The Upshot of Down Rounds
June 01, 2020
The impact of the Coronavirus and COVID-19 on venture capital investment will likely be similar to what we saw in the aftermath of the 2008 recession and the 2001 dot-com meltdown. VC investors will redirect their attention away from sourcing new deals and toward managing their existing portfolios, trying to determine which should survive and which should be liquidated or shut down. Faced with a distressed investment market, many surviving companies without sufficient reserves will be forced to try to raise additional funds in “down rounds”, i.e., at pre-money valuations lower than the post-money valuation of their previous round. This blog post will address the resulting economic dilution and other consequences to previous investors and founders, as well as the protection against economic dilution that VCs always negotiate for.
The first consequence of a down round is economic dilution to founders and previous investors. Suppose a company raises $4 million in a Series A round at $1 per share at a pre-money valuation of $12 million ($16 million post-money). The investor would receive 4 million shares constituting 25% of the post-money capitalization. Now imagine the company is later forced to raise an additional $4 million but at a pre-money valuation of only $10 million. The company would issue the new investor 6,400,000 shares at $0.625 per share ($10,000,000/16,000,000 shares). As a result, the previous investor’s shares would now be worth only $2.5 million (4 million shares x $0.625), a $1.5 million writedown from its original $4 million value representing economic dilution of 37.5%.
Just as down round investors negotiate aggressively on valuation, they also tend to push for more favorable features in other non-price terms. If the lower valuation and lower price reflect the new investors’ perception of higher risk, down round investors are likely to want to protect against such greater risk with enhanced rights such as multiple, senior and participating liquidation preferences, milestone based staggered funding, cumulative dividends, redemption, board control, senior tag-along and drag-along rights, more robust vetoes and other enhanced rights. Faced with no alternatives, companies may have no choice but to accommodate these demands.
The aggressive terms sought by down round investors would typically leave existing shareholders worse off. But because the approval and/or cooperation of these shareholders may be needed to complete the down round and beyond, the company may be forced to sweeten the deal for these shareholders. For example, if the down round investors demand a multiple liquidation preference, the shares held by junior preferred and common shareholders could be worthless. In the hypothetical $4 million down round above, if the down round investors negotiate for and receive a 4x liquidation preference, they would receive $16 million off the top from the proceeds of any sale of the company and the other shareholders and optionee employees would get nothing unless the company were sold for more than that.
One source of leverage earlier preferred investors often have at their disposal is that they typically have a series-based veto over future funding rounds, i.e., a funding round requires the consent of some vote threshold of that series of preferred. Similarly, founders and other key employees may have leverage to the extent they’re considered indispensable to the future operations and ultimate success of the company. This in turn may result in the down round investors being forced to relax their position, or the company agreeing to more favorable voting rights for the preexisting investors and founders or other protections to ensure against any transaction that doesn’t result in any portion of proceeds paid to them.
An earlier round investor can protect itself against percentage dilution from a subsequent round by exercising its preemptive rights to buy its pro rata share of the next round, thus preserving pre-round percentage ownership. But the preemptive right holder may not have the means to participate in the next round. One way to protect against economic dilution from a subsequent down round is through exercising a veto right over future issuances. But a veto right will only give an investor the ability to block a transaction; if the investor waives the veto or otherwise elects not to exercise, the veto won’t protect the investor from the negative economic impact. For that kind of protection, the investor will need to negotiate in advance for anti-dilution protection in the form of price adjustments. Preferred stock is almost always convertible into common based on a conversion formula that typically starts out at a 1:1 ratio, i.e., one common share on conversion for every preferred share owned. If there’s a down round, the anti-dilution provisions kick in and automatically adjustment downward the conversion price of the holder’s preferred shares resulting in a larger number of common shares being issued to the investor upon conversion.
The magnitude of the conversion price adjustment, and thus in the number of additional shares issuable upon conversion, depends on which of the three basic formulas are used: broad-based weighted average, narrow-based weighted average and full ratchet. In either type of weighted average anti-dilution formula, the adjustment amount will depend on the relative size of the down round and measured by comparing the number of shares issued in the down round against the number of shares outstanding on a fully-diluted basis, with the difference being how broadly or narrowly “fully-diluted” is defined.
Under a broad-based weighted average formula, we look at the number of common shares outstanding on a fully-diluted basis after giving effect to the exercise or conversion of all outstanding warrants, options, convertible securities or other equity derivative securities. This formula dampens the magnitude of the conversion price adjustment the most by spreading the dilutive effect over the most possible securities.
The narrow-based weighted average formula, on the other hand, only takes into account currently outstanding common and preferred stock, or in a more granular version only outstanding common stock and issuances of common stock equivalents at a conversion or exercise price lower than the then applicable conversion price (e.g., in-the-money stock options). A more extreme version of this formula only includes the protected security and the dilutive issuance itself (together with outstanding common). In any event, this type of formula provides an intermediate adjustment by arriving at a blended conversion price higher than the down round price.
The most extreme version of anti-dilution and the most protective for the preferred shareholder is called full ratchet because the conversion price would simply ratchet all the way down to the down round price irrespective of how few or how many shares were issued in the down round. This results in the largest downward adjustment in the conversion price and greatest upward adjustment of shares on conversion to the protected holder and the most dilution to junior security holders.
One overlooked impact of anti-dilution rights is that they also increase the voting power of the rights holder, but whereas the economic impact of the additional shares resulting from a lower conversion price is only experienced upon a liquidity event such as a sale of the company, the shift in voting power happens right away because voting on general matters at the common stock level is based upon shares owned on a fully-diluted basis.
As mentioned above, anti-dilution adjustments cause junior investors and common stockholders who have no anti-dilution protection to suffer disproportionate dilution from the down round. The value of their securities shrinks as a proportion of the pre-money capitalization of the down round. Consequently, approval for the down round (if required) may be difficult to secure from these stockholders without an upward adjustment to the conversion price of the protected holder’s shares (i.e., higher than if the anti-dilution adjustments were strictly followed) and, even where junior security holder approval is not needed, it may be necessary to sweeten the deal for founders and key employees by offering them additional stock options or bonuses in order to retain and incentivize them.