The decline in value of venture-backed M&A exits, the paucity of venture-backed IPOs and the decline in new funds raised by venture capital firms has resulted in a difficult follow-on financing environment for venture-backed companies.
Notwithstanding execution against business plans and the achievement of growth milestones, many venture-backed companies are faced with the prospect of raising money against the backdrop of revised valuation expectations, modified investment theses and changing investor bases. When additional financing cannot be raised using a legacy capital structure, a venture-backed company and its investors face recapitalizing the company to accommodate new investment.
Recap Mechanics
Recapitalization mechanics are architected with a view to achieving desired effects on the liquidation preferences, priorities or valuation differentials of the prior rounds of investment. The most popular recapitalization mechanics either preserve or eliminate each of these fundamental aspects of the prior investments (see illustration).
Valuation reset. All previously issued preferred stock (e.g. Series A, B and C) is redesignated into a new series (e.g. Series 1, 2 and 3) according to the amount paid for the previously issued preferred stock. For example, shares of Series A sold at $1 each, shares of Series B sold at $2 each and shares of Series C sold at $3 each are redesignated into one share of Series 1, two shares of Series 2 and three shares of Series 3, respectively. New financing is raised by selling Series 4. The aggregate liquidation preferences of each series of prior investment are preserved, as is the hierarchy of priorities of preferences among those series. But valuation differentials are eliminated so that all prior investment is treated as having been raised at the same valuation.
Flattening. All previously issued preferred stock is redesignated into a single new series (e.g. Series 1). New financing is raised by selling Series 2. The aggregate liquidation preferences of each series of prior investment are preserved, but the priorities among those series are eliminated and all prior rounds are “flattened” into a single series. The previously issued preferred stock can be redesignated into shares of Series 1 according to the number of shares of previously issued preferred stock held to preserve the valuation differentials of the prior rounds (a “flattening by shares”) or according to the amount previously paid (e.g. one share of Series 1 for each dollar previously invested) (a “flattening by dollars”).
Preference reset. The liquidation preferences of the previously issued preferred stock are reduced and new financing is raised by selling the next series of preferred. The reduction in liquidation preferences may be applied ratably or, with sufficient stockholder approval, disproportionately, among all prior rounds of investment. Priorities and valuation differentials of the prior investment rounds remain intact, but the aggregate liquidation preference attributable to the prior investment (the so-called “preference overhang”) is reduced.
Many recapitalizations are structured to incentivize prior investors to participate in the new financing.”
Preference and valuation reset. All previously issued preferred stock (e.g. Series A, B and C) is redesignated into a new series (e.g. Series 1, 2 and 3). The redesignation is done according to the amount paid for the previously issued preferred stock, as is done in a valuation reset. The new series have aggregate liquidation preferences that are less than the aggregate liquidation preferences of the previously issued preferred stock, as is done in a preference reset. Priorities among the series of prior investment are preserved, but valuation differentials are eliminated and the preference overhang is reduced.
Wipeout. Some or all of the previously issued preferred stock is converted into common stock and new financing is raised by selling Series 1. A wipeout eliminates liquidation preference and priorities among the prior rounds of investment. Previously issued preferred stock can be converted into common stock at existing conversion rates to preserve the valuation differentials of the prior rounds and the effect of any prior antidilution adjustment (a “wipeout by shares”). Alternatively, preferred stock can be converted into common stock according to the amount paid for the previously issued preferred stock to eliminate the valuation differentials of the prior rounds (a “wipeout by dollars”).
A wipeout by dollars requires the selection of a single valuation at which all previously issued preferred stock is converted to common. For example, shares of Series A sold at $1 each, shares of Series B sold at $2 each and shares of Series C sold at $3 each could be converted to common at a valuation of $2.50 per share, such that each share of Series A, B and C convert into 0.4, 0.8 and 1.2 shares of common stock, respectively.
Pay-to-Play Mechanisms
Many recapitalizations are structured to incentivize prior investors to participate in the new financing. To punish non-participating prior investors, many recapitalizations employ a “pay-to-play” mechanism whereby prior investors must participate in the new financing to preserve the liquidation preferences, priorities or valuation differentials of their investments.
In an “auto-convert to common,” prior investors that fail to participate in the new financing suffer the automatic conversion of their preferred stock into common stock. The conversion can be “all or none” such that a prior investor must purchase its entire pro rata share of the new financing to avoid the conversion of all of its preferred stock, or “partial” such that conversion is applied according to the extent of the prior investor’s participation in the new financing.
In an “auto-convert to shadow preferred,” prior investors that fail to participate in the new financing suffer the automatic conversion of their preferred stock into a shadow series of preferred stock. The shadow series of preferred stock is deprived of one or more rights, such as blocking voting rights, board seats, pre-emptive rights or antidilution protection. The aggregate liquidation preferences of the previously issued preferred stock are preserved. Previously issued preferred stock can be converted into different series of shadow preferred to preserve priorities and valuation differentials of the prior rounds of investment, or into a single series of shadow preferred to eliminate priorities either according to the number of shares held (to preserve valuation differentials) or according to the amount paid (to eliminate valuation differentials).
To punish non-participating prior investors, many recapitalizations employ a “pay-to-play” mechanism whereby prior investors must participate in the new financing to preserve the liquidation preferences, priorities or valuation differentials of their investments.”
In a “complete redesignation,” all of the previously issued preferred stock is redesignated into new shares of preferred stock based upon a prior investor’s participation in the new financing. The shares of non-participating Series A, B and C investors are redesignated into shares of Series 1, either according to the number of shares held (to preserve valuation differentials) or according to the amount paid for the previously issued preferred (to eliminate valuation differentials). The shares of participating Series A, B and C investors are redesignated into shares of Series A-1, B-1 and C-1, respectively, either according to the number of shares held (to preserve valuation differentials) or according to the amount paid for the previously issued preferred (to eliminate valuation differentials). The Series 1 is given the most junior liquidation preference and is deprived of rights such as blocking voting rights, board seats, pre-emptive rights or antidilution protection. The Series A-1, B-1 and C-1 preferred stock preserves the priorities among liquidation preferences and retains the voting rights, board seats, pre-emptive rights and antidilution rights of the previously issued preferred stock. New financing is raised by selling Series 2.
Closely related to pay-to-play mechanisms that operate by way of charter-based impacts on stock held by non-participating investors are “pull through” and “pull up” mechanisms, which operate by way of contractual exchanges of securities outside of the corporate charter.
In a common variant of the “pull through” mechanism, participating investors are given the opportunity to exchange their shares of previously issued preferred stock for an equal number of shares of a shadow series of preferred stock with identical rights, after which all unexchanged shares of previously issued preferred stock are converted to common stock.
In a “pull up” mechanism, participating investors are given the opportunity to exchange their shares of previously issued preferred stock for more senior series. In one variant, participating investors are allowed to exchange their shares of previously issued preferred stock for an equal number of shares of a shadow series of preferred stock with identical liquidation preferences and priorities among themselves, but senior to the liquidation preferences of the unexchanged shares of previously issued preferred stock.
In another variant, participating investors are given the opportunity to exchange their shares of previously issued preferred stock for an offset against the purchase price of shares in the new financing. In another variant, participating investors are allowed to exchange their shares of common stock issued upon prior conversion of preferred stock (e.g. as a result of the prior application of a pay-to-play mechanism) for shares of a new series of preferred stock depending on the extent of their participation in the new financing, thereby restoring previously lost liquidation preference and other preferred rights.
To architect, analyze and fully understand recapitalization or pay-to-play mechanisms, entrepreneurs and investors rely on flexible and robust spreadsheet models that reveal the sensitivity of various inputs and provide “what if” analysis across a broad range of scenarios. Even after a mechanism has been designed, the ability to implement a recapitalization or pay-to-play mechanism depends on the ability to garner the requisite board and stockholder support and navigate a web of statutory, charter and contractual requirements.
Timothy Harris is a partner at Morrison & Foerster LLP and co-chair of the firm’s Emerging Companies and Venture Capital Group. He may be reached at tharris@mofo.com.
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