Trends in VC Terms Suggests Investors Are Not Expecting a Quick Rebound

Data recently released by Carta provides a bit of detail that is helpful to understanding the general trend towards more investor-favorable terms in VC financing the past few quarters. The chart below shows that two standard terms – the type of dividends on preferred stock and the liquidation preference multiple – have moved distinctly in the investors' favor over the past six months after moving in the other direction most of the prior three years. Meanwhile, the percent of rounds that include participating preferred stock has remained fairly steady. While it's hard to draw too many conclusions without knowing how these changes break down by the stage of the investment, the overall trends are still notable. 

The increase in cumulative dividends – dividends on the investors' preferred stock that do not require approval of the company's board of directors and, unless waived by the investors, must eventually be paid out in cash or converted to stock – is understandable in a market with high inflation and even more uncertainty than usual about the prospects of achieving a good exit. The potential economic impact of dividends is most significant if the company is eventually sold for a modest amount that is neither a failure nor a home run. If a company is wildly successful, the value of the dividends relative to the overall returns to the stockholders will be trivial, and if a company fails there will not be any money to pay dividends. Between these extremes, however, dividends can take a significant bite out of a founder’s payout when her company is sold.

So long as the the liquidation preference is not "participating" (more on that below), the increase in deals with a liquidation preference greater than 1x has a very similar effect to cumulative dividends in that it is most meaningful where the eventual exit is neither a home run nor a fire sale. The difference is that while the impact of cumulative dividends increases over time the liquidation multiple is the same whether the company is sold in six months or six years, which makes it a much harder pill to swallow for companies expecting an exit in the near term.

At first glance it may seem surprising that in a particularly investor-favorable fundraising environment the percentage of deals with "participating" preferred stock – which gives investors the right to receive the preference amount and share with the common stockholders, on an as-converted-to-common basis, in the distribution of any remaining proceeds (this is generally referred to as “double dipping”) – has not significantly increased in the past year. However, the participation aspect of participating preferred stock only comes into play if the proceeds generated from a sale of the company are enough to cover the liquidation preference and then some; if the proceeds are not enough to cover the liquidation preference the participation is irrelevant. For that reason, if investors are expecting more middle-of-the-road exits over the next few years, it stands to reason that they would be more interested in cumulative dividends or a higher liquidation preference multiple than in participating preferred. That investors are using their additional leverage in this way suggests they are not expecting a quick return to the halcyon days of 2021.