Venture Capital Lives, But The Rules Are Changing (Back).

The on-going shake out in the technology industry has had several effects on venture capital financing. Eighteen months ago, later round investors were calling in favors in order to have the opportunity to put their money into hot deals, where companies and early round investors were negotiating terms that gave the new money almost no rights. Now new investors are scarce and the old rule that "the new money makes the rules" is back in full force. Business people seeking venture capital should be aware of the issues now important to venture capitalists and how those issues affect the rights and financial opportunities of founders, management and other investors.

The good news is that many VCs in southern California are still investing, even if more slowly and carefully than in the recent past. Early stage companies are being funded by a number of southland VC firms that specialize in first round investment. Just as important, later stage funding, though often at reduced valuations, is available. Unfortunately, a lot of companies that would have gotten funding a year ago (and worse, many that did) are now being turned down.

By now, most everyone has heard that VCs have returned to fundamentals. No longer will funding go to business plans that extol "first mover advantage" or new paradigm business models that apparently don't involve revenues. VCs are focusing on more traditional business strategies that emphasize basics, like positive cash flow. In addition, they are much more focused on the economics of their deal with the company and, particularly in later rounds, the mix of control rights they share with other shareholders.

Later round investors typically put in the most cash at the highest price, and are now insisting on preferential rights that reflect the magnitude of valuation risk they are accepting. They are now insisting on voting rights from the company that essentially give them approval power over major decisions. Further, they are limiting the scope of similar rights held by earlier round investors so that only they wield that authority.

Another area where VCs are focusing on their rights relative to other investors is in provisions that penalize early round investors for failing to invest their proportionate share in later rounds. Often the obligation to invest is triggered by the vote of one major investor, or sometimes a small group of investors. These penalties typically involve a forced exchange of the non-participating investors' shares into a lower priority security. In milder cases, it is an exchange of the investors' preferred stock for a new, low priority preferred, usually with limited voting preferences. At the other extreme, it can mean a forced conversion of the non-participating investors' preferred stock into common stock, with forfeiture of the contractual rights usually available to converted preferred stock, such as registration rights.

The impact of these kinds of provisions sterns from the amount of power being granted, in many cases, to a single investor. The subordinate VCs don't like ceding that power, which means that, if they're already investors, they may want to reject the new money, and if they are potential new investors, but not going to be the leader of the new round, they may choose not to make the investment. Founders and management want to avoid impediments to attracting money, so this is a difficult situation for them. On the other hand, having one VC who calls the tune can streamline matters significantly if existing investors get fractious.

As to investment terms that focus on the company, and hence management and common shareholders, there don't appear to be any major new rights being designed. The trend is simply to make the typical venture investor rights more favorable to the investors.

One example that directly affects founders and management is the issue of acceleration of vesting for stock option holders upon a change of control, usually a sale, of the company. For management and founders, more acceleration means more vested share ownership, and therefore a bigger share in the payoff from the proceeds of the sale of the company. For VCs, acceleration means that more shares will be outstanding when it comes time to divide up the proceeds of the sale, which means fewer dollars per share. In addition, acceleration provisions may create a burden on the company's buyer that may lower the sale price, or even may drive the buyer away.

VCs are getting much tougher on vesting acceleration. Many are now insisting on no acceleration, although most will agree to a minor amount, triggered only upon both the sale transaction and the loss of the individual's job. With the demise of pooling accounting, we may see a return to no formal policy on acceleration, with boards of directors retaining the right to accelerate on a discretionary basis.

Investors also are getting much firmer on liquidation preferences. When a company is sold, the preferred shareholders get their money out first. The sticky point is what happens next. In transactions completed over the past several years, the VCs' preferred stock would share proportionately with the common stock on additional distributions until the total amount paid to the preferred shareholders reached some multiple of their original investment

Though the terms are stiffer, and the valuations are down, the good news is that the VCs are out there, lots of them have money, and they are investing it. Companies should expect VCs to present tough terms and should be prepared to expend some effort in blending together the rights of existing and new investors in a reasonable way. And there is no question that, dealing with these issues in the current market, companies need to plan for a longer cycle to close a venture transaction.

Dana Warren is a principal at Riordan & McKinzie in Los Angeles.