Although the value crisis in high-tech companies began with declines in public shares, it also gradually permeated the market of private companies – that of start-ups, growth companies and unicorns.
The current crisis has created a new problem for private high-tech companies that depend on fundraising to keep moving: unprofitable technology companies that used to raise millions of dollars once a year or a year and a half, will now have to work hard to persuade investors to invest above their previous fundraising value.
Whereas in previous years, which were characterized by years of prosperity in the high-tech field, investors softened their investment conditions in favor of entrepreneurs, and did not demand special protections for their money – the situation is now about to change.
With the onset of a new crisis, senior executives in the high-tech industry are predicting the return of exorbitant conditions to the investment rounds that may come at the expense of entrepreneurs, previous investors and employees – often without the knowledge of the latter.
Globes reviews the mechanisms that may “star” in the near future and that are expected to significantly limit employees’ exits when selling or issuing in the future.
Mechanism 1: Investors will inject capital and get more
First, we will try to explain what causes investors to be impatient (or have more demands) for high-tech companies.
The value crisis in public high-tech companies has also seeped into private companies. Both of these phenomena are caused by the same reasons in general: rising inflation and interest rates, and fear of economic slowdown. The rise in interest rates lowers the amount of capital that investors can raise in order to invest in high-tech and increases the cost of loans taken by technology companies; Inflation, for its part, reduces the capital available among consumers to shop for luxury goods, among other things.
These phenomena have made high-tech investors – venture capital funds and private equity – less tolerant of continued support for distant companies. This is despite the fact that investors have raised billions of dollars in the last year.
Since the value of public companies crashed on average between 60% and 90% compared to the previous summer, investors are pushing entrepreneurs of private companies to lower the value of the company they set up during the capital raising. But such a move – known in the industry as a “down round”, a new round of investment that reduces the value of the company, may leave employees “out of money”, ie with an option price higher than the share price, and lead to a general drop in morale and employee departure.
To avoid such a situation, in recent weeks investors and entrepreneurs have begun to reach an agreement on freezing the value of companies. In what is called a “fencing” round of raising, existing investors in companies agree to inject capital into the company while freezing the value, in order to receive a 20% or 30% discount on their investment in a future round of raising, while diluting employees, entrepreneurs and early investors.
“Currently, fencing is mainly seen, such as those that postpone the company’s determination of the future value,” says Adv. Eyal Shenhav of the Gross firm, whose clients include Israeli and foreign venture capital funds.
Dr. Eyal Shenhav / Photo: Osnat Rom
“But the correction in the private market following the public market is only in its infancy. Some companies have fallen 80% or 90% in their stock market value, and this has not yet happened in the start-up market, so I think we will soon see more significant protections for investors. Rights for investors in Exit that give them priority or an option for additional investment. “
Mechanism 2: Investors will require exit priority
Another mechanism that has almost disappeared from the world in the days of prosperity is one that gives investors a higher priority in exit – over employees, entrepreneurs, or other investors who have not sought such protection. An unprotected investor will usually receive his proportionate share of the company shares along with the rest. For example, an investor who has invested millions in exchange for 10% of the company’s shares will receive $ 10 million when it is sold for $ 100 million.
In the coming months, Shenhav predicts, investors will continue investing in the company or entering a new company with additional protections that have not been seen in Israeli industry for several years. First, investors may demand a higher return on their investment in the so-called participating preferred mechanism, so that an investment of 10% in the company will actually give them 15% or 20% of the company’s receipts in the event of a sale, in addition to the $ 10 million they originally invested. , What is known as the “Double Dip” mechanism.
Investors may also demand interest on their investment amount so that instead of getting a 10 million return on exit, they will be able to demand a higher amount. These additional millions of dollars will inevitably come at the expense of unprotected workers, entrepreneurs and investors.
Mechanism 3: Allocation of options to investors as well
In the last two years, high-tech workers have learned to appreciate the contribution of the options granted to them as a key component in their pay package, at least until last summer. With the advent of hard times, investors also tend to demand their own options. It is estimated that investors are likely to demand investment options (Warrants), which give them an option to increase their investment and benefit from larger analysts in the exit.
For example, a fund that invests $ 10 million in exchange for 10% of the company may now require an investment option of $ 10 million in exchange for an additional 10%. If the company closes, the fund will lose only $ 10 million, but if the company is acquired, it will have the option to inject the remainder of the amount it promised in exchange for 20% of the company’s shares. If the company is sold, for example for $ 1 billion, the fund will receive $ 190 million at the time of exit instead of $ 100 million if it had not been given the option.
In recent years, these special conditions have almost disappeared from the market. According to a report by the law firm Wilson Soncini, the proportion of investors who did not apply for preferential terms (non-participating) stood at 84% while in 2021 it stood at 90%, and in the first quarter of the year rose to 92%. The proportion of investors who sign up for another mechanism called Pay to Play, ie the possibility that entrepreneurs will “strip” investors’ preference shares of excess rights if they refuse to continue providing additional financing to the company according to their relative share in the company, also peaked in recent years. .
Latest to know: Employees will be updated retrospectively on dilution
Preferred terms for investors is not an invention of the current crisis. In periods when bargaining power returns to the funds, they are able to achieve strong defenses against loss scenarios. Recruitment with such extensive protections will allow the company to maintain a high valuation visibility, and even reach the $ 1 billion mark and be considered a unicorn, even if the company’s fair value is cut. This is because the value that companies report is based on preference shares with the same strong protections, while the rest of the shares have inferior rights and are accordingly less equal.
“Researchers who examined more than a hundred unicorns demonstrated in 2018 how the excess rights of the funds increase the reported value of the company on the one hand, and decrease the value of ordinary shares, on the other hand. Aran, Corporate Researcher in the Faculty of Law at the University of Haifa.
Dr. Yifat Aran, University of Haifa / Photo: Adv. Boris Feldman
“For example, in a scenario where a company raises $ 100 million at a value of $ 1 billion after the money, if instead of raising with standard hedging losses investors are given preference shares with the right to a double refund of the amount they invested before the ordinary shareholders participate in the distribution, The company will grow from 28% to 110%, which means that every dollar that employees think they have is actually worth less than half a dollar. 36%, while the fair value of the company decreased by 67%. “
Dilution of employees is no different from dilution of any entrepreneur or investor who holds ordinary shares of the company. However, employees are usually the only one who does not share the secret of the dilution, since the entrepreneurs in the private companies are usually satisfied with a laconic recruitment notice that does not list all its conditions, especially if these conditions were done to the detriment of the employees.
Elon Musk. The Case of Spice X / Photo: Associated Press, Ringo HW Chiu
“Most employees can not know what is going on around the board table and what the implications will be for their options,” says Shenhav. “Theoretically, an assessment can be made by removing printouts from the Companies Registry, but this is an effort that is not suitable for everyone, and in any case greater transparency is needed on the part of the developers to share with the employees what is happening in their stock portfolio.”