Today, the VC ecosystem, as well as economic life as a whole, cannot be described as stable or predictable. The market is mainly characterised by volatility, publicly listed shares are struggling, and numerous macroeconomic challenges and, of course, geopolitical tensions must be faced, not to mention historic inflation. At the same time, EU statistics show that the investment market has not slowed down: by the end of 2021, the value of deals invested in European-based companies exceeded EUR 103 billion, while in the first three quarters of 2022 the figure stood at EUR 76 billion, meaning that the market has remained more or less stagnant. In addition, however, the value of exits in the EU exceeded EUR 130 billion in 2021, while by Q3 2022 the same figure amounted to only EUR 33 billion.
From the capital side, investments therefore continue to flow into the market, while exits are taking place in significantly fewer cases. There are several reasons for this, but perhaps the most important is the combined effect of the issues mentioned above. We could also say that investors and businesses feel that this is simply not the right moment for an exit, especially not for an IPO.
Although no slowdown is yet apparent, it is clear that the market is undergoing transformation. This transformation is particularly visible in investment agreements in relation to downside protection, as investors have begun to apply new strategies.
But what is downside protection? The term is a collective name for strategies and tactics that primarily aim to limit investors’ economic exposure, reducing the frequency and extent of losses arising from stock market and economic downturns.
As a result of the above, the investment market is tending towards longer-term returns, and it is hard to find an investor who would provide an investment without some form of downside protection. The type of downside protection applied by an investor largely depends on the industry-specific characteristics of the business and its forecasted growth rate, whether the business offers longer-term returns or short-term returns. Accordingly, provisions such as anti-dilution, liquidation preference and various forms of vesting are typically found in investment agreements.
Anti-dilution protection primarily protects the investor against a company valuation disrupted by a subsequent funding round: if, in the next round of financing, a new investor enters the company at a lower valuation, the shareholding of the earlier investor — reduced as a result of the new investment — is adjusted according to a predetermined calculation.
By contrast, liquidation preference grants priority rights to the investor in the event of the sale, dissolution or termination of the company, that is, in the case of a liquidation event. This priority right also has several forms, but it generally extends up to the value of the investor’s investment increased by a return.
Vesting and reverse vesting are investor special rights linked to the founders’ ownership stake. The two concepts essentially arise from the differences between US and European practice. In the US system, following the investment, the founders transfer part of their shareholding to the investor, which they may then gradually regain upon the fulfilment of certain KPIs, or key performance indicators. By contrast, in Europe, the established practice is that the founders’ above-mentioned ownership stake is not transferred to the investor; however, if certain KPIs or other conditions are not fulfilled, the investor may unilaterally take it over.
Naturally, as longer-term returns come to the forefront, a certain slowdown can also be observed, or is likely to be observed, in the market, which will reshape the current fast-paced investment market that forecasts quick and high rates of return. It can also be observed that, in parallel with all this, the secondary market is undergoing a kind of renewal, the directions of which will primarily become foreseeable in Q1–Q2 of 2023.
The transformation of the VC sector caused by economic challenges has steered, and continues to steer, both investors and target companies in a new direction. This new direction may be defined by two keywords that the market has so far largely sought to avoid: patience and prudence.