When the markets are frothy, term sheets from venture investors typically are pretty straightforward. Investors receive preferred stock with a liquidation preference, special voting rights, and other protections — but the valuation is the primary focal point of negotiation. In Q4 2021 at the peak of the tech market hype cycle, it was “normal” for a seed stage company to raise a preemptive A round within months of closing their seed round, with no change in their product maturity, revenue metrics, or their pipeline.
Times have changed (unless you have a buzzy AI vision investors are hungry for). When markets are down, Series A rounds get smaller and harder to come by. There is no longer a single metric, but investors look for predictability, which requires a strong pipeline and happy customers with growing contracts.
Seed extensions and bridge rounds are becoming increasingly common for strong teams that don’t have that predictability just yet. Term sheets have gotten tougher, with terms that improve the economics for investors and price in additional risk — what is “standard” changes with the market.
First, let’s call out the difference between extensions and bridge rounds. While both essentially extend the runway for a startup that is not ready for its next round yet, a seed extension tends to include new participants, unlike a bridge round, which usually involves current investors providing a startup with additional capital.
This article gives a brief tour of some of the terms to be aware of if you’re planning to raise a seed extension or bridge round. Securing new financing for your company is your most important job as a founder and being aware of how these terms might impact all your shareholders is critical.
Liquidation preferences
The economic deal with your investors is more than just about the pre-money valuation. Liquidation preferences come into play when the company is sold — and that is the most common upside scenario, so the preferences are very important.
Data from our portfolio company Carta shows that the percentage of funding rounds with aggressive liquidation preferences (>1x or participating) has increased sharply in 2023.
The effect of the liquidation preference can be that the investors receive a higher percent of sale proceeds than are reflected in relative ownership percentages. While almost all deals have liquidation preferences — it’s the key feature that defines “preferred stock” — there are two elements that we are seeing change in recent offers:
1. The Multiple
The liquidation preference is a right held by the investor to receive a certain amount of money, before any other shareholders, in the event that the company is sold or liquidates (it does not typically apply if the company goes public).
Typically the liquidation preference multiple is one — meaning that the investor is paid out 1x the amount of money that they initially invested. But in challenging markets (or when your company is in distress), you might see higher multiples. The higher the multiple, the more the investors will receive before common stockholders begin to share in proceeds. For example, if an investor has a 2x liquidation preference, they would be entitled to receive twice the amount of their initial investment before any other shareholders receive anything.
2. Participating vs. Non-Participating Preferred Stock
This can be a little complicated. In recent times, it’s “normal” for investors to receive “Non-Participating Preferred” stock. Non Participating Preferred is founder/company-friendly since investor stock converts according to their equity percentage. In contrast, investors with “Participating Preferred” will receive both preference multiple (see above) and also the amount they would receive based solely on their equity percentage.
Less common in seed extensions and more in insider-led Series A rounds are provisions and control limitations.
Provisions & control limitations
Certain provisions can impact the valuation of the company in the financing and/or increase the investor’s ownership. Of note here are warrants — similar to options that allow investors the right to purchase shares in the future at a certain price. Another provision is that of anti-dilution — a clause that protects investors from dilution when founders raise capital at lower prices per share than they have in previous rounds (also known as down rounds).
Control provisions — how the Board seats are allocated, what decisions require approval of the directors elected by the investors, what decisions require approval of the investors as shareholders, etc. — are negotiated as part of every term sheet. And it’s not all about who owns a majority of the equity; control is much more nuanced. Founders should pay attention to what matters require either supermajority Board approval or approval of investor-designated directors. Founders should also be aware of “Protective Provisions,” which might give owners of preferred shares a veto.
Goals and the impact of terms
The most important exercise for founders is to think through plausible scenarios and see how these terms might impact each outcome. The two most common outcomes at this early stage are that you are able to complete a successful Series A/B raise after this round and a sale of the company to an acquirer. If the company gets wound down, the bridge terms most often don’t matter.
The two questions founders should answer
- The most important question founders need to answer for themselves and the board is: “What is the goal of this additional funding?” Most companies will only get an extension/bridge round once. You need to ensure that you focus your strategy with clear eyes on the best outcome for your business with it.
For seed extensions, there are three typical goals a company might have for its extension: traction, stickiness, or acquirability
- Traction: Increase revenue to X and grow pipeline to Y to demonstrate product-market fit for a Series A raise
- Stickiness: Improve conversion/retention ratios by making X changes to the product and focusing on a specific ICP that we have PMF with
- Acquirability: Align product to buyer category X with integrations and streamline headcount down to Y to decrease burn rate to a minimum
Depending on where you are lacking in terms of your readiness for an A round, you might need to focus on very different goals to become fundable or acquirable. Having the right plan A and not hedging your bets can result in a much better outcome than simply having to wind your company down. For instance, if you have been unable to validate your company’s core value hypothesis, you might be better off planning for an acquisition than trying to hit a revenue metric for a Series A round.
- When it comes to the actual terms, the most important question to ask is: “What happens in case we pursue an acquisition?” If your company ends up getting acquired for a small amount that doesn’t clear the preference stack instead of being able to raise an A round, how would your cap table and new terms impact all your shareholders? While this might not be the outcome you are shooting for, being aware will prevent surprises and conflict down the road.
Unusual Ventures is building the premier seed stage fund to help technical founders find product-market fit. With over $1B under management and investments like Carta, Arctic Wolf Networks, and Traceable, Unusual invests in founders on day zero and supports them throughout their lifecycle. For more insights into building software startups and finding product-market fit, check out The Unusual Field Guide and subscribe to the Startup Field Guide podcast.
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