Capital Markets

VC Deals More Company-Friendly

Investors are granting more favorable terms to start-up companies than they were four years ago, according to a Dow Jones study.
Sarah JohnsonNovember 9, 2006

Venture capital backers are getting friendlier. In the past four years, the deal terms they’ve been handing start-up companies have shifted in favor of fledgling companies, says a new survey released by Dow Jones VentureOne’s. Indeed, new deal terms offer improved liquidation preferences and decreased percentages of investor ownership, noted the study, which surveyed 350 executives.

The data provider attributes the shift to increased competition among VCs that are vying for the most promising entrepreneurs. “Since our first report in 2003, there has been a wider discussion of deal terms that has helped investors and entrepreneurs fend off some of the worst practices of 2001 and 2002,” wrote Russ Garland, the author of the report. “A saner investment climate has led to healthier companies who are better able to negotiate more favorable terms.”

For example, more VCs are willing to take lower rates of returns if a start-up tanks or is sold, said the study. To be sure, 82 percent of start-up companies negotiated liquidation preferences of one times the capital invested. Only 73 percent reported deal terms that favorable last year. But older companies aren’t seeing these same improvements; firms closing third or later round financing reported higher multiples, although no U.S. company said it had promised a liquidation preference of over three times invested capital.

Another bright spot for start-ups is that the company founders retained more ownership when the VC deal closed, compared to a year ago. VentureOne, which surveyed U.S. and European companies from April 2005 to June 2006, calculated that the median share of companies sold in first rounds fell to 40 percent, down from 50 percent last year. The median founder stake for first round funding was 31.5 percent compared with 26.5 percent in last year’s study.

Dow Jones also observed a decline in “full-ratchet” dilution provisions. Nineteen percent of survey respondents reported having the investor protection provision on their term sheets, while 34 percent had them in 2002. The provision offers protection to start-up investors, allowing them to maintain their percentage of economic ownership and voting power whether or not company shares are sold for less in the future.

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