Navigating venture financing in down markets

Global venture funding dropped 35 percent in 2022, this year has started slow, and the outlook for the remainder of 2023 is not much better.

Given that the last time most venture firms had to deal with the impact of a recession was about 15 years ago, now is a good time for a refresher on deal structuring and fiduciary duties around down rounds.

Deal terms and structures

Economic downturns make investors more cautious with their capital, and it may become more difficult for start-ups to obtain funding. This creates opportunities for investors to negotiate favorable terms, but these also often carry heightened fiduciary and litigation risks due to conflicts.

Down rounds occur when a company issues preferred stock with an original issue price lower than that issued in a prior financing round. Companies and investors should be aware that due to dilutive impacts of prior rounds, convertible securities, or option pool dynamics, a new round that appears to be a flat round relative to a prior financing may actually be a down round when the cap table math is finalized.

A down round can be a negative sign for the company, but it also provides investors with the opportunity to purchase shares at a discounted price. A simple down round follows the mechanics set out in the existing charter and therefore requires less structuring and negotiation, so it may be easier to execute.

Another frequently used term in a downturn is a liquidation preference multiple, which gives investors the right to receive a multiple of their initial investment before other shareholders in the event of a liquidation or sale of the company. In a normal market, investors typically get a 1x non-participating liquidation preference, but in a rockier market, there are variations that include higher multiples and participation features. These can provide investors with some protection if the company does not perform as well as expected, and companies should be aware of the economic impacts of these terms before entering into a term sheet.

“Anti-dilution provisions” also protect investors from dilution of their ownership stake; they can take different forms, such as “weighted average” or “full ratchet,” that adjust the conversion price of the investors’ securities. We see many varied approaches here in a turbulent market, including a mix of full ratchet and weight average, in order to meet valuation targets and downside protections for the parties.

Restructuring the capital stock structure of a company via a recapitalization or “recap” (often at a lower valuation) can lead to a simplified capitalization structure, with a reduced liquidation preference to better align with the company’s current value.

Pay-to-play financing incentivizes investors to participate by penalizing those who do not participate and/or providing some additional benefit to those who do participate. This structure may leverage mandatory conversion provisions in the charter to restructure the company’s capitalization table and allow a new financing round to take place while meeting economic objectives of the parties. If the company charter does not include a pay-to-play provision, it may (but not always) need to be amended to include terms addressing future financing and forcing conversion, or allowing holders who participate in a new financing to “pull through” their shares of preferred stock into a more senior series of preferred stock. A “pull-up” allows converted preferred holders that participate at a certain level (often pro rata) to convert their recently converted common stock into a new series of preferred stock that sits junior to the new preferred shares.

Approvals and governance matters

Down market deals can often trigger additional approval rights from different classes or series of capital stock and stakeholders, complicating the approval process. For example, Delaware law may require additional class/series approvals by both preferred and common stock.

If the company has a credit facility, down-market financings are more likely to require lender approvals. Anti-dilution rights and waivers are often required with respect to each affected series of preferred stock.

In board restructurings, legacy or non-participating investors that the company and/or new investors want off the board often have the right to keep their board seats, which can create extra complexity.

Fiduciary duties

In all these scenarios, companies and their investors need to be cognizant of their fiduciary duties, as directors and officers owe fiduciary duties to the corporation and its stockholders warranting special consideration in down-market financings.

A director has an active “duty of care.” They cannot be passive or fail to fulfill their duties on behalf of the company, and they must be fully informed and seek out any necessary information to make an informed decision.

Directors and officers also have a duty to act in the best interests of the corporation and its stockholders as a whole, and not in their own – or the controlling stockholders’ or preferred stockholders’ – interests. They are obligated to focus on maximizing the corporation’s value for the benefit of its stockholders.

Directors who act in good faith are entitled to the protection of the “business judgment rule,” which protects them from personal liability exposure through corporate indemnification and D&O insurance. Acting in bad faith is a breach of fiduciary duty that may lead to personal liability and losing the protection of corporate indemnification and D&O insurance.

A conflict of interest may be inferred if a director participates in a financing as an investor or receives some direct benefit from the transaction. Investor directors must be especially careful if they or their funds participate in or lead a financing. A conflict may also arise if a C-level executive receives a “top-up” grant or other consideration in connection with a down market financing to compensate for dilution. A director can even be conflicted due to a close personal or economic relationship with a party participating in a transaction, even if that director is not participating.

If a majority of the directors approving the transaction are found to have an interest, they will be subject to the “entire fairness standard,” which imposes a heightened level of scrutiny and shifts the burden of proof from the complaining stockholders to the company.

Mitigating risks

Certain mitigation tools may help reduce potential risks to negotiating new financing terms in a down market, such as:

• An independent board committee of “disinterested” directors to conduct the financing search and the evaluation, negotiation and initial approval processes.
• A “majority of minority” stockholders vote to obtain approval of a majority of stockholders who are not participating.
• A market check for alternative sources of financing.
• Valuation backup through analysis and documentation of the bases for the new valuation.
• Board meetings with a strong record of deliberation and analysis, including conflicts and recusals.
• Offering all stockholders who are accredited investors the right to participate.
• Full disclosure to stockholders of all approval and rights-offering processes.
• Venture financing during a downturn offers both challenges and opportunities for the parties involved. It is important for the board to consider its fiduciary duties when negotiating these terms to ensure that the board is acting in the best interest of the company and its shareholders.

Carl J Hessler is a partner in Lowenstein Sandler’s Tech Group, Seed Stage Investing & Startups, Venture Capital and Tech M&A practice groups. Based in Palo Alto, he represents emerging technology companies and their investors. He may be reached at chessler@lowenstein.com.