The March 2023 collapse of the Silicon Valley Bank (SVB) sent shockwaves across the global tech industry. While we know that the consequences will be far reaching for the venture industry, the full effects will not be known for a while. The failure of the SVB could not have come at a worse time. Now more than ever the big transitions that we face in energy, healthcare, food, agri and deeptech need funding. Our Van Doorne venture capital (VC) team provides legal support for the funding of these innovative companies. With our blog-series, we hope to provide guidance on venture financings in the Netherlands which will support innovation. We do so by discussing the various terms and conditions that are typically found in term sheets agreed upon by VC investors with companies attracting capital.
The majority of the terminology used and the terms and conditions agreed upon in VC transactions originate from the United States (US) market. The US VC market is, in terms of funding, by far the largest VC market worldwide and therefore more mature and standardized than the European VC ecosystem.
The increasing number of successful innovative companies in the Netherlands, the Netherlands' ability to attract world-class talent and serve as one of Europe's main technology hubs for innovative companies, have made the Netherlands an attractive destination for US VC investors.
In these blogs, we will dive into the terms agreed upon in equity funding rounds in the Netherlands and specifically focus on the differences between the US and the Netherlands. We will be covering a range of topics, from the basics of term sheets to other more common terms agreed upon in VC financings, including liquidation preferences, anti-dilution protection, leaver provisions and drag and tag-along rights. Today we deal with preferred shares, liquidation preference clauses and dividend payments.
Equity financings of growth companies are typically structured through the issuance of preferred stock. The word 'stock' used in American English reflects securities that denote the ownership of a company. In the Netherlands, it is more common to use the word 'share' (in Dutch: 'aandeel') to reflect the ownership interest in a Dutch company. The legal meaning of a share under Dutch law is similar to the meaning of a 'stock' in equity financing rounds used in the American English context. For the purpose of these blogs, we will refer to a share as the instrument issued by a company to reflect the ownership interest in Dutch equity financings.
Venture capital investors in the US generally favor preferred shares as the instrument for their investments. Under Dutch law, we do not need to create preferred shares to give investors the rights attached to such preferred shares. The Duch market has followed the US practice nevertheless. Hence, preferred shares are the type of security that companies almost always sell to investors in a series of equity financing in the Netherlands as well. The specific rights of preferred shares in any given series of financing are a matter of negotiation.
In equity financings, preferred shares typically carry a liquidation preference, which allows it to get paid ahead of ordinary shares (but after debt) in a liquidation or sale of the company. Preferred shares also have other economic rights, such as the right to receive dividends before the ordinary shares. The preferred shares often carry specific voting rights as well; the holders of preferred stock often have the ability to elect one or more members of a company’s board of directors, and to veto certain significant corporate actions, which we will explain in our next blogs.
Companies backed by traditional venture capital firms will almost certainly never issue dividends. Because of this, most founders did not negotiate dividend rights in term sheets in the past years.
There are two types of dividends that can be agreed: non-cumulative and cumulative dividends. A non-cumulative dividend can be declared by the management board of a company and distributed to shareholders at any time. They were most common in venture-backed companies both in the US as in the Dutch market in the past years. Non-cumulative dividends are often referred to as “if, when and as” or “when, as and if” dividends in term sheets. This is included in the NVCA template term sheet and common for Dutch equity financing term sheets as well.
A cumulative dividend can accumulate at a fixed rate (for example between 6-8%) annually to be paid out on a certain event (e.g. an IPO or M&A) and are essentially a guaranteed return on investment. They are much more common in private equity or hedge-fund style investments. Though not so common the last decade in equity financings, we are expecting a shift in the current market. We are seeing some investors now insisting on mandatory cumulative dividends in their proposed equity financing term sheets.
The liquidation preference clause is typically the most important economic term in preferred equity financings, after the valuation. It is designed for the situation where the proceeds from a (liquidation) event are lower than expected as it arranges which part of the proceeds will be received by the preferred shareholders (i.e. investors) before any of the proceeds are distributed to the holders of ordinary shares (i.e. the other shareholders of a company) in case of a liquidation event. The definition of a liquidation event will depend on the arrangements that are made between the parties, but apart from the typical situations such as a dissolution, liquidation, bankruptcy or a suspension of payments often also any change of control, including a sale or a merger are included.
There are basically two types of liquidation preferences in growth equity financings: non-participating and participating. The non-participating liquidation preference is the most basic form and entitles the holders of preferred shares to a predetermined portion of the liquidation proceeds, usually equivalent to the amount they paid for their shares. It is also possible to increase the amount by agreeing on a multiplier (i.e. between 1x-3x) or including any declared but unpaid dividend if cumulative dividends have been agreed. Once the holders of the preferred shares have received their predetermined portion, they stop sharing in the proceeds and the remainder is shared pro rata between the remaining shareholders. As a result, and in the event of a liquidation event where the proceeds are significantly higher than the amount the holders of preferred shares have paid for their shares, their proceeds could be lower than the amount they would have received if they had converted their shares in ordinary shares. This is solved by providing preferred shareholders with the ability to convert their shares into ordinary shares prior to any liquidation event. To prevent the need for actual conversion and to provide flexibility to investors, the non-participating liquidation preference clause can be phrased in a way that allows investors to choose between receiving the proceeds on their preferred shares (up to the amount of the liquidation preference) or the amount they would have received if they had converted their preferred shares into ordinary shares.
The liquidation preference clause could further also outline the order in which different series of preferred shares will be paid out, if multiple series of preferred shares are outstanding. In the last years, the liquidation preference of all preferred shareholders in most term sheets in the Netherlands was pari passu, as was market practice in the UK and US. In the current economic environment and specifically in a down round, we are seeing a shift, and new investors are insisting on enhanced liquidation preference rights. In that case preferred shares issued in a new financing round will rank senior or ahead of the holders of preferred shares issued in earlier rounds, as well as ahead of the holders of ordinary shares, leaving the new investment group as the sole holders of preference following the completion.
When a participating liquidation preference is agreed, the holders of the preferred shares do not only receive the predetermined amount but also share pro rata in the remaining proceeds together with the owners of the ordinary shares. Essentially, this means that investors have similar protection as with a non-participating liquidation preference, but with a higher potential for returns as they will also share in the remaining proceeds after the repayment of their investment. This repayment feature is called a "double dip". To protect against excessive dilution, a cap can be placed on the investor's participation in the remaining proceeds. This means that the investor will receive all the benefits of the participating preferred shares, but the total return will be capped at a certain multiple of the original investment. Once the investor has reached this cap, they will no longer share in any remaining proceeds. This can result in a situation where the investor's pro rata share in the total proceeds would yield a higher return than their preference and participation cap allows, in which case they will have to give up their preference and participate pro rata with the ordinary shareholders.
In Dutch series seed or series A equity financings a 1x non-participating liquidation preference with a conversion rights was most common. Multiples of x2 or x3 were very uncommon for healthy companies. In 2021 we hardly saw any participating liquidation preference agreed. In the current environment, we are suspecting that more investors will negotiate participating liquidation preferences without a cap. We also might start seeing an increase in multiples.
However, even in a downturn, early-stage investors may want to be cautious about negotiating for too many investor-friendly liquidation preferences as later investors will likely require at least the same rights or even stronger ones. Non-standard liquidation preferences can misalign the interests of the company and the investors and established VC firms will be cautious to create that. Every company will be in a different situation right now and the terms will change depending on the where in the market you are looking. Market conditions are changing rapidly these days. Founders and investors need to think really carefully about the structure they go with and calculate the exit waterfall before they agree to it and have it reviewed by an experienced counsel.
If you have any questions about the topics that we have covered or if you would like further assistance, please do not hesitate to contact us. We are always happy to assist and provide further explanation on any (legal) aspect of VC deals.