Within the final 12 months or so, enterprise capital buyers have needed to get more and more artistic to generate income for his or her buyers as startup exits have been few and much between.
The necessity for liquidity has led VCs to think about secondary gross sales (promoting shares in portfolio firms to different VCs) and have a look at fund buildings like continuation funds — which let VCs maintain onto shares of firms after their conventional fund cycle of sometimes 10 plus two years attracts to an finish, whereas enabling their buyers, LPs, to get some a refund.
Just lately, some VCs have additionally began tweaking funding spherical paperwork to provide them extra flexibility to promote startup stakes sooner or later.
Enter the portfolio sale clause
Extra buyers have been attempting so as to add a selected clause to funding spherical paperwork, dubbed unofficially a “portfolio sale clause”, enterprise legal professionals inform Sifted. Merely put, this clause permits VCs to promote their shares within the firm they’re investing in with out giving different buyers the proper to dam it or promote their very own shares on the similar time. This provision would solely apply if the VCs have been to liquidate their complete portfolio, not simply the person stake in that one firm.
It’s been displaying up extra within the final two years, says Shing Lo, a VC and startups-focused associate at London legislation agency Latham & Watkins.
“We have now seen of late buyers asking for revisions within the lengthy kind paperwork which permits them to bypass preemption, co-sale and the like,” she says. In different phrases, proper of first refusal and “tag alongside, drag alongside rights” — phrases whereby an investor seeking to promote shares in an organization must first supply these as much as different present shareholders. Or, in the event that they need to promote shares which might represent a change of management, they’ve to permit different present buyers to promote their shares concurrently.
This portfolio sale clause is usually utilized by funds which have been round for fairly some time, and haven’t seen many exits — “in order that they want to have the ability to wind up the fund or promote among the property to a different fund, maybe,” says Lo. “[That] is why they’ve requested for the flexibility to have that form of sale with out triggering preemption or co-sale.” Lo says this clause would mostly be launched throughout a brand new funding spherical when paperwork should be negotiated.
A fund may need extra flexibility to liquidate stakes in the event that they wished to create a continuation fund, for instance. Though continuation funds aren’t widespread in Europe, HV Capital grew to become the primary German agency to launch one in 2022, whereas Lo says she’s heard extra funds starting to speak concerning the choice.
Legal professionals say the portfolio sale clause continues to be uncommon within the startup world — nevertheless it may grow to be extra widespread.
Though she hasn’t seen it utilized in relation to secondary gross sales, Lo says, “I would not be shocked if that is beginning to emerge as a factor that buyers will ask for”, particularly as VCs start to have interaction in additional secondaries.
Shopping for and promoting stakes on the secondary market has grow to be extra well-liked within the final 12 months or so to money in on investments, and VCs have even been elevating funds to capitalise on the development. Lo’s colleague Mike Turner says secondary transactions have picked up — “each time we do a major spherical now, there’s the expectation that there is some secondary [shares being sold] in there,” he tells Sifted.
Bastian Reinschmidt, associate at German legislation agency Neon (previously BMH), has noticed the portfolio sale clause used to do extra than simply wind down an previous fund. “It’s simple to say, ‘There’s the tip of the lifecycle for the fund and there is three investments remaining, and so they simply need to promote it,’” he says.
However he’s additionally seen it utilized by a VC that wanted to shut down a fund earlier than its 10-year time period was up, “for different causes”. On this occasion, which occurred throughout the final two years, he says, the VC wished to promote their portfolio to a different investor.
A crimson flag for startups?
Deal phrases have usually grown extra investor-friendly in recent times because the downturn has made funding even more durable to get (until you’re an AI firm). However is a “portfolio sale clause” a nasty factor for founders?
In keeping with Latham & Watkins’ Turner, it’s not a crimson flag. It may even be advantageous.
“In case you do have an investor wanting an exit, as a result of they have been in for such a very long time needing liquidity, truly having the ability to clear up your cap desk fairly simply is an effective factor,” Turner says.
Nevertheless, Lo notes that if startups need to give buyers this clause, they’d most likely need to make sure that the investor wouldn’t find yourself promoting their shares to a fund that owns a direct competitor.
Reinschmidt, however, factors out that the definition of a “portfolio sale clause” could be murky, relying on the precise wording within the contract. “The query is, what’s the portfolio sale? Is it, you might have 10 investments, after which they determine to liquidate three of them collectively? Is {that a} portfolio sale? … Or do you should liquidate your total portfolio?”
Past the paradox of language, it may be a danger to permit one in all your buyers to incorporate it. “In case you open Pandora’s field, and also you give it to 1 investor, the others will even request it,” notes Reinschmidt.
For these causes, he advises each events — the founders and buyers — to have an amicable negotiation over the phrases. “It’s an comprehensible request from the investor aspect, so it is crucial to have a sensible negotiation type there,” he advises. Nevertheless, he provides it’s key to “not make it too simple for them to name the clause.”
