Down rounds—equity financing rounds where the company’s valuation is lower than at least one of its previous rounds of financing—have been rare in the sellers’ market of the past few years, where high valuations fueled by an abundance of capital is the norm.
However, as the impact of COVID-19 and other black swan events permeates global economies, an increasing number of companies will grapple with fundraising in an environment of increased investor caution around valuations and deployment of capital, particularly for pre-profit companies in harder-hit sectors.
In this installment of the MoFo PE Briefing Room, we discuss a few tips for investors when navigating a down round, both as an existing investor and as a new investor coming into the company.
1. Understand your rights. What are they, and how can you use them?
2. As a new investor, use your negotiation leverage over both the company and the existing investors.
3. Use the down round as an opportunity to renegotiate for better terms.
What Does a Down Round Mean?
Both the company and its existing investors generally want to avoid a down round, as it tends to send a signal that the company’s business is not doing well and potentially that the company was overvalued during its previous financing round.
In addition, when a down round occurs, private equity investors could suffer immediate financial implications, as the market value of their investment in the company will need to be revised downward (except to the extent their anti-dilution protection counteracts this). See “Anti-Dilution Rights” below.
What is a down round for later investors may not be a down round for early stage investors who entered at low valuations, but no investor comes off easy. While these early investors may not have as significant mark‑to-market issues, they will still be subject to increased dilution as a result of any new shares issued at a low valuation and will experience further dilution if anti-dilution adjustments are triggered for the later investors. Accordingly, investors who invested in the company at different valuations may have different attitudes towards a down round, with early investors pushing later investors to waive their anti-dilution protection to “share the pain.”
Existing Shareholder Rights of Relevance
There are a number of rights typically given to holders of preferred shares that are intended to protect the holders against the negative financial impact of the company undergoing a down round. These rights could give existing shareholders significant additional leverage in negotiations with both the company and the new investors.
Generally speaking, preferred shares are convertible into common shares (known as “ordinary shares” in English law based systems) at a conversion price that is initially equal to the original issue price of the preferred shares. An investor’s originally contributed capital is protected through ownership of preferred shares that bear liquidation preference, but participation in upside comes through conversion to common shares, with voting rights and overall ownership tracked on an as-converted to common shares basis.
If a company issues new securities for a per-share price that is lower than the conversion price of a series of preferred shares (i.e., a down round), unless waived, anti-dilution rights will be triggered to reduce the conversion price of those preferred shares. Upon the closing of the down round each preferred share will be convertible into more common shares, giving the holder of the preferred shares a greater percentage ownership in the company. This effectively resets the original valuation for the preferred shareholder’s investment while keeping their liquidation preference the same.
Anti-dilution rights can be drafted differently to give differing levels of adjustment in the case of a down round. The best protection comes in the form of “full ratchet” protection, which reduces the conversion price of a preferred series to exactly the price paid by new investors in the down round—but this formulation is very uncommon. It is more market to see “weighted average” anti-dilution protection, which moderates the impact of the anti-dilution based on a number of factors, including how much lower the per-share valuation for the proposed down round is compared to the preferred shareholders’ entry price, how much money is being raised in the new financing, and how many preferred shares are outstanding relative to the overall capitalization of the company. Depending on the circumstances, triggering of the anti-dilution rights could have a very dramatic effect on the shareholding percentage of the preferred shareholders, potentially even resulting in a change of control.
As mentioned above, anti-dilution rights may allow private equity investors to avoid having to write down the value of their investment after a down round or reduce the write down, since, even though the company as a whole may be valued at a lesser amount, the value of the investor’s investment in the company remains the same (in the case of “full ratchet” protection) or is only partially reduced (in the case of “weighted average” protection).
Note that, in some jurisdictions, it is more usual to see anti-dilution managed through the issuance of new shares to the diluted investors rather than through the adjustment of conversion prices. U.S.-based investors, however, typically prefer the conversion price adjustment structure to avoid potential adverse tax consequences associated with receipt of newly issued shares.
Preferred shareholders acting as a class often have veto rights over amendments to organizational documents that would permit issuance of new preferred shares, which inherently provides a veto over down round issuances. In addition to needing the requisite percentage of preferred holder class approval, in some cases an individual series of preferred may also have veto rights over any new financing round or only over down rounds specifically.
Pre-emptive rights give existing shareholders a priority right to participate in a new financing round, usually pro-rata to their equity holding percentage in the company. In a down round scenario, this allows existing shareholders to participate at the lower valuation and thereby maintain their ownership stake.
Negotiation Points for Investors During a Down Round
Investors Committing New Capital
If a company is considering doing a down round, investors who are putting the new capital in the company are likely to have a great amount of leverage. New investors can therefore be fairly aggressive and creative in negotiating the investment. Aside from asking for the usual investor-friendly terms, investors may seek greater board or governance control and often require existing shareholders to waive their anti-dilution rights. Investors can also consider structuring part of the investment as a secondary purchase from existing investors who wish to exit at a lower valuation than for the newly issued shares, but in certain ways this may also be “doubling down” on a distressed business where a substantial part of the invested funds would not be put to use sustaining or growing the company. An investor could also seek to structure its new investment as convertible debt where the instrument assumes a valuation for the company and gives the holder substantially the same rights as preferred equity but gives better downside protection as a debt instrument. This is a fairly aggressive approach and is likely to be resisted quite strongly by the company and particularly the existing investors. We see this type of convertible debt instrument more frequently in Asia, whereas in the United States they are less common.
That said, since preferred shareholders generally have a veto over future financings, including down round transactions, a balance will need to be struck in agreeing to a set of investment terms that give the new investor strong deal economics and governance rights, but are still acceptable to the existing preferred shareholders.
Existing Investors not Committing New Capital
Indeed, existing investors with control over financing veto rights may be able to condition their approval on renegotiating the terms of a down round to minimize the adverse impact. For example, they may insist that a company raise less money at the down round valuation and operate on a tighter budget in the immediate term, or the investors can request additional governance protections to help “right the ship.” Additional rights and protections that do not negatively impact the interests of the new investors will likely be easier to negotiate.
Ultimately, however, if the company is distressed and requires the additional capital in order to keep operating, the choice before the existing investors may be between (a) giving up some of their rights and accepting terms that may be less than optimal in order for the company to secure the new investment and (b) not accepting the terms of the new investment and endangering the future of the company (and therefore their investment).
While a down round is in many ways just a new round of financing and many of the usual considerations remain applicable, the dynamics between the company, the existing investors, and the new investors are drastically different and give rise to different considerations. Much closer consideration of the rights of the company’s existing shareholders will be required, and there will be more interface between the different investor groups than a regular financing round. Keeping these differences in mind will help investors optimize their position when considering a down round investment.