April 30, 2020

Venture Capital: Finding Your Way Around “Down-Rounds”

Like many other companies, a lot of VC portfolio companies have recently taken a big valuation hit due to the fallout from the pandemic – and to make matters worse, a lot of those companies need to raise capital right away.  This one-two punch means that these companies face the prospect of going to market at a valuation that’s a lot less than the last time they raised money from investors.

That’s a “down-round” financing, and it’s about as much fun as a root canal – but if you have a client in this position, this Wilson Sonsini memo on navigating down-round financings is a very helpful resource.  It addresses many of the key issues associated with down-rounds,  Here’s an excerpt from the section discussing issues surrounding deal structure:

At a minimum, a down-round financing may trigger the anti-dilution provisions of existing preferred stock terms, which generally allow the relevant preferred stockholders to receive a more favorable conversion rate (for purposes of converting into common stock) if new stock is sold below a certain price. Such adjustments typically also involve a correlative improvement in the affected stock’s voting power. A company and investors considering a down round will want to consider the impacts of such adjustments.

Many certificates of incorporation provide that preferred stockholders can waive the application of such adjustments upon a specified vote of the existing stockholders, which may be of interest if the vote is obtainable. Where such a provision does not exist but there is a desire to avoid the application of anti-dilution adjustments, the company’s certificate of incorporation can potentially be amended to alter or avoid the adjustments. In that case, however, it is important to consider whether such an amendment triggers particular stockholder votes —including on a class- or series-wide basis—under the company’s existing protective provisions or under the Delaware corporate statute.

In addition to structural & technical issues associated with down-round financings, the memo addresses their impact on employees and existing investors; fiduciary duty considerations and litigation risks.  It stresses that the risks of such a financing can be significantly mitigated by implementing common-sense and achievable process mechanisms, and that a solid and well documented process can also help position the company for future transactions.

This recent blog from Keith Bishop points out that one issue that is often overlooked when renegotiating the terms of outstanding securities is the fact that a change in their rights, privileges, preferences or restrictions may be subject to the securities laws.

John Jenkins