Macro volatility gives investors opportunity to target growth equity at a discount

Issue

The current macro instability and associated fall in public equities has left many privately held companies scrambling to avoid a down-round financing. Larger businesses at a later stage in their growth journey may be more comfortable issuing equity in less favourable periods, from founders feeling more financially secure to the company’s equity documents no longer having early-stage investor protections.

But if an early-stage company launches an equity raise that doesn’t match its preceding valuation, it will trigger anti-dilution provisions designed to ensure existing investors are not unfairly diluted. Down-round financings are therefore about more than negative PR – founders hold a different class of share and invariably take a hit.

Towards the end of 2022 the prevailing trend was for founders to give more away to boost their equity value and avoid a down-round. Investors were able to negotiate significant perks and preferences that gave them added protections over existing shareholders in the event of an insolvency, along with enhanced information rights, better veto powers, preference dividends and more.

Unpriced instruments take variety of forms depending on parties’ risk appetite

However during 2023, while we have seen the market rebalance somewhat, deal terms remain stubbornly investor-friendly. To tackle this, companies are adopting tools that enable short-term financing to be raised without valuing the company at all, and which also avoid opening up a lengthy re-cut of the company’s constitutional arrangements.

These unpriced instruments take a variety of forms depending on the parties’ appetite for risk. In the past they were used to raise small amounts of money, for example during bridging rounds. But now we see the amounts invested creeping up.

This is likely due to a combination of increased familiarity with the instruments among the investor community, and also because they are used more and more to extend the financing runway, thus calling for larger sums.

Solutions

• Advanced subscription agreements or simple agreements for future equity (SAFEs) are among the most company-friendly options. Here, the investor provides up-front cash and receives equity at a later conversion event, whether that’s the next funding round (this is typically the case), a sale, an IPO, an insolvency or an agreed long-stop date. What makes these so company-friendly is the fact that, generally, the company won’t be required to repay the money.

The funds convert to equity at a discounted subscription price or with a valuation cap attached (the lower the cap, the better for the investor). For the business, SAFEs are fast, low-cost alternatives to equity issuance and are quick to negotiate.

On the flipside they may dilute existing shareholders and could also impact future funding rounds as new investors know they could be diluted from day one. Likewise, businesses with lots of convertible instruments can have complex cap tables that can result in heavy equity discounts if the terms don’t align.

For the investor, the fact SAFEs are interest-free is a risk if there’s a significant gap between the funds being paid and any trigger event, and they can be difficult to explain to investment committees as they carry limited investor rights. Most importantly, if the company fails or gets into financial difficulty, it is highly unlikely that the investor will see any value returned in the SAFE.

• Convertible loans work in a similar way, allowing investors to exchange debt for the most senior class of equity at specified future trigger points. Unlike SAFEs, most convertibles accrue interest (which can also be transferred for stock) and have repayment mechanisms, giving greater protection on an event of default.

Greater protections in convertible loans make them more palatable to ICs

Again they convert at a discounted subscription price or with a valuation cap applied, and generally have a maturity date. Convertibles have similar pros and cons as SAFEs and ASAs, although their greater protections make them more palatable to investment committees (ICs). For companies, taking on debt with a repayment date comes with risks, particularly in the context of a scaling business which may not yet be profitable.

• Keep it simple securities (KISSs) share common features with ASAs and SAFEs, with debt converting to discounted equity upon a future trigger event. However they often have debt-like features (eg interest rates, repayment/default mechanics) and may be issued simultaneously to a range of investors on identical terms.

Importantly, KISSs also carry “most favoured nation” rights as standard that enable an investor to participate in all subsequent funding rounds, making it a much more valuable instrument from the investors’ perspective. Typically more tradeable/transferrable than a SAFE or an ASA, KISSs will often convert automatically when the company raises $1m or more, although this can be negotiated. As with the instruments outlined above they raise the risk of dilution and can make cap tables complex, while the fact they are less common outside the U.S. can make them more challenging to agree.