Venture capitalists add tough riders to fund-raising pacts

VC investors have chosen to protect their capital through downside protection clauses such as so-called liquidation preference (LP), which comes into play when a firm gets sold. Photo: iStockPhoto

Mumbai: Venture Capital (VC) funds have invested billions of dollars in Indian start-ups in the last two years, often at seemingly outlandish valuations. But as valuations have risen, investors have ensured their capital is protected by adding tough clauses to their fund-raising agreements. In the process, start-up founders and employees may be left with very little after a sale.

VC investors have chosen to protect their capital through downside protection clauses such as so-called liquidation preference (LP), which comes into play when a firm gets sold. To put it simply, at the time of the sale of a start-up, LP allows an investor to take back its entire capital or the amount due to it in proportion of its shareholding in the firm, whichever is higher.

LP has become a standard practice and a non-negotiable clause for VC investors. This provision can, in certain cases, lead to investors walking away with all the money from the sale of the firm.

From January to October this year, VC funds invested $4.41 billion (across 368 deals) in Indian Internet start-ups, while VC investments in 2014 and 2013 stood at $2.39 billion (308 deals) and $1.53 billion (251 deals), respectively, according to data from VCCEdge, the financial research platform of VCCircle.com.

“It’s a function of what valuation you ask for. If an investor is willing to pay a certain valuation but the entrepreneur wants a higher valuation and if the investor is still keen to participate in the company then he will demand a higher LP,” said Sumir Verma, managing director at investment bank Merisis Advisors, adding that, by nature, entrepreneurs tend to be optimistic and believe that things will never go down.

However, as the ecosystem evolves, even entrepreneurs with early-stage firms are becoming more aware and cautious while signing off on such conditions.

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