Down and Out? While Down Rounds Are Increasing in Frequency Among US-Based Start-Ups, the Phenomenon Has Yet to Take Root in China
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COVER STORY [email protected] avcj.com Down and out? While down rounds are increasing in frequency among US-based start-ups, the phenomenon has yet to take root in China. Desperation, dirty term sheets and willing investors are delaying the inevitable FOR THE FIRST TIME IN 13 YEARS, APPLE have raised a lot of money in the past, so they listed tech companies and filtering through to has posted a year-on-year decline in quarterly don’t need any more for now.” private round valuations. There are very few cases revenue – and China is in a large part to blame. of down rounds or flat rounds at the growth The 13% decline in the first three months of Behind the numbers stage right now, so early-stage companies are 2015 included a 26% slump in Greater China. Are The overall venture capital investment still enjoying high valuations,” says David Wei, these difficulties Apple’s alone, or do they reflect environment has cooled, with later-stage activity founding managing partner at Vision Knight a broader malaise in domestic smart phone chiefly responsible. Law firm Cooley handled 135 Capital. “But down rounds will eventually happen demand? disclosed VC deals totaling more than $3.1 billion across the board.” The question is particularly pertinent for of invested capital globally in the first quarter, Those losing out tend to be online-to-offline Xiaomi, the largest player in the Chinese market down 15% and 12%, respectively from the last (O2O) services players in segments such as car ahead of fellow homegrown brand Huawei three months of 2015. Series A deals accounted maintenance and home delivery - typically Technologies and Apple, and a PE darling. for nearly half of transactions, the highest level in companies that are burning through cash to Founded just six years ago, the company’s over a year, while median pre-money valuations build market share against strong entrenched growth has been meteoric, fueled by numerous increased at both the Series A and C stages, but competition. Some are not even getting flat or rounds of equity funding from VC and PE firms. declined for Series B and D and above. down rounds, but simply shutting down. The most recent of these closed at $1.1 billion in AVCJ Research’s numbers for China alone Meanwhile, there is a clutch of high-quality late 2014, valuing Xiaomi at $45 billion. Despite show a similar picture. Venture capital investment companies – often with large strategic backers concerted efforts at diversification, 90% of the came to $2.3 billion in the first quarter of whose presence makes outside investors company’s shipments are within mainland China. 2016, marginally up on the previous quarter. comfortable – that raise substantial sums at high And having targeted smart phone sales of 80-100 million in March of last year, the overall total for 2015 came in at around 70 million. China TMT private equity and venture capital investments With uncertainty about the start-up’s ability 30,000 600 to maintain its stellar growth, numerous industry sources claim that valuations of Xiaomi shares 500 in the secondary market have plummeted. 20,000 400 However, the company has not been forced to raise money at a lower valuation to meet its 300 US$ million 10,000 capital needs. Xiaomi was able to eschew equity Disclosed deals 200 funding for debt financing, thereby avoiding the perceived ignominy of a down round. 0 100 Many start-ups globally must face this kind of 2010 2011 2012 2013 2014 2015 2016 YTD reckoning, although perhaps not with the same Disclosed deals Amount (US$m) outcome. On the back of the technology boom, Source: AVCJ Research the last two years have seen a proliferation in unicorns – privately-held technology-related companies worth $1 billion or more – as Transaction volume was also more or less the valuations. There have been four growth rounds investors have piled into late-stage round at ever same. However, growth-stage deals in the in excess of $1 billion for IT-related Chinese higher valuations. computer-related, IT and media industries businesses since the start of the year and three A series of markdowns and down rounds in amounted to $2.3 billion, down from $5.2 billion of them are affiliates of leading internet players: the US suggest the exuberance has faded, but in the previous quarter. JD.com’s finance platform and Alibaba-linked China has yet to see much of the same. Is it only a Deals are also taking longer to get done. Cainiao Network Technology and Ant Financial. matter of time? Transaction practitioners note that ordinarily it The fourth, food-ordering platform Ele.me, got its “In China a few companies are closing down, might take about two weeks for a term sheet to capital from Alibaba and Ant Financial. but there aren’t many down rounds,” says J.P. Gan, be completed, but now negotiations are lasting Xiaomi was able to raise debt financing managing partner at Qiming Venture Partners, an two months or more. At the same time, more rather than do a down round because it is a large early investor in Xiaomi. “Chinese entrepreneurs term sheets are going unsigned as investors walk company with substantial assets and cash flow. would do almost anything to avoid a down away due to market uncertainty. Most start-ups have yet to turn a profit so this round, whether that means delaying new rounds “The market correction will be pass through is not an option. Traditional banks are unlikely of funding or cutting costs. And some of them the value chain – it will start from the publicly- to lend money to them, while venture debt 6 avcj.com | May 03 2016 | Volume 29 | Number 16 Asian Venture Capital Journal To subscribe, please contact: [email protected] COVER STORY avcj.com [email protected] – providing loans to start-ups without equity complicated by multiple vested interests and at a higher valuation than its previous round, so dilution – is still at an early stage in China. Many conflicts often prevent actual implementation. existing shareholders suggested that it join forces are therefore resorting to “dirty term sheets.” If new investors offer unattractive terms, with Dianping. “In a dirty term sheet, it looks like the existing backers could use their preferred right The deal meant that the two companies, as valuation is slightly up, but the terms have a to block the financing round. On the other hand, the single dominant player in the market, would lot of conditions attached which would be new investors could only agree to participate in a no longer consume so much cash fighting one triggered if the company cannot achieve certain down round if pay-to-play clauses are triggered, another. M&A can also facilitate cost-cutting performance criteria,” says James Lu, a partner which means the existing backers would have through redundancies if certain employees at Cooley who has seen fewer down rounds in to commit additional capital alongside them are performing duplicate functions. Meituan- the China than the US, but a number of dirty on a pro rata basis. Existing investors that refuse Dianping subsequently raised a round of funding term sheets. “For a lot of companies and existing to contribute capital would see their preferred at a higher valuation than their combined worth investors, this is worse than a down round, shares converted into ordinary shares or at least when operating as independent entities. because all future financing will become very heavily diluted. However, this approach is not necessarily complicated.” New investors argue that a pay-to-play is sustainable. On one hand, not all entrepreneurs First of all, if an investor is uncertain about a necessary because of the turnaround risk they welcome mergers, particularly if they are start-up’s prospects it could split the deal into face. The standard retort from existing investors essentially being acquired. On the other, cutting several tranches. Rather than committing $10 that don’t want to comply is the terms do not costs to generate positive cash flow can be easier million up front, there will be an initial $5 million acknowledge the significant sums they have said than done. For example, existing investors payment, followed by $2.5 million when the historically invested in the company and the might want a company to pursue an aggressive company turns profitable. The final $2.5 million early-stage risk they took. growth strategy ahead of an IPO or trade sale. is conditional on the achievement of certain milestones. If the targets are not hit, the investor can re-adjust the valuation of the round, perhaps “In a dirty term sheet, it looks like the turning it into a down round. Another favored term is the full ratchet anti- valuation is slightly up, but the terms have dilution protection. If a start-up subsequently issues shares at a lower price than the round a lot of conditions attached which would be in which an investor participated, the investor triggered if the company cannot achieve certain has the option of retroactively reducing the price of the previous round to ensure parity. The performance criteria” – James Lu rebalancing is comes about by issuing more shares to the investor in compensation, usually by converting preferred shares to common stock “While the new capital infusion may be in Over the last two years, GPs such as DCM at a higher ratio. the best interest of the company in its fight for Ventures, Banyan Capital, Shunwei Capital Other forms of investor protection focus on survival, the terms may be too bitter of a pill for Partners and GGV Capital have raised sidecar liquidation events.