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Trends in Deal Terms (3Q, East Coast)

Jonathan Aberman and David Dutil, Fish & Richardson, PC


Set forth below are our findings based on a review of the 34 publicly-reported venture capital financings that took place in the Mid-Atlantic region during the third quarter of 2003.

Financing Round

The financings we reviewed ran the gamut from Series A to Series F with a distribution as follows:

Series Current Quarter
A 11 out of 34 or 32%
B 5 out of 34 or 15%
C 9 out of 34 or 26%
D 1 out of 34 or 3%
E 6 out of 34 or 18%
F 2 out of 34 or 6%

Price Direction

Overall, a significant majority of transactions were Down Rounds.

Price Change Current Quarter
Down 22 out of 28 or 79%
Unchanged 1 out of 28 or 4%
Up 5 out of 28 or 18%

There was no statistically significant variation within the various rounds:

Series Current Quarter
B 4 out of 5 or 80%
C 7 out of 9 or 78%
D or later 6 out of 9 or 75%

Cumulative Dividends

Overall, a significant majority of transactions included cumulative dividends:

Current Quarter
23 out of 34 or 68%

There was no discernable pattern within the various rounds:

Series Current Quarter
A 8 out of 11 or 73%
B 5 out of 5 or 100%
C 5 out of 9 or 56%
D 1 out of 1 or 100%
E or later 4 out of 8 or 50%

Liquidation Preferences

Preference Multiples

Each deal had a Liquidation Preference for the most recent round that was at least pari passu with previous rounds, and in almost every case the latest round was senior to previous rounds. The preference multiples had the following distribution:

Liquidation Preference Current Quarter
1X 22 out of 34 or 65%
1X - 2X 8 out of 34 or 24%
2X-3X 0 out of 34 or 0%
3X+ 4 out of 34 or 12%

Participation

While the Liquidation Preference multiples were fairly low, almost every deal included participation for the most senior series of Preferred Stock:

Current Quarter
28 out of 34 or 82%

Redemption

Mandatory or Voluntary Redemption provisions are a staple term of most deals in the region:

Current Quarter
27 out of 34 or 79%

Antidilution

Full Ratchet Antidilution Protection is used in a significant number of deals.

Antidilution Type Current Quarter
Full Ratchet 17 out of 34 or 50%
Weighted Average 17 out of 34 or 50%

Pay to Play

Pay to Play provisions were not present in significant numbers in the most recent quarter and such deals were evenly divided between those that forced conversion to Common Stock versus those that forced conversion to a shadow Preferred Stock:

Conversion to Current Quarter
Common 2 out of 34 or 6%
Shadow Preferred 2 out of 34 or 6%

Corporate Reorganization/Recapitalization

A few of the transactions we reviewed included a Reorganization or Recapitalization where the outstanding capital of the company was significantly changed at the time of the financing.

Current Quarter
5 out of 34 or 15%

The two types of reorganizations that we found were (1) reverse splits (aka combinations), which were present as follows:

Current Quarter
3 out of 34 or 9%

and (2) forced conversion of senior securities into junior securities:

Current Quarter
5 out of 34 or 15%

Conclusions

The overall dollar level of venture investment in the Mid-Atlantic region continued to decline in the Third Quarter of 2003 from the historical highs of mid-2000. Nevertheless, anecdotal data suggests a resurgence of transaction activity in the pipeline for the Fourth Quarter of 2003, continuing into 2004.

A comparison of this quarter's data with publicly available historical data suggests that actual Series A Rounds (i.e., a Round not coupled with a restructuring or recapitalization) are increasing as a percentage of transactions. Additionally, it appears that Liquidation Preferences are trending back towards a customary 1X to 2X level. Down Rounds continue to constitute the great majority of financings, which suggests that the "post bubble" price correction continues. Also, interesting is a decline in the number of restructuring transactions, which also suggests that the companies that are able to obtain venture financing are generally progressing in a way that does not require draconian measures to obtain the financing.

The combination of a healthier technology stock market, a higher percentage of truly "new" Series A deals, and a lower number of restructuring transactions, leads us to believe that the venture market is much closer to the end of its "post bubble" adjustment than the beginning. If this is correct, we would expect to see a higher percentage of Up Rounds in subsequent surveys.

We do not see this market returning to 2000 levels any time soon (if at all), but are optimistic that 2004 will be a good year for venture participants.

For further information Please contact Jonathan Aberman (aberman@fr.com; (202) 626-7703) or David Dutil (dutil@fr.com; (202) 626-7702). Jonathan and David are attorneys at the Washington, DC office of Fish & Richardson P.C.

Methodology

We defined the Mid-Atlantic Region as North Carolina, Virginia, Washington, D.C., Maryland, Delaware and the area of New Jersey and Pennsylvania south of Princeton. We reviewed 34 Preferred Stock investments made by venture capitalists within the Mid-Atlantic Region during the period July 1, 2003 - September 30, 2003. For preparation of our survey we examined publicly available sources and gathered additional information and insights on a confidential basis from market participants.

We counted an Antidilution Protection as Full Ratchet even if the ratchet expired after a condition, such as the passage of time, was met. In addition, we did not break down whether Weighted Average Antidilution was Broad or Narrow.

Percentages in the charts may not add up to 100% due to rounding.

Please see the attached glossary for an explanation of the terms used in this survey.

Venture Capital Glossary

The following is a general review based upon standard practice among venture capitalists and does not constitute an opinion or legal advice. Many of the terms are loosely defined in practice and there are exceptions to every rule, but we have created definitions based upon the most common usage. For further information Please contact Jonathan Aberman at aberman@fr.com; 202 626-7703 or David Dutil at dutil@fr.com; 202 626-7702. Jonathan and David are attorneys at the Washington, DC office of Fish & Richardson P.C.

Antidilution Protection: Broadly, purchasers of shares in venture financings look for protection against subsequent offerings at lower prices, as well as structural protection against changes in a corporate structure (such as a stock split or recapitalization) affecting in itself the pro rata portion of the company of originally purchased. Antidilution Price Protection gives investors in early rounds the benefit of a reduced effective price per share if the company later has a Down Round. Antidilution Price Protection is accomplished by changing the Conversion Ratio and comes in two basic flavors, Weighted Average and Full Ratchet.

Full Ratchet Antidilution Price Protection: "Full Ratchet" (sometimes called "Ratchet") Antidilution provisions reduce the effective per share purchase price of the investor's shares purchased in a round to the actual, lower price set in a later offering or event (for example, a subsequent financing round or issuance of shares as consideration for a transaction) thereby raising the number of shares of Common Stock into which the investor's Preferred Stock will convert. Full Ratchet is more favorable for the investors who receive it and can result in significant dilution for founders and other holders of Common Stock in the event of a Down Round.

Weighted Average Antidilution Price Protection: Weighted Average Antidilution provisions reduce the effective purchase price per share of the investor's shares purchased in a round by a weighted percentage reduction determined by reference to the price decrease and the comparative number of cheaper shares issued to the total number of shares outstanding.

There are subcategories of Weighted Average Antidilution Price Protection, Narrow Based and Broad Based and each of these two terms has fairly loose definitions. Generally the main difference is in the definition of outstanding shares, with a more broad definition having the result of lessening the price effect of a Down Round on the effective price of an earlier offering. For example, a Narrow Based Weighted Average Antidilution Price Protection Provision might include only Common Stock and convertible Preferred Stock then outstanding, while a Broad Based Weighted Average Antidilution Price Protection Provision would include Common Stock outstanding or issuable upon conversion or exercise of all Preferred Stock, warrants, convertible debt, options and any other contingent right to Common Stock.

To summarize:

  • Broad Based Weighted Average - most favorable to company/founders
  • Narrow Based Weighted Average - in the middle
  • Full Ratchet - most favorable to investors

Antidilution Protection of a non-price based nature would be protection against changes to the Conversion Rate in the event of a stock split, stock dividend or similar reorganization. Normally, when investors and venture market participants talk about "Antidilution Protection" they are referencing Antidilution Price Protection.

Common Stock: The standard unit of equity in a company. Common Stock is generally held by founders and some angels. Employee options typically convert into Common Stock. Common Stock is usually the type of security issued in a public offering.

Conversion Rate: The ratio at which each share of Preferred Stock converts into Common Stock. Venture Capitalists typically purchase Preferred Stock that converts into Common Stock at a stated ratio, usually one to one, which then may adjust based upon triggering events such as a Down Round in accordance with Antidilution Provisions.

Cumulative Dividends: Dividends that accrue at a fixed rate until paid are "Cumulative Dividends" which are payments to shareholders made with respect to an investor's Preferred Stock. Generally, holders of Preferred Shares are contractually entitled to receive dividends prior to holders of Common Stock. Dividends can accumulate at a fixed rate (for example 8%) or simply be payable as and when determined by a company's Board of Directors in such amount as determined by the board. Because venture backed companies typically need to conserve cash, the use of Cumulative Dividends is customary with the result that the Liquidation Preference increases by an amount equal to the Cumulative Dividends. Cumulative Dividends are often waived if the Preferred Stock converts to Common Stock prior to an IPO but may be included in the aggregate value of Preferred Stock applied to the Conversion Ratio for other purposes. Dividends that are not cumulative are generally called "when, as and if declared dividends."

Down Round: Issuance of shares at a later date and a lower price than previous investment rounds.

Issue Price: The price per share deemed to have been paid for a series of Preferred Stock. This number is important because Cumulative Dividends, the Liquidation Preference and Conversion Ratios are all based on Issue Price. In some cases, it is not the actual price paid. The most common example is where a company does a bridge financing (a common way for investors to provide capital without having to value the Company as a whole) and sells debt that is convertible into the next series of Preferred Stock sold by the Company at a discount to the Issue Price.

Liquidation Preference: The amount per share that a holder of a given series of Preferred Stock will receive prior to distribution of amounts to holders of other series of Preferred Stock or Common Stock. This is usually designated as a multiple of the Issue Price, for example 2X or 3X, and there may be multiple layers of Liquidation Preferences as different groups of investors buy shares in different series. For example, holders of Series B Preferred Stock may be entitled to receive 3X their Issue Price, and then if any money is left, holders of Series A Preferred Stock may be entitled to receive 2X their Issue Price and then holders of Common Stock receive whatever is left. The trigger for the payment of the Liquidation Preference is a sale or liquidation of the company, such as a merger or other transaction where the company stockholders end up with less than half of the ownership of the new entity or a liquidation of the company.

Participation: Describes a right of a holder of Preferred Stock to enjoy both the rights associated with the Preferred Stock and also participate in any benefit available to Common Stock, without converting to Common Stock. This may occur with Liquidation Preferences, for example, a series of Preferred Stock may have the right to receive its Liquidation Preference and then also share in whatever money is left to be distributed to the holders of Common Stock. Dividends may also be "Participating" where after a holder of Preferred Stock receives its Cumulative Dividend it also receives any dividend paid on the Common Stock.

Preferred Stock: The unit of equity in a corporation that is typically sold to venture and other institutional investors. Preferred Stock will usually have preferential rights over the Common Stock with respect to dividends, liquidation, voting, redemption and/or Antidilution Protection. There is nothing automatically "preferred" about Preferred Stock, but rather it has whatever rights are associated with the particular class or series as described in the company's certificate of incorporation. Preferred Stock can be subdivided into one or more different classes or series. Typically, the first series sold to investors will be designated Series A, the next will be Series B and so on. Series A is not necessarily better than Series B, rather the relative rights are governed by the company's certificate of incorporation and one series may have a better dividend preference while another may have a better liquidation preference. However, it is important to note that within a series all shares must have identical rights and be treated equally by the company.

Pay to Play: A "Pay to Play" provision is a requirement for an existing investor to participate in a subsequent investment round, especially a Down Round. Where Pay to Play provisions exist, an investor's failure to purchase its rata portion of a subsequent investment round will result in conversion of that investor's Preferred Stock into Common Stock or another less valuable series of Preferred Stock.

Redemption: The right or obligation of a company to repurchase its own shares.

Mandatory Redemption: is a right of an investor to require the company to repurchase some or all of an investor's shares at a stated price at a given time in the future. The purchase price is usually the Issue Price, increased by Cumulative Dividends, if any. Mandatory Redemption may be automatic or may require a vote of the series of Preferred Stock having the redemption right.

Voluntary Redemption: is the right of a company to repurchase some or all of an investors' outstanding shares at a stated price at a given time in the future. The purchase price is usually the Issue Price, increased by Cumulative Dividends.

Reorganization or Corporate Reorganization: Reorganizations are significant changes in the equity base of a company such as converting all outstanding shares to Common Stock, or combining outstanding shares into a smaller number of shares (a reverse split). A Reorganization is frequently done when a company has already had a few rounds of venture financing but has not been able to successfully increase the value of the company and therefore is doing a Down Round that is essentially a restart of the company.

Round: Investors typically buy a series of Preferred Stock within a short time frame and frequently all at once. Each of these investment periods is a Round and will generally be associated with a specific security. For example, a "Series A Round" is when a company sells its Series A Preferred Stock. A Round may be open for a stated period of time to enable the company to accommodate investors who require additional time and investors who may want to put their money to work sooner.