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The legal complexities of late stage tech deals

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Co-authored by Dylan Kennett, associate at DLA Piper, and Louis Lehot, a partner at DLA Piper, this article explores how tech investors are seeking greater downside protections in deals.

Valuations of double digit multiples are often no surprise when it comes to technology companies, whether in Silicon Valley or here in the UK. Commonly known as “unicorns,” they are often defined as private companies valued at over $1bn. There are currently 169 unicorns globally with a cumulative valuation of $609bn and whilst they remain a somewhat exclusive club, they are frequently associated with technology startups – and by extension, deep pocketed investors.

This is not another article about unicorns and the ‘inevitable’ pop of the tech bubble, rather, how some tech investors in the private markets in 2016 are showing discipline and proposing ‘downside’ legal protections in deals.

Putting quality first

Investor appetite is evolving and the bar has risen for quality. Over the course of the last year deal volume has dropped significantly and funds invested have reduced rather modestly. Global economic and political uncertainties partly explain the change (and it is currently unclear how the UK’s recent vote for to leave Europe will impact VC activity, both in the UK and in the US), but our experience shows a theme of disciplined and more measured approach to investing. The money remains out there and despite investors deploying their capital into fewer deals, the initial view on 1H 2016 is that we are going to be seeing some big valuations and large sums of money invested, especially at the Series C and D rounds.

Where investors previously valued tech companies that championed “growth at all costs,” this ethos may not have necessarily delivered the companies they had hoped in the longer term. Having watched growth vectors maturing among the big tech stars, or having felt the impact directly through portfolio write-downs, we are seeing investors in both the US, UK and Europe becoming more reserved and seeking greater downside protections attached to their money.

Adding to the mix, we are also seeing strategic corporate venturers and non-traditional tech investors (so-called ‘crossover investors’) such as sovereign wealth funds and mutual funds. These players, who perhaps have less risk appetite and therefore also assign more demands to their money, may well contribute to the overall environment.

Lofty private valuations are therefore at greater risk as complex legal protections in shareholders’ agreements aim to ground them in reality.  This is not necessarily a bad thing, as it focuses the mind of the investee company’s main decision makers – the board, as well as its shareholders – on what they truly value.

Conceivably many late stage tech companies are remaining private for much longer, possibly in fear of the IPO (and its heightened legal and financial scrutiny) lifting the veil and thus acting as an unfortunate down-round.

Investor protection mechanisms

Although more common in the US, similar protections are becoming the norm in British venture deals, especially at the late stage, as investors with deep pockets arrive later to the party.

The legal toolbox available for investors varies. From senior liquidation preferences, that protect investors when a company goes bust, by ensuring the latest investors’ money comes out first, to preferential, guaranteed or exponential returns for the investor on exit events (such as a trade sale); veto or blocking rights over when the company can IPO to a ratchet, a type of downside protection mechanism that ensures that certain shareholders – often the latest investor – are protected from a fall in valuation on an initial raise.

While many of these protections may come at the expense of the earlier round investors, these mechanisms have become increasingly commonplace and necessary to attract new rounds, at a time when companies are going deeper into multiple private rounds of funding and delay the once inevitable IPO.

A natural change

Following the performance (and dearth) of tech company flotations in recent months, companies are choosing to stay private for longer. However, this doesn’t mean that they have completely fallen out of favour and they should not rule out the IPO altogether.

Investors are focusing on companies with strong balance sheets or business models that show a robust plan to achieve profitability. It is becoming less about growing market share at all costs and taking advantage of short-term peak valuations and more about the long-term return that these investments offer.

Nonetheless, greater investor demands, such as some of the protections mentioned above, while casting a more detailed eye over the financials and assessing the long term prospects of companies is ultimately a positive for the future of the tech industry.

The future of tech

The US has encouraged a new way to approach tech investments, embedding different legal concepts to UK investors.

Silicon Valley is now a global phenomenon, and its markets reach well beyond the 101 and the 280.

We believe fast-growing companies should expect to see a more disciplined and measured approach from the investment community in 2016, wherever they may be.

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