VCs: Tougher terms for investment deals

For a while, there was so much investment money looking for the next hot IPO that venture capitalists were forced to give up once-standard protections that gave them, for example, a seat on a company's board or oversight of a company's finances.

"That's the old environment," said lawyer Steve Bochner, a partner with Wilson Sonsini Goodrich & Rosati in Palo Alto, Calif. "Now VCs are taking their time and tougher terms are creeping back in."

Among them is the "living dead" clause that requires a company to return investors' money if the business is still operating after a specified period, but has little chance of going public or getting acquired--the two ways in which venture capitalists recoup their investments.

Another protection cropping up in offer letters, or term sheets, is a steep "liquidation preference" clause. Designed to protect an investor in a down market, it frequently calls for investors to not only get their investment back in the advent of a sale, but also a profit upward of four times their original investment. And that's before any other investors--even the company founders and executives--get a dime.

Also as part of this liquidation preference clause, some venture capitalists also want a slice of the pie that remains after they take their initial piece, which is doled out to the remaining investors and company officials.

"Investors who were involved in the first round are usually the ones who have the tougher term sheets," said Jim Koshland, a partner with Gray Cary Ware & Freidenrich, a Palo Alto, Calif., law firm.

Koshland noted that investors are going beyond the traditional request of just getting their money back and some of the remaining proceeds. Now they want a profit of two, three and sometimes four times what they initially invested.

"In the past, investors wanted some downside protection in a sale," Koshland said. "Now they want some upside protection added."

The new attitude stems from investors taking a bath recently on buyout deals where cash-strapped dot-coms sold for far less than investors envisioned.

Funding methods have also been tweaked to benefit venture capitalists, attorneys and entrepreneurs say. Traditionally, investors would issue the money in one lump sum without requiring that milestones be met along the way. Now funding is doled out in phases based on milestones achieved, especially for troubled companies.

"In the last five months, the revenue and liquidity outlook have not come to fruition and some investors are saying, 'We overpaid,'" Bochner said. "The gloves are coming off."

In one recent case, an institutional investor threatened to sue a semiconductor company that missed its milestones, Bochner said. The investor, who has already issued the funds, wants the deal repriced to reflect a valuation drop of 30 percent to 40 percent.

Entrepreneurs also have to contend with the return of the "full ratchet" anti-dilution clause. That calls for investors to have their stake reconfigured to the new valuation, if it drops in the next funding round. For example, an investor who paid $8 a share for a 10 percent stake would get more shares to maintain that stake if the next valuation dropped to $2 a share. That investor would basically pick up four shares for every $8 share he or she previously held.

"Before and during the Internet bubble, you'd typically see some standard-weighted average, or partial ratchet. Now, we're starting to see full ratchets. It's not sweeping across the industry yet, but they are popping up," Bochner said.

Vinodh Bhat, co-founder of New York-based Nano, a company that provides real-time connections to relevant information, said his company's financial advisers have warned him he may see full-ratchet requests when Nano begins seeking funding later this year. He noted those requests were absent when his company secured $3 million in its first round of funding in 1999 and $19 million in a second round last July.

"I can't blame the VCs for this. I know it's a function of the market and that's the way it is," said a circumspect Bhat.

Marco DeMiroz, managing partner with European Internet Capital's Palo Alto, Calif., office, has seen the challenges of entrepreneurs and venture capitalists from both sides of the table.

"If you have VCs exerting very difficult terms, or entrepreneurs doing the same, it doesn't help the deal," said DeMiroz, a former entrepreneur. "If you force something down an entrepreneur's throat, their excitement for the company will be affected. This is a long-term relationship and we want to make sure that when you look around the table, everyone feels good about each other."