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Surprise! A new Silicon Valley survey has found that 57 percent of venture capital deals in the first quarter saw their valuations fall. The study, a first by technology law firm Fenwick & West, quantified a trend that is already widely perceived amid a calamitous venture market and offers further proof that investors are imposing ever more draconian terms on entrepreneurs. “The results were more confirmation than revelation,” said Barry Kramer, a partner at Fenwick & West. “We know that fewer deals are getting done, that valuations are down and deal terms are tougher. But now we have the data so we don’t have to rely so much on our gut and we can track the situation to see if it is improving.” The Palo Alto, Calif., firm surveyed 45 technology deals in the Bay Area, all but 7 percent of which were follow-on rounds. Aside from the majority decline in valuations, it found 10 percent of the rounds were flat and 33 percent were uprounds, mostly among those deals that were Series A and B. Venture-backed companies are worth far less than a couple of years ago and often their valuations have dropped below the amount of capital they have raised. “It is obviously hard for companies to attract additional funds without some unusual terms,” Kramer said. The tough terms generally provide incentives for new investors and attempt to provide protection for initial investors. Liquidation preferences, which ensure that investors receive a certain return on their money before all the other involved parties in the event of an exit through an IPO or a trade sale have rebounded. The study found that liquidation preference in 62 percent of the financings during the first quarter were senior to the existing liquidation preferences, a percentage Kramer said was unheard of before the bust in early 2000. Most of the so-called senior liquidation preferences were arranged for later rounds, with 44 percent of the Series Bs including the provision increasing up to 100 percent of Series E and higher. Of those, 58 percent provided for a so-called multiple preference. That’s when an investor receives a multiple of the original investment. For instance, an investor with a two times liquidation preference on a $5 million investment would receive the first $10 million thrown off by a sale. Even more drastic, one-third of the deals called for three times or more of the original investment, potentially leaving entrepreneurs with little or nothing. “The new investors want to get their money out first before everyone else,” Kramer said. “Without that, there is less incentive to put in money.” The survey also noted that nearly one-third of the deals included ratchet anti-dilution provisions and more than two-thirds provided for weighted average anti-dilution provisions. “VCs in this environment obviously want to know that if they invest now and the company raises funds at a lower price their shares will not be diluted — the provision retroactively adjusts the price of their shares.” Weighted average provisions, which Kramer said are more friendly to management, considers the number of shares issued in the round in direct proportion to all of the outstanding capital of the company when making adjustments. A full ratchet considers only the price of the diluted shares regardless of the amount that has been issued. The latter can mean trouble for management of funded companies since their stake in company can be diluted more severely. “Funded companies hate ratchet provisions,” Kramer said. “VCs use it sometimes, when they can get it and when there is real uncertainty about valuation. On the other hand if the valuation is already very low then the ratchet is less important to them.” Pay-to-play provisions have also become popular, with 20 percent of the surveyed deals using them. This arrangement forces prior investors to return under the threat of subordinating their preferred stock if they don’t. In the deals studied, 56 percent of the pay-to-play provisions converted and subordinated non-participating investors’ preferred stock into common stock. “Two years ago the situation was almost the opposite,” Kramer said. “Everyone was fighting to get as much of the deal as possible previous investors didn’t want others to play.” VC are also looking to lock in an exit strategy through redemption provisions. In 36 percent of the fundings surveyed, startups agreed to buy back the shares of the venture investors at an agreed-upon date. “These provisions are not unique to other financial transactions, but seeing these in the venture capital world is significant,” said Jonathan Aberman a partner at Fenwick & West. “It puts the VC in the position to force a company to sell since more likely than not, the company won’t have cash to buy out the investors position.” �Copyright 2002, The Deal, LLC. All rights reserved.

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