Survey on Legal Terms of Venture Capital Transactions – For the First Half of the Year 2017
We are pleased to present the results of our survey for the first half of the year 2017, which analyzes legal terms of venture capital (VC) investments in Israeli and “Israeli related” hi-tech companies, and comparing these terms to those common in the Silicon Valley, United States.
As always, this survey was produced in collaboration with Fenwick & West LLP., one of the leading Silicon Valley law firms. Our cooperation with Fenwick & West in producing this survey enables us to also present an interesting comparison, using the same tools and terminology, between the terms commonly practiced in Israel and those commonly practiced in the Silicon Valley.
For the first time since 2015, a slight increase was observed in the number of down-rounds and the number of flat-rounds; this was at the expense of the number of up-rounds which decreased! Likewise in Silicon Valley, a slight increase was observed in the number of down-rounds.
Much of the decline was observed in B and later rounds. While down-round in later rounds maybe called for, as it acts as a natural screening process of companies that were ultimately unable to take off, down-rounds in B rounds is a very early filter in the food chain of investments. On the one hand, such screening may indicate that low-quality investments were made in the first stage (quantity at the expense of quality), which points to an unhealthy industry that is willing to fund projects indiscriminately. On the other hand, it can be said that this is a healthy process that drops companies in the early stages, rather than dragging these companies and investing in them until later stages and only then dropping them.
In our previous survey covering the year of 2016, we questioned whether the slowdown that originated in Silicon Valley, coupled with the new foreign investment regulation in China, making it difficult to inject money originating from China into Israel’s high tech sector, would impact 2017. Furthermore, the results we observed infact demonstrate a slight increase in the number of up-rounds. These results also come alongside the results of other surveys published which pointed out that the first half of 2017 had an unprecedented low in the number of exits in the last five years. That being said, it is too early to tell whether these results indicate the beginning of a trend reversal, as they are still minor.
Alongside the increase in down-rounds we also observed an increase in the rate of the use of the senior liquidation preference of preferred shares in the framework of distribution events. The rate returned to 81%, a rate which has not been observed by us since 2009! In this regard there is a significant difference compared to Silicon Valley where the rate hovers around 27% only and rates that have continuously been significantly lower than those prevailing in Israel throughout the entire period that we have been conducting our surveys. The ongoing dissimilarity between Israel and Silicon Valley concerning the rate of use of the senior liquidation preference appears to reflect a cultural difference between the two, in that the Israeli industry continues to make significant use of this term, despite its more limited use in Silicon Valley.
On the other hand, a significant decline in the rate of the use of participate rights of preferred shares was observed, which dropped to the lowest rate we have surveyed thus far – only 27%. It appears that regarding this term, the Israeli industry has adopted the view that sees a certain inequitableness in the participation right, which entitles the preferred investor to receive a return on its investment larger than its pro rata share in the company, and has therefore significantly reduced its use. In the past we observed such a trend taking place with the anti-dilution mechanism, where similarly to the Silicon Valley, the vast majority moved to the weighted average mechanism as supposed to the full ratchet mechanism.
The results of this survey leave us in anticipation of identifying the prevailing market trend, which we will hopefully be able to determine according to the findings of our next survey. The increase in the rate of down-rounds is minor; and in respect of the transaction terms, on the one hand, there is heightened usage of the senior liquidation preference in Israel, but on the other hand there is a significant drop in the rate of use of participation rights in distributions.