Q3 Venture Capital Terms: Like a Rolling Stone
For me, the latest venture financing report for the third quarter that ended September 30 brings to mind Bob Dylan’s revolutionary rock ballad, “Like a Rolling Stone.”
There is not only a sense of shattered hubris throughout the industry (granted, in some places more than others); there are no clear trends in the analysis of venture financings that the Cooley law firm recently released. Instead you see contrary indicators—some up, some down, some sideways. If there’s a trend, it is the aimless variety—with no direction home.
The report analyzes 92 deals nationwide with a total capital investment of approximately $988 million. The aggregate dollars and deal volume was generally consistent with prior quarters. So it’s been like this all year. (Bear in mind, these were all Cooley deals, which enables the firm to analyze the financing terms in detail. But Cooley deals represent only a portion of the venture survey totals we reported in October, based on stats from CB Insights and other sources.)
The law firm has made a complete version of its report available here.
In its analysis, Cooley characterized the quarter as “a mixture of optimism and caution.” The report shows a small decrease in “up” rounds, in which new investments are made at a higher price than previous rounds, and a corresponding increase in flat or down rounds during the quarter. Still, the majority of the deals were up rounds, and the percentage of up rounds, compared with flat or down rounds, was consistent with prior quarters. On the other hand, the report says that pre-money valuations were mixed, and it cited several other signs of investor caution. That wariness is reflected in these highlights:
—Median pre-money valuations, a term that refers to the valuation of a company prior to an investment or financing, increased to $7.8 million (from $7.4 million in the prior quarter) for Series A deals. It was the fourth consecutive quarter of increased valuations for Series A rounds, which is an encouraging sign for early stage ventures. Valuations for Series B deals increased sharply—doubling from $15.9 million in the prior quarter to $32.5 million—which Cooley suggests could be due to the year-long trend of increasing Series A valuations. On the other hand, valuations for Series C stage deals dropped to $34 million from $48.4 million in the prior quarter. And Series D deals decreased to $44 million from $50 million.
—The percentage of deals with a liquidation preference of greater than 1x increased in both Series A and Series B deals. This refers to the amount per share that a holder of a given series of Preferred Stock will get before any money is distributed to investors with lower ranking shares of Preferred Stock or Common Stock. It’s another sign of caution when the preferred shareholders at the top of the food chain insist on getting a payout that is a multiple (e.g. 2x) of other shares.
—The report notes that the use of “drag along provisions” increased to 76 percent, up from 60 percent in the prior quarter. The increase, “to levels not seen since 2008,” occurred across all series of financings. “Drag along” refers to a clause that gives a majority equity investor who wants to sell its stock to an unrelated third party the right to force other stockholders to also sell all or a portion of their shares to such third party.
—While the percentage of recapitalization transactions declined to 8 percent (from 10 percent in the prior quarter), the report says pay-to-play provisions increased to 13 percent for all types of deals, (compared to 11 percent in the previous quarter.) A pay-to-play provision requires an existing investor to participate in a subsequent investment round, especially a down round. The jump in pay-to-play provisions was bigger in later-stage deals—about half of all Series D and later rounds included pay-to-play provisions.
— The percentage of tranched deals, another signal of investor caution, increased to 27 percent in the third quarter (from 22 percent in the previous quarter). Cooley says the percentage of deals that were structured in tranches returned to levels seen throughout much of 2009.
—The percentage of third-quarter deals that included broad-based weighted average anti-dilution provisions declined to 78.5 percent. That compares with 91 percent in the previous quarter and 83 percent over the last two years. Dilution prevention provisions are designed to protect a venture investor from dilution that may occur in subsequent financings where stock is sold at a lower price than the investor originally paid—a so-called “down round.” It’s hard to say whether this one is a sign of optimism or caution, and Cooley did not provide an interpretation of what it means.