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With down rounds looming, startup founders have a lot less dealmaking leverage than they did in 2021. If new to the fundraising game, the changing market will require an accelerated class on less-favorable term sheet provisions like liquidation preferences. The information may have been forgotten during the last cycle, but at least it’s available, which is less the case for university spinouts and M&As. Let’s dive in. — Anna
Investor protections are back
When it comes to startup fundraising, there’s a lot more open discussion these days around deal terms than there was 10 years ago. But with founders only getting a few coin tosses in their lives, compared to the multiple deals that VCs and lawyers get to see, it is as important as ever for entrepreneurs to understand what they are signing onto.
“Deal terms look different in a downturn,” my colleague Rebecca Szkutak wrote. The lawyers she talked to predicted that certain clauses meant to protect investors are going to make a return — which also echoes what we are hearing through the grapevine. Among the provisions to watch out for are liquidation preferences, pay-to-play, and antidilution protections, including the dreaded full ratchet.
Founders won’t always have enough leverage to say no to these terms. They may also be a trade-off to secure a higher valuation. On the other side of the table, investors would be breaching their fiduciary duty if they didn’t try to generate the largest return possible from their funds. The key here is to reduce information asymmetry to make sure that entrepreneurs are familiar with the new type of term sheets they may be presented with.
The good news for startups is that there is a lot of information available on term sheets. When the book “Venture Deals” first came out in 2011, it was one of the very few resources first-time founders without a network could use to learn about deal terms. It has been reedited multiple times since then, but there are now plenty of other resources available, such as Mountside Ventures’ recent report, Demystifying Venture Capital Term Sheets.
Over time, more information shared about deal terms led to a certain standardization in term sheets, also helped by innovations such as Y Combinator’s SAFE. However, that same level of transparency and standardization is still out of reach in other instances of startup life, such as spinning out of a university or being acquired.
Put your collar up
While there may be information asymmetry between founders and investors, pretty much nobody has as much expertise as M&A lawyers.
For instance, when the news emerged that Glovo’s acquisition by Delivery Hero was closing at a much lower price tag than originally estimated, corporate lawyer David Miranda pointed out that a “collar” could have prevented the issue. The provision can establish a fixed range for the stock with which the acquirer is paying for a deal.
A collar can make a huge difference when a merger takes time to close, as stock can fluctuate a lot over that period. This is what happened to Delivery Hero: Its shares plunged almost 60% in Q1. The difference for Glovo is huge, as its price tag plummeted from €2.3 billion to €800 million ($2.6 billion to $811 million). As Spanish financial newspaper Cinco Días noted, Glovo’s shareholders will definitely have to take this into account when deciding when to sell their shares.
It is worth noting that it wasn’t necessarily unfair to Glovo that the deal didn’t have a collar. “I guess it was not considered necessary as buyer and seller are in the same industry and it was felt that fluctuations should affect both companies,” Miranda said.
Taking this one step further, it could be argued that Glovo is partially responsible for Delivery Hero’s troubles: “The Glovo deal continues to baffle us,” an HSBC analyst declared last March. And the fact that the deal is now under antitrust scrutiny likely won’t help either.
Still, from drag-along to leveraged buyouts, it’s hard not to feel out of depth when dealing with M&A terms and concepts. But luckily, startups that get to this stage have expert counsel. In contrast, their peers who start university spinouts often lack guidance, leading them to accept onerous deals that could derail their companies even before they really get started.
Bringing transparency to university spinouts
Air Street Capital partner Nathan Benaich has long been advocating for better terms for university spinouts — startups born out of educational institutions. He thinks deal-terms transparency can help. “Founders often lack information to negotiate their spinout deals,” Benaich wrote. “They end up with unfair deal terms and an unnecessarily awful spinout experience.”
This desire for increased transparency led Benaich to launch the Spinout.fyi database, a crowdsourced resource on spinouts. With some 140 entries so far, it shows that terms can vary a lot, especially equity retained by the universities.
Commenting on the data, Spinout.fyi noted that “on average across all locations, universities took a 12.8% equity stake in spinouts. But the founding equity take ranges by universities is very wide, from 0% to 70%.” Yes, you read that right: Some founders gave up 70% of their ownership to their backing institution — not exactly starting their startup journey on their best foot.
On average, the equity percentage retained by universities is particularly high in the U.K. — 19.8%, compared to 7.3% in the EU and 5.9% in the U.S. This hasn’t entirely prevented successful spinouts from emerging out of British institutions. Just a few days ago, TechCrunch reported that an Oxford University spinout, Oxford Quantum Circuits, had raised a $47 million Series A round.
Still, more transparency should give European and British founders more leverage when negotiating with their universities — and making sure onerous terms won’t kill their venture (or their motivation) before they reach their next round. This is important for founders, but also for their countries. As we reported, university spinouts have a key role to play for deep tech in Europe.
From launching a startup, to fundraising for it, to selling it, founders deserve a clear understanding of the deals they are negotiating, and how these will play out in the long run. Maybe not to get the best terms in the world — beggars can’t be choosers, and leverage has changed hands again recently — but they should at least know what they are getting into.