Venture Capitalists Offer Better Deals to Start-Ups

Venture capitalists are offering start-ups better deal terms than they were four years ago, according to a new report by Dow Jones VentureOne, a venture capital research firm.

"A saner investment climate has led to healthier companies, better able to negotiate favorable terms," said Russell Garland, editor of the report, which covered VC trends from April 2005 through June 2006.

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Among the good news for companies seeking capital is an increase in "up rounds" — second and third rounds in which valuations are higher than the first round. Eighty percent of companies saw an increase in second-round valuations. In last year's survey, only 73 percent of companies reported up rounds, compared to 61 percent in the 2003-2004 survey.

The report also found that bankruptcy terms are growing more favorable, while liquidation preferences are getting smaller. In the event of liquidation, VCs are given the option to either receive their liquidation preference as their return or convert it into common stock and receive percentage ownership as their return. The latest report found that no U.S. companies agreed to liquidation preference more than three times the size of the investment.

Additionally, full-ratchet dilution, which protects shareholders from "down rounds" at the expense of everyone else, was found to be less common than it was a year ago. This year, only 19 percent of respondents reported deal terms that included anti-dilution protection, compared to 22 percent a year ago.

Garland explained that experienced players on both sides of the table are returning things to how they used to be.

"In the old days, venture capital was a handshake-type thing" Garland said. "Everything got out of whack during the bubble and its aftermath." In 2000 and 2001, after the dotcom bust, venture capitalists started asking for more ownership and less risk if things went south. The past couple of years, however, there has been a return to simplified deals terms.

"VCs are realizing again that deal terms only get you so far," Garland said. "More important is a good team and the ability to work harmoniously."

"Now, if you put onerous terms on the table, entrepreneurs will walk away," he added.

Looking forward, Garland said he expects the trends to continue. "Valuations have been stable or rising," he said. "Unless there is another influx of people in the business, or a big downturn, things will stay pretty stable."

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