For startups, investor money now comes with many strings attached

The end of the easy money era, rising interest rates and the rout in technology stocks have prompted investors to become more cautious. With heightened risks, investors are adding stringent conditions to the term sheets to ensure their investments don’t blow up.

The terms range from negotiating higher liquidation rights to mechanisms to claw back founders’ shares if they exit the startup upon vesting to valuations based on internal rate of return (IRR), multiple investors and founders said.

For instance, the founders of a health-tech company that recently raised a seed round were told a part of their stake would be clawed back should they leave the company, one of the founders said, requesting anonymity.

“Investors are no longer doling out largesse. They are in no mood to humour founders any more,” he added.

Some investors, founders said, are putting in an IRR based clause, which makes the convertible securities they hold less risky in case of a tepid market or if the next round of fundraising takes longer than estimated.

In this case, the investor gets shares at a discount to the valuation in subsequent rounds. The longer it takes to raise the next round, the higher the valuation discount.

A growth-stage private equity investor said he had secured senior liquidation preference rights on his most recent transaction, which was hard to get last year.

A liquidation preference right allows investors to get paid first in the event of an exit or a liquidation. An investor with senior liquidation preference would get priority over some other classes of securities.

A second startup founder said that investors could also negotiate a higher sum—around 1.15 to 1.25 times the principal investment—in their liquidation preference agreements.

In some cases, terms in the share purchase agreements are being enforced more rigorously, especially in the case of ‘reserved matters’.

“Some of us had a few things that could be done without going to the board. Sometimes, even if it was in the agreement (as reserved matters), it was not enforced, but today, investors want a greater say,” the founder of a unicorn said, also requesting anonymity.

Reserved matters refer to a list of items in a shareholder’s agreement that need a sign-off from the majority of the board, including investors.

Typically, it includes strategic items such as a decision on an IPO or an acquisition or a sale of a particular business; but sometimes, investors also seek to sign off on new business lines, borrowing or commercial business transactions, or related-party transactions. Getting approval from investors on minor business decisions can be challenging for a founder.

“We are able to get better covenants on agreements which allows investors more protection. It is easier to get ‘senior liquidation preference’ or add to the list of ‘reserved matters: that require investor consent,” said Sudip Mahapatra, a partner at law firm S&R Associates.

This may continue for a while till there is a reversal in the sentiment, said Manish Kheterpal, founder and managing director of WaterBridge Ventures, an early-stage venture capital firm. “Smaller rounds, internal investor-led rounds are the norm, especially for later stage investing. There are early signs of down rounds as well and more onerous terms like higher liquidity preference for new rounds of funding”, Kheterpal added.

Investors are also asking founders to work towards stronger unit economics, reduce cash burn and think about business sustainability, he added.

To be clear, many of these clauses kick in only if the business fails or stares at a total shutdown. But that investors are now asking for such clauses to be included indicates their anxiety.

Transitional markets like the ones we are seeing now are tough to navigate for investors, argued Kashyap Chanchani, managing partner, The Rainmaker Group. “Firstly, you don’t know whether giving 4X or 10X of revenues is a fair entry valuation. Secondly, there is a risk whether the investee company will have sufficient liquidity to live out the funding winter,” he said.

“A structured round protects the downside risk for the investors—an iron glove in case an investment ends up being a falling knife. For founders, it gives them the much-needed liquidity immediately, putting the onus of value discovery to sometime in the future,” he added.

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