Down rounds commonly share many of the following characteristics and implications:
- Lowered Valuation. Substantially reduced valuations relative to prior rounds and comparables. Depressed public securities markets drive private company valuations down, as investors benchmark their proposed investments against the publicly available stock prices of their issuer’s competitors. In addition, disruptions in IPO and M&A markets cause investors to fear that their investments will take longer to reach maturity, leading them to negotiate lower entry valuations.
- Tranched Financings. To “de-risk” their investments and capture more “upside” from their successes, venture capitalists will often tranche their investments by limiting their initial financial commitments to the company and tying additional financing to the attainment of financial or performance milestones.
- Enhanced Liquidation Preferences. To enhance their returns and to address the fact that many of portfolio companies already have substantial “preference stacks” in place, many VCs insist on enhanced liquidation preference entitlements set at multiples of their investment amount. These liquidation preferences represent the senior entitlement of the company’s equity in the event of a change of control. In certain circumstances, existing liquidation preferences may be reduced or eliminated entirely, leaving the new investment group as the sole holders of preference following the completion of the down round.
- Employee Retention Issues. Down rounds raise retention issues, as employees recognize their prior equity awards are “out of the money” or sit beneath substantial preference entitlements that are unlikely to clear in an exit, issues which can be addressed through the grant of additional equity awards, the implementation of a management “carve-out” plan, or both.
- Participating Preferred Stock. While traditional preferred stock structures require the holder to elect between receiving a change-of-control payment capped at the liquidation preference amount or converting to common stock and participating fully in change of control distributions, down round financings often involve participating preferred stock which allows the holder to receive its liquidation preference payment and still participate in distributions to the common stock on a pari passu More subtly, participation preferred structures have the effect of further decreasing the effective valuations at which a financing takes place by increasing the returns payable to the preferred stockholders.
- “Full Ratchets.” In contrast to weighted-average anti-dilution protection, which provides only relatively modest dilution protection to the holders, down rounds are commonly accompanied by “full ratchet” anti-dilution protection which has the effect of “re-pricing” the prior round at the lower price at which future financing rounds are consummated, forcing the holders of preferred stock and common stock that do not benefit from such protection to bear all of the dilution burden caused by the new financing.
- Redemption Rights. As investors prepare for turmoil in the IPO and M&A markets, many VCs negotiate for stock redemption rights as part of their down round investment. Such redemptions will commonly take place at the original cost of the investment, perhaps coupled with a coupon, or at the fair market value of the stock at the time the redemption is triggered. Such redemption rights are often viewed as tantamount to a forced liquidation provision, as venture-backed companies will commonly have insufficient cash flow or cash reserves available to them to meet their future redemption obligations, and redemptions may not be permissible under applicable debt covenants.
- Cumulative Dividends. The typical venture preferred stock dividend is non-cumulative; it is payable, if at all, only when declared by the issuer’s board of directors. In contrast, dividend provisions in down rounds are more commonly cumulative dividends which represent a fixed dividend entitlement that continues to accrue, and perhaps compound, during periods where it is not paid.
- Protective Provisions. To address issues related to the perceived increase in risk associated with down-round financings, investors will commonly negotiate for enhanced protective provisions that give them consent rights, not only with respect to “big ticket” fundamental matters, such as a change of control, the issuance of senior or pari passu stock, charter amendments and the like, but also operational items, such as the incurrence of indebtedness, expansion of management equity plans, affiliate transactions, the hiring and firing of the issuer’s chief executive officer, approval of company budgets and business plans, and other changes to the issuer’s operations. New investors may demand more than pro-rata participation on the board of directors as well.
- “Pay-to-Play” Structures. Structures which impose penalties on current shareholders of a company who decline to participate in a financing, whether in the form of a loss of anti-dilution protection, conversion of preferred stock to common stock, being subjected to a reverse stock split, or otherwise, are common features of down-round financings, as lead investors seek to incent the current shareholder base to support the issuer during the current distress period. Commonly known as “pay-to-play,” these structures may sometime also afford participating shareholders additional benefits, such as the ability to exchange existing junior preferred stock for the security issued in the down round, in order to encourage participation.
- Directors and Management. Because of the adverse impact that down rounds have on the existing stakeholders of an issuer, greater scrutiny is often placed on the decisions of management and the directors in negotiating and approving the terms of the down round. The risk of derivative suits from disgruntled stockholders or creditors increases, so directors should pay particular care to their duties of due care, loyalty and candor, and fiduciary duties owed to creditors. Issuers should be sure to implement a thorough process and clearly document its reasons for approving the financing despite the negative effect on other stakeholders. Issuers should document thoughtful and robust deliberation by the directors, demonstrating a consideration of the specific circumstances of the issuer, such as liquidity position and alternative sources of financing (or lack thereof), that the board was apprised of its duties, and that ultimately the transaction at hand was deemed to be the best source of funding available to the company. Finally, the enhanced scrutiny on the decision-making process also means that down rounds often take longer to negotiate, document and close, thereby consuming more time on the issuer side, time which might be spent focused on the response of the business to the issues presented by the pandemic (rather than ensuring that the company’s capital needs are met).
- Controlling Stockholders. Controlling stockholders, who often have representation on an issuer’s board of directors, should similarly be incentivized to make sure that a diligent and thorough process is implemented, as the risk of controlling stockholder liability also increases with down round financings. If a down round is led by current investors who control a majority of the board of directors, the issuer should consider forming a special committee of independent directors to approve the transaction. If a majority of the board of directors is interested in the transaction, the board’s approval may not be protected by the business judgment rule and would instead be reviewed under the entire fairness doctrine, which is a stricter standard. Additionally, stockholders who are deemed to “control” the company have fiduciary duties to the minority stockholders. Control can be found through holding a majority of the issuer’s voting stock or the exercise of control over the company’s decision making, such as through the stockholder’s participation on the board of directors. If a controlling stockholder uses its control to push through a transaction where it benefits at the detriment of the minority interests, the transaction may be reviewed under the entire fairness standard. Finally, a controlling stockholder could be found liable for aiding and abetting a breach of fiduciary duty by the board of directors due to its control.
As is plain from the above, down rounds can negatively, sometimes devastatingly, affect the equity positions of a startup’s existing investors, founders and employees, giving rise to concerns around breaches of the fiduciary duties and controlling shareholder liability. Pillsbury’s attorneys are well versed in the structuring and minimizing liabilities associated with down-round financings. Those strategies are the subject of a forthcoming client alert. In the meantime, should you have any questions respecting these matters, please contact the authors or the other attorneys at the firm with whom you regularly work.