Why East Coast VCs are better protected if the market slips

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A new trends report published by the law firm Cooley report suggests that the venture market remains largely healthy for now. In the fourth quarter, for example, Cooley handled 187 “disclosable” (versus stealth) deals that represented more than $2.7 billion of invested capital. That’s 18 percent more deals than it closed in the fourth quarter of 2015 — though the amount of money involved fell 23 percent from the year-earlier period. (VCs were writing smaller checks into a greater number of startups.)

Of slightly more interest to us were the deal terms involved in these fundings, some of which suggest that East Coast VCs have more safeguards than their West Coast peers if the market changes.

We talked with one of the study’s authors, Cooley attorney Dave Young, about what he found and what it might mean.

TC: This report seems pretty positive on its face.

DY: I think it shows a surprisingly strong, healthy venture market. In 2015, there was this sense that maybe things were getting overheated, with nontraditional investors coming in and leading later-stage rounds in companies that hadn’t proven themselves yet. And that led to the view that things would slow down meaningfully in 2016. That didn’t really happen, though. People were being more disciplined around valuations and the size of rounds, but a lot of deals were getting done.

TC: You also focus on the terms in this report. Are you starting to see anything onerous? 

DY: I’d say founder-friendly terms are still really prevailing, and by that I mean plain vanilla terms. Whenever we inevitably head back to where the economy turns down, terms will get tough, and the levers will shift back toward [investors].

TC: So no pay-to-play provisions [meaning if a company needs to raise money and resorts to insiders for it, those who can’t or don’t want to contribute their pro rata share will see their preferred shares reduced to either common stock or some other subset of equity with fewer rights]. I think there was some expectation that those would start reappearing in deals as this tech boom runs on and on.

DY: We’re seeing some, but it’s been steady over the last three or four quarters or so, which is a good sign. We’re seeing them in situations when it makes sense — when it’s the right tool for that particular situation. But it’s not something people are defaulting to.

That said, sometimes with those down rounds and recaps and pay-to-plays, there’s a bit of a lag, because if companies are having a hard time getting funded, earlier investors will put in six, nine, 12 months of cash. If you have $10 million in a company already, you’d rather do that than see it crater. But you only do it once. Without a new lead investor and a new plan, those companies [are going to go out of business].

TC: East Coast investors have historically been a little more metrics-driven than West Coast investors. Is that still true and does that impact how the market could shake out if there’s a downturn?

DY: This has always been the case, but you see East Coast terms that are way more investor favorable, compared with West Coast [terms]. It’s more surprising to me that that hasn’t changed over time.

TC: How do the terms differ, exactly?

DY: In East Coast deals, you see more of what are called redemption provisions and cumulative dividends. Redemption provisions basically give investors the right to be bought out four or five years down the line — to get their money back if a company joins the living dead. They’re very rarely seen in Silicon Valley, but they appear in 25 to 30 percent of the deals on the East Coast.

Cumulative dividends are interest that accrues that you get upon a company’s exit, so you don’t just get your liquidation preference but also 6 to 8 percent [interest] per year on our investment, which is very rare in Silicon Valley and probably a part of 20 percent of East Coast deals.

TC: Interesting! Before we go, how are you feeling about President Trump and the deregulation that’s expected to be a feature of his administration?

DY: I think with deregulation and tax [cuts], it will add extra fuel to the fire, but at some point things have to slow down. We’re 7.5 years into this cycle, and these cycles run 7 years on average, so you’re kind of on borrowed time after a point.

The market seems surprisingly normal. But that a lot of deals are getting done doesn’t mean a lot of [follow-on] deals are getting done. At least, in the last couple of downturns, VCs kind of nursed their own portfolio companies. They’d give them 18 months of cash, tell them to cut their burn, and hope to get them through [the downturn]. But they do stop funding each other’s deals [when things turn], and the whole venture system is built around having a new lead investor. When it stops, that’s when things hits the skids.

Featured Image: Amanda Hall / robertharding/Getty Images