August 4, 2022
Financing: The Return of the Down Round
Private company valuations have taken a pounding this year, so it’s no surprise that we’re hearing a lot more talk about “down round” financings than we’ve heard in recent years. In case you need to broach this topic with a client, you may find this Foley blog helpful. It provides an overview of down rounds, their implications and potential alternatives. Here’s an excerpt from the discussion of the implications of a down round:
Down rounds can have a negative perception. They can lead to greater dilution, loss of confidence in the company, as well as lower employee morale. But for some companies, a down round may be the only way to survive, and with current conditions, the need for funding might outweigh these negative factors.
In any investment round, the founders and previous investors are going to see dilution and a reduction in their ownership percentage. As new investors come on board, their piece of the pie is reduced. The difference is that in an up round, that dilution is combatted a bit by the higher stock price of the new shares. In a down round, that does not happen and the impact of the dilution for founders and previous investors is greater.
A down round can also trigger anti-dilution protections for investors. These protections are built in for investors as they have a different category of stock than the founders and company employees. If anti-dilution protections are triggered in a down round, their stock would be diluted less than that of the founders or employees.
There are two different anti-dilution protections that can be used in a down round.
Weighted Average Adjustment: This is the more commonly used protection. In this case, the adjustment is based on the size and price of the down round in comparison to the previous round.
Full Ratchet Adjustment: This option provides greater protection for existing investors as it essentially adjusts the price of investors’ prior rounds to the lower pricing. This means that the founders and employees’ stock would take the brunt of the dilution resulting from the down round.
The blog also has an interesting discussion of possible alternatives to a down round, including other sources of financing and the possibility sweetening the economics of the deal to investors in ways other than reducing the baseline price of the securities.
– John Jenkins