Investment terms will toughen; employees will take the hit

Tech employees Photo: Shutterstock
Tech employees Photo: Shutterstock

The value of options held by workers in tech startups could fall substantially, without the workers even knowing.

The valuation crisis in high-tech companies may have begun with the slide in the shares prices of public companies, but it has gradually spilled over into the private market, to the startups, growth companies and unicorns.

The situation has created a new problem for the private tech companies dependent on raising money in order to keep moving: companies that are not making profits and that during the times of plenty would raise millions of dollars once a year or every eighteen months will now have to work hard to persuade investors to invest in them at valuations higher than in their previous rounds.

In the past few years, investors have softened their investment terms in entrepreneurs’ favor and have not demanded special protection for their money, but all that is about to change. Senior people in the industry now expect stringent terms to be reintroduced for investment rounds, at the expense of the entrepreneurs, previous investors, and employees, mostly without the employees being aware of it.

A number of mechanisms are likely to feature in the near future that will substantially limit the value of an exit for employees when a company is sold or is floated on a stock exchange.

Mechanism 1: Investors will inject capital and receive more

First of all, we should explain why investors will be less patient towards tech companies, or more demanding of them.

The decline in value of technology companies, both public and privately-held, stems from the rise in in inflation and in interest rates, and the fear of an economic slowdown. The rise in interest rates reduces the amount of capital that investors can raise in order to invest in technology, and makes loans taken by technology companies dearer. Inflation, meanwhile, reduces the amount of consumers’ disposable wealth for spending on luxuries.

These phenomena are making investors in tech companies - venture capital and private equity firms - less tolerant when it comes to continuing to support companies that are a long way from profitability, despite the fact that these investors raised billions of dollars last year.

Since the values of public technology companies have plunged by 60-90% since last summer, investors are pressing founders of privately-held companies to reduce company valuations in the course of fund-raising rounds. A move like that, however, known as a "down round", could leave employees holding options "out of the money", that is, with options the exercise price of which is higher than their company’s share price, and that would be liable to lead to a general loss of morale and to employees leaving.

To avoid such a situation, in recent weeks investors and entrepreneurs have begun to reach agreements on freezing company valuations. In what is known as a "SAFE" (simple agreement for future equity) round, the existing investors in a company agree to inject capital into it while maintaining its valuation, with the aim of receiving a discount of 20-30% on a future round, while the holdings of the employees, the founders, and early investors are diluted.

"At the moment, we are mainly seeing SAFE rounds, that defer setting the company valuation to the future," says Dr. Ayal Shenhav, head of law firm Gross & Co.'s Hi-Tech and Venture Capital Practice, among whose clients are Israeli and foreign venture capital firms.

"The correction in the private market in the wake of the public market is only just starting," Shenhav adds. "There are companies whose market caps have fallen 80% or 90% on the stock exchange, and that still hasn’t happened in the startups market, and so I think that we shall shortly see investors demanding more substantial protection for themselves, such as, for example, rights for investors in an exit that gives them priority or an option for further investment."

Mechanism 2: Investors demand priority in an exit

Another mechanism that almost disappeared during the boom times is one that gives investors higher priority in an exit, over the employees, the founders, or other investors who have not requested protection of this kind. An unprotected investor will usually receive his proportionate share of the shares in the company together with everyone else. For example, an investor who invested millions in exchange for 10% of a company’s shares, will receive $10 million when the company is sold for $100 million.

In the coming months, Shenhav predicts, investors will make follow-on investments in a company, or will invest in a new company, with additional protections not seen in the Israeli industry for years. First of all, investors are likely to demand a higher return on their investment through participating preferred stock, such that our investor investing in exchange for 10% of the company will actually receive 15% or 20% of the proceeds in the event that the company is sold, plus the amount they originally invested, which is known as a "double-dip" mechanism.

Investors might also demand interest on the amount they invest, so that, instead of receiving $10 million in an exit, they will receive more. The additional millions of dollars will necessarily come at the expense of the employees, the founders, and the unprotected investors.

Mechanism 3: Options for investors as well

In the past two years, high-tech workers have learned to appreciate the contribution of options as a main component of their compensation package, that is, until last summer. With the coming of hard times, investors are tending to demand their own options. They are expected to demand warrants giving them the option of raising their investment and benefiting from a larger slice of an exit.

For example, a fund that invests $10 million for 10% of a company could demand a warrant giving it the right to invest $10 million for a further 10%. If the company shuts down, the fund only loses $10 million, but if the company is acquired, it will have the option of injecting the additional amount for 20% of the company. If the company is sold for, say, $1 billion, the fund will receive a net $190 million, instead of the $100 million it would have received without the warrant.

In recent years, these kinds of special terms have almost disappeared from the market. According to the latest quarterly "Private Company Financing Trends" report by US law firm Wilson Sonsini, the proportion of investors not demanding preferential terms (non-participating) was 90% in 2021, and 92% in the first quarter of this year. The proportion of investors signing on another mechanism, known as "pay to play", whereby the founders strip the preference stock held by investors of the extra rights it carries if the investors refuse to provide further finance for the company in accordance with their relative shares in it, reached a peak in recent years, but the phenomenon disappeared completely in the first quarter of this year.

The last to know: Workers will be informed retrospectively

Preferential terms for investors are not an invention of the current crisis. In periods in which the bargaining power returns to the side of the funds, they can obtain stronger protection against loss scenarios. Raising money with such expanded protection enables a company to preserve the appearance of a high valuation, and even to reach the billion dollar threshold and be considered a unicorn, when in fact the fair value of the company has been cut. This is because the valuations that companies report are based upon the preferred stock carrying those strong protections, while the remaining stock carries inferior rights, and accordingly is worth less.

"Researchers who examined more than one hundred unicorns demonstrated in 2018 how the funds’ preferential rights on the one hand raise the reported value of the company, and on the other hand reduce the value of the ordinary shares. That is to say, the extra rights divert much of the risk to the founders and the employees," says Dr. Yifat Aran, a researcher in corporate and venture law in the Faculty of Law at the University of Haifa.

"For example," she says, "in a scenario in which a company raises $100 million at a post-money valuation of $1 billion, if instead of standard protection against loss the investors received preferred stock carrying the right to receive double the amount they invested before the ordinary shareholders participate in the division of proceeds, the over-valuation of the company’s ordinary share will rise from 28% to 110%. This means that each dollar that the employees think they have is actually less than half a dollar. In SpaceX, for example, in the company’s fourth round, the investors received preferential rights on liquidation worth double their investment, and so the company valuation rose by 36%, while its fair value fell by 67%"

Dilution of the employees is no different from the dilution of any founder or investor who holds ordinary shares in a company. Nevertheless, the employees are generally the only group not party to the secret of the dilution, since the founders of privately-held companies usually make do with a laconic announcement of an investment round that does not go into detail on all its terms, particularly if these terms are to the detriment of the employees.

"Most employees cannot know what happens around the board of directors table, and what consequences it will have for their options," says Shenhav. "Theoretically, an estimate can be made from printouts from the Registrar of Companies, but that’s an effort that not everyone is capable of making, and in any event there is a need for greater transparency on the part of the entrepreneurs to keep employees informed of what is happening to their securities portfolios."

Published by Globes, Israel business news - en.globes.co.il - on May 30, 2022.

© Copyright of Globes Publisher Itonut (1983) Ltd., 2022.

Tech employees Photo: Shutterstock
Tech employees Photo: Shutterstock
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