An economic downturn is a great time to back startups on better terms. But investors should be careful of the tricky politics of down rounds.

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Photo by kaleb tapp on Unsplash

The rollercoaster is on the downward slope. The exuberant startup valuations of 2020 and 2021 have been hit by increasing interest rates and supply chain shocks — and corporates, like other investors will have to adjust their tactics.

On the one hand, it is an optimal time for corporates to dig in and keep investing. As competition from venture capital firm recedes, corporate venturing units can be more selective and strategic about investments that are priced more cheaply.

On the other hand, corporate investors will have to navigate through the difficult territory of down rounds, where startup valuations are lower than in the previous rounds, founders are stressed because their holdings are being whittled down and all the existing investors are protecting themselves from having their equity diluted too far.

Less competition

The tide certainly has changed from the rapid pace of investments last year when cheap capital caused the pace of investments, driven by crossover funds coming into the venture sector, to shoot through the roof. CVCs, in turn, faced strong competition. “There was in inkling that corporates were experiencing pressure to jump in without necessarily seeing the milestones they were hoping for yet,” says Dennis Liu, managing director of tech clients for Orrick.

Forecasts for the economic downturn over the past six months have tempered valuations and the number of deals that corporate venturing units pursue. GCV data show the number of rounds involving a corporate backer decreased 8% from the same period last year. The total value raised in those rounds was down 42% from one year ago.

Downward pressure on valuations cuts across all sectors, says Ian Goldstein, partner at law firm Fenwick & West. Technology and life sciences are particularly subject to downward price pressure.

“Valuations in the public markets have gone down a significant degree and that is dragging down valuations in the private markets for venture-backed companies that are raising finance today,” says Goldstein.

The fall has implications for CVCs that invested in startups in previous rounds and that now face attempts to raise capital with new financing terms.

Navigating the politics of a down round

“We are beginning to see down rounds,” says Goldstein. “Prior investors are being asked to waive anti-dilution to bring in new money for that down round.” Anti-dilution provisions protect investors against their equity in a company becoming less valuable.

Corporates and traditional venture investors have an economic interest in keeping their existing anti-dilution adjustment provisions intact, but “might concede to waivers or amendments to those provisions from time to time if necessary or appropriate, as part of the deal negotiations around a specific down-round financing,” says Goldstein.  “This can often become a challenging part of the deal negotiations,” he adds.

More complicated deal structures, such as pay-to-play provisions when existing investors are required to asked to participate in a subsequent investment round, are yet to happen on a big scale. “My guess is those types of financings will begin to emerge if the economic outlook continues to look challenged,” says Goldstein.

He adds that it is important for CVCs to engage in “healthy and collaborative dialogue” in the boardroom to help startups search for new investors and get the best terms in financings. “Financings become messy when there is tension among board people and lack of time to find new investors or structure around complicated issues,” says Goldstein.

He adds that CVC investors sitting on boards or acting as board observers should help companies navigate a down round by making sure there are active discussions among board members and enough time to search for new investors and get the best financing terms.

Welcome back investor preference terms

Some do not expect a deluge of investor-friendly terms to emerge unless economic conditions deteriorate. “If we see more than a slight pause, which is where we are today, then we will get adjustments to valuations as well as some structured solutions in terms of the class of security that is acquired,” says Shawn Atkinson, partner at Orrick.

When markets were frothy, it was less common for investors to get protections such as a liquidation preferences, more participation in preferred stock, weighted voting, and last in, first out provisions. However, in markets where it is harder to raise capital, these could make a comeback.

Observers are positive about the opportunities for CVCs to increase equity holdings for less money and acquire companies. It will be challenging for corporates to exit positions because of the fall in valuations, making it a more optimal time for buying rather than selling, say commentators. Moreover, the extra value that corporates bring to the table, such as market insights and expertise, will appear even more attractive to startups that may be faced with fewer options to raise capital.   

“If there is an opportunity for value acquisitions, that could be a huge positive for the corporate investor base seeking those,” says Liu.

Independent CVCs may also be more active than corporate venturing units that have more ties to the parent. “Given recent volatility in public equities, those CVC units further along the independence spectrum – either completely spun out or with unassailable dedicated pools of capital – will appreciate exponentially greater freedom to operate in this climate than those funds tightly controlled by their corporate parent,” says Neel Lilani, global head, tech clients, at Orrick.

And for those independent CVCs that are in a position to keep investing during the downturn, this is an ideal time to expand. “While it is a down market, it is also a window of opportunity for corporates to lean in, find investment opportunities and gain more influence in the startup ecosystem,” says Goldstein.