A “down round” is when a company raises capital based on a valuation that is lower (often materially so) than the company’s valuation in one or more prior financing rounds. Depending on the severity of the situation, a “down round” also may be referred to as a “cram down” or “washout” financing when the financing would dilute or subordinate the payment priority of existing investors who do not participate.
Anti-dilution adjustments can even exacerbate the overall dilution of the round unless they’re waived by existing investors, particularly if the anti-dilution formula is a “full ratchet” and not a weighted average adjustment formula. Down rounds are certainly not the first choice for follow-on financings given the typical dilution of existing investor ownership percentages; questions of fiduciary duty around the pricing, terms, and timing of the “down round” financing; negative publicity; and potential demoralization of employees and investors.
Over the last two years, more and more businesses, startups in particular, have found themselves needing to raise additional capital while the business is not profitable or its trajectory and prospects call into question the value, and perhaps the viability, of the business.
Total startup shutdowns reached 770 in 2023, a substantial increase from 467 in 2022. Seed deal count was down 27% in 2023, with only 462 seed investments closing in Q4 2023. 2023 also saw the four highest quarterly down-round rates since 2018.
Unfortunately, there is not yet any material signs of improvement. Q1 2024 had the highest share of down rounds in the last five years at 23%. Globally, Q2 saw the amount and deal value of private equity/venture capital (PE/VC) investments decrease by 14.3% and 8.3%, respectively, from the same period in 2023. June 2024 alone saw a year-over-year decline of 24.1% in venture capital financing deal value and a 27.2% decline in number of venture capital financings.
Startup shutdowns in Q1 2024 increased 58% from the previous year to 254. However, seed-stage investment statistics (including both primary and bridge financings) are a bit more promising. Median seed-stage valuations increased from $13.3 million in Q4 2023 to $14 million in Q1 2024 and increased again to $14.8 million in Q2 2024. Median primary seed valuations, however, increased at a greater rate than median bridge round valuations during this period, up 13% from $12.6 million in Q1 2024 to $14.3 million in Q2 2024.
While the global state of PE/VC investing may not be entirely positive, there is good reason for startups seeking seed and bridge round financings to remain hopeful. Down rounds may be an unfortunate necessity. Sometimes they may be the pragmatic, or even only, path forward. However, it is important to consider down round alternatives before proceeding.
These alternatives to down rounds are particularly viable and effective if the company and its current investors are reasonably confident the downturn in valuation is temporary. Similarly, these alternatives may be a viable option for companies in “hot” industries or for businesses where a lack of profits is expected and quickly investing in and scaling the business will “make or break” the investment, and there is a reasonable chance the next round of financing will achieve a significantly higher pre-money valuation. However, if these options aren’t available, there are ways to mitigate the potential negative consequences of a down round through careful implementation.
Companies should consider two main factors when implementing a down round: relevant constraints and implementation techniques. Down rounds are constrained by fiduciary duties, which are always in the background of business decisions, but even more vital when those decisions are not immediately favorable to existing shareholders. The fiduciary duty of care generally requires that directors exercise care in managing the company and performing their corporate responsibilities. The fiduciary duty of disclosure (sometimes referred to as “candor”) relates to the fiduciary duty of loyalty to the company’s stockholders, and requires that directors disclose to stockholders all material facts that are relevant to the given stockholder action sought (in this context, the facts material to the investment decision they are being asked to make and any stockholder consents or approvals they are being asked to give).
It is particularly important to consider what information rights (and any notice, consent, or other approval rights) existing investors may have. The duty of loyalty also requires directors to act in good faith, on an informed basis, placing the stockholders’ interests ahead of the director’s own personal interests, and generally to act in the best interest of the company and its stockholders.
Finally, while courts typically will defer to a board’s business judgement in the exercise of their duties and responsibilities as directors, in “interested party” transactions (transactions in which there is a controlling stockholder involved), the burden shifts to the board to demonstrate that the actions taken were “entirely fair.” Additional constraints on a down round may also include enhanced or additional notices or approvals of third parties or the company’s stockholders under Delaware law, existing charter provisions, contracts with third parties (such as lenders) or investor rights or similar agreements with investors. To mitigate legal exposure and avoid delays or challenges to a financing being pursued in what may be exigent circumstances, it is imperative to carefully evaluate and comply with any such applicable constraints.
Satisfying applicable fiduciary or contractual duties implicated by a down round can be achieved by taking a few careful steps. Coordinate with counsel early to understand the relevant fiduciary standards of review that may be involved, to understand any legal or contractual restraints or requirements applicable to the proposed financing, and design and implement the best financing process possible.
Prior to implementing the down round, the company should seek to identify a broad range of potential investors (unless it is obligated to first offer the financing to existing investors), consider and explore all reasonably available alternatives, and conduct a thorough market check on pricing and terms.
The company’s directors and officers should obtain the advice of qualified legal counsel and may need to consult with accounting, valuation, or other advisors to satisfy the requirement that they be fully informed when making decisions. The directors and officers should also be thoughtful and deliberate in any negotiations.
It is also critical to prepare in a timely manner detailed minutes and records of the market checks and deliberations to demonstrate the directors’ compliance with their fiduciary duties. Directors, officers, advisors, and any other employees or representatives of the company also should avoid communications that could give ammunition to potential claimants. This would include taking care when drafting short emails and texts which may be misconstrued.
To further mitigate risk in doing the round, a disinterested lead investor could be recruited to lead and price the round and negotiate terms, subject to any required stockholder approvals and the directors’ ultimate approval of the final terms on behalf of the company and for the benefit of the existing stockholders. Having a lead investor may be helpful in demonstrating that the terms were negotiated on an arm’s-length basis in compliance with the duty of care and loyalty.
If negotiations involve a majority stockholder, founder, or other parties who may have (or appear to have) leverage or may seek favorable treatment, the directors also should consider whether a special committee of independent directors or other processes should be implemented to achieve a fair process and outcome and possibly to shift the burden of proving compliance with fiduciary duties off the company and its directors.
While often not possible because of the composition of the board, a properly functioning committee of disinterested independent directors may be beneficial in retaining a business judgment standard of review if the transaction is challenged. This committee may also help cleanse the deal and shift the burden of proving a fiduciary breach or lack of fairness onto the party challenging the transaction. Similarly, consider submitting the transaction terms to the stockholders (even if their approval is not required) to try to obtain majority approval of disinterested stockholders (i.e., a “majority of the minority” approval), as this could be the most effective tool, if feasible to be obtained in a timely manner, to combat any claims by minority stockholders.
Some of these procedural protections may require a potentially time-consuming analysis of matters such as which stockholders are disinterested, and often will result in additional time, effort, and expense, which may make it difficult to complete before the deal goes through.
Finally, even if the stockholders do not have preemptive or other contractual rights to participate in the proposed financing, consider conducting a rights offering to all eligible stockholders. This would provide them with the opportunity to participate in, and sufficient time to consider, the financing or recapitalization. Offerings typically are limited either to all preferred stockholders or all stockholders who are “accredited investors.” These procedures can also be a useful tool in negotiating with existing investors of whom the company may request waiving their anti-dilution or other rights, while demonstrating that a careful and fair process has been followed, resulting in a market-based, arm’s-length valuation and other terms.
To new investors, down rounds typically indicate higher risk. It is essential to incentivize new investors who may be skeptical about the long-term value opportunity of investing while protecting existing shareholders from severe and unwarranted dilution of their ownership percentage.
Some key terms to consider in a recapitalization, or “recap,” structuring and negotiations include voting and consent percentage ownership thresholds; other stockholder protective provisions; board composition and board observer rights; and the timing, conditions, and stockholder votes required (whether by specific class, combined classes, or on an as-converted basis) for puts, calls, other redemptions, and for drag-along and tag-along terms and thresholds.
In connection with these negotiations, a “recap” can be beneficial or even necessary. A recap can be viewed as a restart and redo of a company’s existing capitalization, often done in conjunction with a down round financing. Recaps are usually necessitated by some combination of the following factors
Recaps are sometimes referred to as “pay-to-play” rounds because in order to receive the benefits of the new equity terms (and in some cases avoid the loss of other rights, due to falling below minimum ownership percentages to hold certain rights) the investor must invest in the securities being issued in the recap. Additional details regarding “pay-to-play” financings are below and the same considerations, fiduciary duties, and other potential restraints described above that apply to a down round are also relevant and applicable in the context of a “pay-to-play” financing.
A few key questions and economic considerations should be kept in mind for a recap. Will there be a total flattening or reset, a liquidation preference flattening or reset, or both? If so, to what degree? Recaps can be accomplished by converting existing shares of one or more series of preferred stock into common stock, or into one or more series of new preferred stock with reduced dividend or liquidation preference terms or returns. This can be done by modifying the liquidation preference, conversion price of one or more series of existing preferred stock, or by any combination of these methods. Preferences can be totally flattened (i.e. no preferences for outstanding equity), retain their priorities but with the valuation or priority return amounts flattened, or prior valuations and percentages could be respected, but with a cap or other limits on the total aggregate preference amount that is flattened or reduced. Existing shares can be reclassified based on prior amounts paid, prior preference priority, or prior valuation distinctions. Recaps should be tailored to the existing capitalization dynamics.
Additionally, “pay-to-play,” “pull-through,” or “pull-up” mechanics can be implemented to further incentivize existing investors to waive their anti-dilution or other rights (such as “put” rights or rights to purchase securities in the new round at a further discounted price), or just to continue as investors in the new round.
Pay-to-play mechanics generally are implemented through charter provisions that either already exist or are included in an amended and restated charter implemented for the recap financing. These mechanics provide that if an existing investor doesn’t invest in a minimum dollar amount of the financing round, or a pro rata share of an aggregate amount of the financing round, some or all of their shares of preferred stock will be converted into either common stock or a class or series of preferred stock that contains potentially less favorable terms.
A pull-through mechanic is a variation of this tool whereby all or particular types of the preferred stock are first converted to common stock under the charter terms, then pulled through into one or more series of new preferred stock conditioned upon the owner of the converted stock participating at the required level in the new financing.
For a pull-up mechanic, rather than receiving preferred stock after participating in the new round, these existing investors receive one or more new series of preferred stock with enhanced terms (such as senior preference, the same terms as the new money, or some other agreed upon set of terms) in exchange for some or all shares of preferred stock they held at the time of the new financing. Existing stockholders also may receive additional warrant coverage or other rights as an incentive to participate in the new financing and agreeing to waive relevant rights and priorities as required under the terms of the recap. A pull-up or pull-through mechanic may also be more feasible to implement than a pay-to-play mechanic if the approval standards to convert preferred stock into common differ from the approval standards to modify a class or series of preferred stock under the charter, the stockholder related agreements, or Delaware law.
These strategies can help weave existing and new investor rights and interests together, create appropriate incentives and reward structures, and allow the company to raise the capital (and reset the capital structure) to support its business and, ideally, to reverse the downward valuation trend.
Venture capital financing markets, valuations, and investor appetite generally peaked in 2021 and went downhill quickly thereafter. Thus, the subsequent uptick in startup shutdowns and down rounds is in many cases due to external macroeconomic factors out of the control of directors, including higher interest rates, tightening lender standards, the size and number of new venture capital fund fundraisings, and generally less bullish investor sentiments.
Even so, down rounds and recaps can be demoralizing for employees and management, particularly if they feel they are being paid a below-market salary in exchange for a stake in the company they believe in, and which will pay off for them in the long run. Thus, like existing or new investors, employees and management may need greater incentivization to the extent their incentive arrangements are “out of the money,” or so deeply subordinated that the odds of realizing material value is remote.
Techniques to accomplish this include increasing unallocated options, creating a new equity incentive pool, and topping up grants to management and employees with additional options based on the reduced company value. Similarly, option repricing or exchanges based on the new post-financing 409(a) valuation (while being mindful of tender offer rules that may be implicated by an exchange offer) can create the requisite incentivization.
Finally, implementing bonus and retention plans or pools tied to exit value and achieving minimum investor return can improve motivation for management, while balancing the need to provide outside investors a priority and amount of investment return, thus incentivizing investment and supporting the company in a difficult time. The board of directors, however, must be careful when considering implementing any management and employee incentives to ensure that they are appropriately designed to also maximize stockholder value.
Down rounds are never the first choice for financings. They bear legal, business, reputational, and even existential risks that can be tricky to navigate. These risks often come at a time when the company has a lot on its plate and is facing imminent financial difficulties. However, when performed strategically, they can be hugely beneficial, bringing in new and perhaps more optimistic or motivated investors. Down rounds can position the company for subsequent up round financings and future success.
Summer associate Benjamin Ezana and file clerk Thomas Mearns contributed to this Insight.