horizons and exit expectations. Due to shifting market dynamics, corporate VCs making new investments may now be able to negotiate additional downside protection in the event of an exit — e.g., a veto right on future financings or an IPO, a veto on a fundraising or IPO below a specific threshold or the right to be issued additional “make whole” shares on an IPO below a certain valuation threshold (such that the corporate VC, following such issuance, holds shares with a value equal to the value of its original shareholding at the relevant valuation threshold). If a corporate VC intends to develop a particular relationship with a portfolio company, it should consider outlining this intent in a commercial agreement upon closing its initial investment. In addition to any such agreement, corporate VCs should focus on information rights from the outset. However, these rights remain heavily negotiated, as founders are often concerned about widening disclosure to a corporate-backed investor, who they may view as a potential future competitor.
Looking forward, corporate VCs could see an increase in bargaining power if the VC fundraising market tightens, or if a challenging economic outlook increases the appeal of corporate VCs — whose sector expertise and resources may be perceived as outweighing those of a venture capital fund and who may not need to achieve an exit within any particular timeframe. In addition, macro volatility may put corporate VCs in a stronger position to capitalise on deal opportunities in the years to come. This may lead to the return of favourable deal terms that became less prevalent during the recent market boom, including veto rights over an exit, extensive information rights, and corporate VC-friendly governance rights.
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