The valuations of both public and private technology companies have been plummeting almost nonstop since the record highs reached in early 2000. In the case of many public technology companies, their valuations are off by up to 95% from their recent highs. Numerous technology companies are seeking bankruptcy protection or simply closing their doors. At the same time, venture financing for start-ups has become increasingly scarce as venture capitalists focus on sheparding their existing portfolio companies through this difficult financing market.
In this environment, even “good” venture-backed technology companies are facing the unpleasant prospect of raising new money at lower valuations than their earlier rounds. These “down rounds” are inherently difficult to negotiate, raise nettlesome issues about employee morale and retention and can be a lightening rod of liability for unwary VCs. Historically, down rounds were limited largely to companies with significant problems that had badly missed on their business plans. Given the dramatic and widespread devaluation that has taken place over the last several months as well as the significant capital needs of many venture-backed companies, more and more VCs and companies will have to contend with down round financings throughout the coming year.
Ideally, emerging companies are able to raise successively larger rounds of private equity financing at ever increasing valuations. By exercising their preemptive rights, early round investors are able to maintain their percentage interest in these companies through subsequent financing rounds. Although management is inevitably diluted by these successive financing rounds, the impact of that dilution is minimized since the increasing valuations allow these companies to give up less and less relative equity in each successive financing round.
To understand the impact of a down round, it is useful to look at an example. Assume that a company obtains $10 million in first round financing at a $20 million pre-money valuation. This would result in the first round investors owning one-third of the company with the remaining two-thirds allocated to the founders and the employee option pool. When the company seeks $15 million in second round financing, the best offer it gets is a $15 million pre-money valuation. This represents a significant shortfall from the company’s $30 million post-money valuation after the first round and will result in substantial dilution to the founders, employees and existing investors.
The existing investors are, however, in a better position to minimize the impact of this dilution than the founders and employees because of the rights typically granted to venture investors. Foremost among these rights is anti-dilution protection, which increases an existing investor’s stake in a company to offset some of the dilution experienced in a down round. The two principal forms of anti-dilution protection are “weighted average” and “full ratchet.” As the name implies, weighted average anti-dilution protection increases an investor’s ownership based upon the proportional impact that a new financing has on a company’s previous valuation. The full ratchet is a more draconian and less common approach, which gives the old investors the full benefit of the new lower price. The other significant right available to investors is their preemptive right to subscribe for their pro rata share of any new financings. Even more important than the right itself, VCs generally have more capital at their disposal than the typical founder or employee and are thus able to participate in down rounds in a more meaningful manner.
Going back to our example and assuming that the company’s existing investors had weighted average anti-dilution protection and fully exercised their preemptive rights, the results are illuminating. The founders and employees would see their equity stake in the company reduced from 66.67% to 30%. At the same time, the existing investors would see their equity stake actually increase from 33% to 36.67%. As this example illustrates, one of the biggest issues in a downround is the dilutive (and potentially demoralizing) effect it has on management and employees.
Down rounds are hard to consummate for a number of reasons. Companies and existing investors are often reluctant to acknowledge that a significant devaluation has occurred. New investors are often rightly concerned about the impact on management’s equity and will require that sufficient equity be allocated to existing management and the employee option pool at the expense of the existing investors. Moreover, the disparity in interest between the new investors and the old investors will often lead to extensive negotiation over adjustments to conversion features, anti-dilution adjustments, liquidation preferences and control provisions. Even figuring out the per share price of a down round is difficult. In a typical up round, the new investors set the pre-money valuation and divide by the fully-diluted share number to arrive at their per share price. In downrounds, the impact of the existing investors’ anti-dilution rights must be taken into account, essentially requiring that the parties solve for two simultaneous equations in order to determine the per share price.
The other big issue in down round financings involves the corporate procedures by which they are negotiated and approved and the fiduciary duties that existing investors may owe to other shareholders. Typically, VCs have significant influence, if not outright control, over their portfolio companies through their stock ownership and board representation. In addition, VCs usually have numerous control rights, including the right to veto the issuance of senior or pari passu securities to investors. As a result of this control as well as their greater familiarity with the private equity markets, VCs typically play a significant role in subsequent financing rounds for their portfolio companies. In the context of a down round, however, this approach can be a prescription for disaster.
Most decisions by corporate directors are entitled to a great deal of deference under the business judgment rule. However, this deference does not apply to transactions in which directors have an interest or a conflict, as is the case with a downround financing in which existing investors are participating. In these situations, the burden is on the company and its directors to show that the transaction was in fact fair to other shareholders who were adversely impacted by the financing. Moreover, a number of states, such as Massachusetts, have imposed significantly higher duties on controlling shareholders in private corporations, generally subjecting them to the same fiduciary standards applied to general partners and trustees.
The potential for liability in downrounds is very real and only adds to the difficulty in getting these financings done. Moreover, the risks do not go away once the financing is completed. In one recent case, three prominent VCs paid a $15 million settlement several years after completing a downround when the company managed to reverse its fortunes, go public and get sold for several hundred million dollars.
Given the difficulties and risks involved in downrounds, what should VCs do? It is not possible for existing investors to forego participation in a downround since new investors are unlikely to invest if the existing investors do not take their pro rata share. Moreover, if new investors cannot be found, the existing investors may be the only source of available capital. The following are some suggestions for mitigating the risks inherent in downround financings that VCs should consider:
Focus on Process. Existing investors should recuse themselves from board deliberations regarding the terms of the financing and, where possible, a committee of independent directors should be charged with negotiating on behalf of the company. The company should also conduct the most extensive possible search for new investors given its cash position and burn rate. The existing investors and the company should have separate counsel, even in inside rounds. It is also important to avoid indelicate characterizations such as “washout” or “burndown” financings or suggestions that the management or founders should get diluted because of the company’s downturn. Finally, any beneficial adjustments to the terms of the company’s earlier financings, such as the introduction of a full-ratchet, should be resisted or agreed upon only in consideration of a significant new investment by the existing investors.
Support Valuations. In an ideal world, boards would obtain fairness opinions or valuation reports to support the pricing of a down round. Realistically, most companies facing a downround have neither the money nor the time to engage a banker or appraiser for such support. In these situations, it is critical that the record establish as much support for the board’s decision as possible by reference to public and private comparables, market conditions, business exigencies facing the company and the negotiation process.
Consider Rights Offerings. By extending the existing investors’ preemptive right to management and other shareholders, the dilutive impact of a downround on these groups can be minimized. Typically, however, these rights offerings are limited to accredited investors because of the extensive securities law disclosures required for offerings to non-accredited investors. Moreover, a rights offering is not a panacea since many managers and other shareholders do not have the capital to exercise their preemptive right and they are free to argue that they should not have to put up more money to avoid unwarranted dilution.
Negotiate Performance Adjustments. It may be possible to negotiate performance adjustments which ratchet back the percentage interest that new investors have in a company once some significant appreciation in value has been achieved. This type of approach can minimize the dilutive impact of a downround for companies that subsequently get back on track with earlier valuation expectations. Even if the new investors are unwilling to agree to any ratchets on their upside, the attempt to negotiate such provisions will help to establish a good record for the company.
Insist on Pay-to-Play. In the current environment, full ratchet anti-dilution provisions are becoming increasingly common. It is also likely that companies and lead investors will increasingly insist on pay-to-play provisions. These somewhat complicated provisions essentially provide that investors who do not subscribe for their pro rata share of a down round will lose their anti-dilution protection and other rights for that round and all subsequent rounds. These provisions have the salutary effect of incenting existing investors to support portfolio companies through tough financing times and ensuring that more equity will be available for management and supportive investors. t
John Egan III and Mark Selinger are corporate partners at the international law firm of McDermott, Will & Emery.