VCs get tough with start-ups

In the wake of this year's technology stock tumble, investors are demanding higher dividend rates or increased equity stakes from entrepreneurs who fail to satisfy specified returns within an agreed timeframe, according to Jason Purcell, CEO and co-founder of VC group FirstStage Capital.

He told silicon.com: "VCs have become more conscious of the potential downside of investing in early stage companies and therefore are seeking to include protection in the event an entrepreneur doesn't secure an exit. You may typically see - in the event of an entrepreneur failing to achieve exit within the required time frame - the actual dividend rate going up four or five times."

The trend is making life increasingly complicated for start-ups looking for more than one round of funding. Under these revised conditions, clauses need to be renegotiated every time a new investor comes onboard.

For this reason, Paul Vickery, ebusiness director with 3i, advises start-ups to avoid stringent clauses - or ratchets. He said: "A ratchet usually happens when the VC and management cannot agree on equity terms from the outset. To bridge the gap you include a ratchet, so if you achieve a value of x in a certain time you get the extra y percent stake you wanted. You only get a complicated deal when you can't agree on a simple one. We usually advise on the simple option."

Vickery agreed that investors are looking to protect themselves as technology stocks continued to drop in value.

He added: "We do see that trend where there is interim financing in expectation of external financing. The value is protected so that if there is a down round or a flat round, the investor can lower the value of the next round of interim financing."

FirstStage Capital's Purcell also agreed that technology companies should attempt to negotiate clauses linked to short-term business progress rather than long-term exit goals.

He said: "A sensible approach for a technology company that recognizes it will need to raise further rounds is a ratchet connected to immediate milestones such as the value of the next round of funding."