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Volume 11, Number 3 ­ January/February 2002
Down round financings
How to cope with lower valuations for your client company
By Dan M. Mahoney
We are in a hostile economic storm. Business models that were the rage a year ago
are now inherently unsound, business plans are being re­evaluated, and valuations
have fallen. As venture capital­backed companies navigate this storm, the path to
future funding is often blocked by an obstacle known as the "down round."
A financing becomes a down round when an investor places a lower valuation on a
company than in a previous round. For example, take Fizzle Out Technologies Inc., a
start­up with promising technology that raised capital in its infancy by selling
common stock to various friends, colleagues and angel investors. Fizzle also
managed to attract the interest of a few venture capital firms. In its first round of
institutional financing, the VCs valued Fizzle at $30 million, often referred to as a
"pre­money valuation." They invested $10 million in the company, resulting in a
post­money valuation of $40 million. One year later, Fizzle is in need of more money. Unfortunately, the $40 million post­
money valuation enjoyed by Fizzle after the first round has eroded. The second­
round investors have placed a pre­money valuation of $20 million on the company. The down round has many consequences, the effect of which can leave an indelible
scar on a young company. These consequences involve the exercise of contractual
rights held by most VCs and legal concerns imposed at both the federal and state
level. While a down round is a disconcerting experience, a defensive position can be
created, allowing a company and its board to successfully cope with its effects.
Dilution of a stockholder's ownership is the most debilitating result of a down round.
Ideally, as a company progresses and its valuations increase, it will raise money by
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selling fewer and fewer shares in each successive round. In a down round, however,
the company must sell more shares than in a previous round to get the same
amount of cash. This erodes the current stockholders' equity stake. VCs, however, have an advantage over the common stockholders ­ a price­based
anti­dilution provision ­ that serves as protection against dilution. This protective
mechanism is triggered by a down round and increases the amount of common
stock the VC will receive on conversion of his or her preferred stock.
To explain further, it is helpful to examine the conversion feature of a typical
preferred stock. The classic conversion formula follows:
shares of preferred original share price shares of common stock to
X
stock to be
=
conversion price
be received on conversion
converted
At the outset, the "conversion price" will mirror the "original share price."
Under this formula, dividing the original share price by the conversion price
would produce a quotient of 1, resulting in a 1­for­1 conversion of preferred
stock to common stock. Accordingly, as the conversion price is reduced, the
number of common shares received on conversion increases. For example, if Fizzle, whose first­round investors negotiated anti­dilution
protection, sold preferred stock in its first round at $2 per share, the
conversion price and the original share price would both begin as 2. When
Fizzle completes its second round of financing at a lower valuation ­ say $1
per share ­ the anti­dilution mechanism is triggered, reducing the conversion
price. That increases the number of shares of common stock that the investor
will receive on conversion. This in turn increases the dilution already caused
by the down round. The reality of most down rounds involves a concession by the VCs of some or
all of their anti­dilution rights. This requires the company to obtain a waiver
from each holder of these rights and, in some instances, may even
necessitate a formal amendment to the company's charter. Without this
concession, the prospects for completing a deal are often bleak. Additionally,
as the employees and founders are crammed down, the incentives to produce
fade, leading to internal upheaval and diminishing returns on the VC's anti­
dilution protection. Nevertheless, in the venture capital game, forewarned is forearmed. When
negotiating its initial financing rounds, a company should be aware of the
different types of anti­dilution provisions — the preferable "weighted­
average" and the more punitive "full­ratchet." Weighted­average provides a
more reasoned approach. It considers the number of shares issued in the
dilutive round in proportion to the outstanding capital of the company. A full­
ratchet, on the other hand, is less forgiving and is usually an indication that
the company had minimal leverage during the negotiating process. A full­ratchet looks only at the price per share of the dilutive issuance,
regardless of the number of shares issued. It then "ratchets" the conversion
price down to that price. So, if Fizzle issues shares of its capital stock at $1
per share, under a full­ratchet scenario, the conversion price for the
preferred stock issued by Fizzle in its first round at $2 per share would
automatically be reduced from 2 to 1. This will be the case regardless of
whether Fizzle issues one share or 1 million shares. Accordingly, the first­
round investors will receive two shares of common stock for each share of
preferred stock they convert, creating significant dilution to the other
stockholders:
2 1
(original share
shares of preferred
shares of common stock
= 2
price)
stock to be
=
to be received on
X
(conversion price)
converted
conversion
A weighted­average anti­dilution provision is more forgiving. It reduces the
conversion price in proportion to the actual number of shares currently
outstanding and issued by the company. If Fizzle, which has 10 million shares
of capital stock outstanding, issues 100 shares at $1 per share, this will have
an insignificant impact, reducing the conversion price by less than $.01.
If, however, Fizzle issues one million shares at $1, the effect on the
conversion and subsequent dilution will be greater. If Fizzle is unable to
negotiate a concession on anti­dilution from its current investors, the
existence of the weighted­average component will certainly mute the impact
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relative to a full­ratchet regime. The upshot is that a company should always try to negotiate a weighted­
average anti­dulition provision. However, depending on the circumstances,
the VC may push for a full­ratchet. Often, the alternative is a hybrid. For
example, Fizzle might try to renegotiate full­ratchet protection down to a
specified level and weighted­average thereafter. Drilling down further, if a company is able to avoid a complete full­ratchet,
the weighted­average component should be "broad­based." In a broad­based
weighted­average formula, the dilutive issuance is weighted against the fully
diluted capital stock of the company (that is, assuming conversion of all
preferred stock, options, warrants, etc.), as opposed to a "narrow­based"
weighted­average formula, which compares the dilutive issuance against only
the common stock then outstanding. Put another way, a broad­based
approach compares a dilutive issuance to a larger pie than does a narrow­
based approach, making the issuance appear less significant.
Regardless of the type of provision the VC receives, the company should
insist on carve­outs (exemptions) from anti­dilution for certain issuances.
These carve­outs allow the company to make potentially dilutive issuances,
such as options to employees, without triggering the anti­dilution provision.
Companies that fail to obtain these exemptions often find themselves
explaining away otherwise innocuous issuances, such as a warrant given to a
bank in connection with a credit facility. The company's securities lawyer
should carefully analyze the capital structure of the client to determine
carve­outs appropriate for the company.
Additionally, if a company has any leverage, it can reduce the impact of an
anti­dilution provision by negotiating a "pay­to­play" provision and
performance adjustments. Under a pay­to­play approach, in order for a VC to
initiate its anti­dilution protection, the VC must participate in the dilutive
financing at its pro rata allocation. This may also be referred to as the "put­
up­or­shut­up" clause since the VC must demonstrate commitment to the
company before receiving the benefit of anti­dulition. A performance adjustment allows the company to recoup its loss of
ownership resulting from a down round as the company meets predetermined
targets. The different permutations for crafting a performance adjustment are
as varied as the imagination of the securities lawyer drafting them. For
example, Fizzle might negotiate a staggered increase to the conversion price
based on achieving certain sales figures over the next few quarters.
The VC typically wears two hats ­ stockholder and director ­ creating fertile
ground for a conflict of interest. The role of director involves fiduciary duties
that often run counter to the VC's obligations to his or her fund's investors.
This conflict of interest is magnified by an inside down round, where the
existing VCs/directors, as participants in the financing, establish the share
price, as well as other favorable terms. This often leads to accusations of
self­dealing on the part of the VC/director. To avoid this volatile issue, the
company's board of directors should create a committee of independent and
disinterested directors to evaluate the proposed terms of the down round. Alternatively, the company could obtain majority approval from the
disinterested directors or stockholders after full disclosure of all the material
facts surrounding the transaction. Further, the company should establish a
valuation for the round through an independent source. A valuation
established by an independent third party creates an aura of fairness. Ideally,
this would be an investment banker who has no financial interest in the
company. But, given the financial condition of most start­ups, it will probably
be an outside investor. The use of a third party in a down round, however, is not a panacea for
exposure to liability resulting from a breach of fiduciary duty. A cautious,
almost paranoid, approach should be taken when faced with a down round,
particularly an inside down round. Toward that end, a company involved in a down round financing should
strongly consider making a rights offering to all stockholders, including
founders and employees. In the context of a private equity financing, a rights
offering is an offer by a company to certain individuals for the right to
purchase shares of stock in the company's pending equity financing. This
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provides stockholders, who would otherwise be precluded from participating
in the round and thereby suffer excessive dilution, the opportunity to
maintain their equity stake or, at least, minimize the dilutive impact. Many
lawyers will not consider a rights offering unless the down round is strictly by
insiders. However, in any down round where existing stockholders are likely
to be diluted and there is a risk that the directors will be accused of self­
dealing, it is an option worth considering. A rights offering, however, raises concerns of its own. The federal securities
laws prohibit the offer or sale of unregistered securities. While the Securities
and Exchange Commission has provided certain exemptions from this
registration requirement, these exemptions contain very specific guidelines
that create logistical difficulties for a company making a rights offering to
every stockholder of record. Regulation D (Rules 501­508) of the Securities Act of 1933, the SEC's safe
harbor exemption from registration, requires the company to provide detailed
disclosure information (including audited financials) to any offeree who is not
an "accredited" investor. An accredited investor is, for simplicity's sake, an
officer or director of the company, and/or a person with a net worth of $1
million, and/or a person who makes at least $200,000 per year individually
or $300,000 with a spouse. Additionally, while Regulation D allows sales to an unlimited number of
accredited investors, it limits sales to 35 nonaccredited investors. For
companies with a significant number of nonaccredited employees, a
wholesale rights offering may be impractical. To fortify its protection against liability, a company and its board should be
cautious of what is put in writing. Board minutes should not be a detailed
dissertation of what was discussed at the board meeting. Instead, the
minutes should contain a brief synopsis of the meeting, documenting that
alternatives were considered and creating a record in support of the final
valuation. In summary, the outcome should be documented without
superfluous detail. Finally, a company should review the indemnification provisions contained in
its bylaws or charter, as well as its D&O insurance coverage, to insure that
its officers and directors are adequately covered. While typical corporate law
prohibits indemnification where self­dealing is involved, the disinterested
directors who are approving the transaction should be confident in the fact
that their liability exposure is limited.
It is difficult to predict when the economic storm will dissipate. Until then, we
will continue to feel its residual effects. Each company's situation will be
unique, requiring forethought and prudence. However, applying the strategies
described above will help a company and its advisers create a bulwark
against the potential ruin of the down round.
Mahoney is an associate at Snell & Wilmer LLP in Phoenix. His e­mail is
[email protected].
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