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What's up with down rounds?

The ‘down round' became a common feature of the venture capital landscape in 2001 and 2002 as the overall malaise of the financial markets took its hold. Yet many private equity investors are unclear as to the nature of such a round of financing and its effects on the industry as a whole. Albert L Sokol, Richard G Small, Stephen O Meredith and Jonathan E Cole of Edwards & Angell clarify.

What's up with down rounds?

The ‘down round' became part of the venture capital landscape in 2001 and 2002.  Most follow-on financings in all but a few business segments are priced at a premoney valuation that is lower than the previous financing round's post-money valuation.  It is now common to see financings that are completed at a price per share that is only a small fraction of the price in the most recent round.  These depressed valuations derive both from problems in some sectors as well as from the overall malaise of the markets and the global economy.  Nor are the low valuations apparently confined to any geographic area.  This price pressure is being seen in European, North American, Australian and Asian deals.  Investors have lost a lot of money, the IPO market is dry, and most venture capitalists are concentrating on managing and funding their existing portfolio companies.  Far fewer new deals are being done now than in the recent past.

This change has affected even the terminology that people use when conducting business.  During the heady days of a couple years ago, it was said that a rising tide lifts all boats, but now it is plain that a lowering tide can lower all boats.  It is now more appropriate to say that to succeed, you must survive.  A filing used to mean a filing of an IPO with the SEC, a round used to mean another financing (usually at a higher price per share), and ROI (return on investment) used to pepper speeches and product presentations.  Now a filing might refer to a bankruptcy or insolvency filing, a round might refer to another round of layoffs, and the use of RIF (reduction in force or layoffs) is more common than ROI. 

When planning and implementing a down round, it is important to plan for success.  At a time when a company is just trying to survive, it is easy to become impatient with legal documents and processes.  And yet, imagine what might happen if a company goes through a down round, the non-participating stockholders are severely diluted, sometimes to the point of being ‘washed out' completely, the appropriate legal processes are not followed, and then the company ultimately becomes a terrific success.  At that point, there would be an asset (the company) worth arguing over, and those non-participating stockholders have everything to gain and nothing to lose by asserting whatever creative legal claims they can think of.  Such claims might range from highly technical procedural irregularities to broad gauge breach of fiduciary duty claims.

Unfortunately for the existing stockholders who do not participate in a down round involving their company, down rounds usually involve many onerous terms and conditions in addition to a low price per share.  Examples include:

• A higher dividend accrual rate.
• Allowing an accrued dividend to be paid in cash or in more shares, at the option of the investors.
• A participating (‘double dip') or even super-participating (‘triple or quadruple dip') preferred stock whereby the investor is assured of a priority payment of one, two, three or even four times its investment plus participation on an as-converted basis in the remaining value of the company.
• Warrants to purchase more shares in the future, and at an advantageous price.
• An upgrade of old stock, permitting it to be exchanged for new stock with its more advantageous terms.
• Extensive special veto powers for new investors, and termination of special veto powers by prior investors.
• Seniority of new money over old money in any liquidity or liquidation event.  Sometimes this is accomplished by structuring the investment as a form of convertible debt.
• Implementing ‘full rachet' anti-dilution protection for the new money, and forcing non-participating stockholders to waive or compromise their existing anti-dilution rights.
• Redemption rights, having the ability to force the company to repurchase shares on a future event.
• Pay-to-play provisions, which deny an investor certain rights if it does not participate in additional funding for the company.

The drama of anti-dilution - when is less more?

Apart from the dramatic decline in valuations, the next most dramatic change in the structuring of such deals may be the now very common use of ‘full rachet' protection for new money.  Little more than two years ago, it had been the norm for years that venture money was protected from subsequent value-dilutive events via so-called ‘weighted average' anti-dilution clauses.  Such clauses would modify the preferred stock's conversion price (having the effect of increasing the number of shares of common into which the preferred became convertible) by employing a formula that took into account the number of new shares being issued and the amount of aggregate consideration.  The modification would be small if only a few shares were issued for not much aggregate money; and the converse was true as well.

Now, however, investors frequently require that the conversion price of the new preferred stock be automatically adjusted to the same level as the per share price of new stock that is issued in the future, regardless of how many new shares are issued and regardless of how large that future deal might be.  For example, if $10m of new stock is issued today at $10 per share (with a conversion price of $10, so that each preferred share is convertible into one share of common), and if $250,000 of stock is issued eight months from today at a price of $5 per share, then the conversion price of today's preferred stock would be lowered to $5, so that each share of today's preferred would be convertible into two shares of common.

Not surprisingly, non-participating stockholders are uneasy about full rachet protection being given to the new money.  Typically, they argue that everyone in the company should bear the risk of future declines in value, and that it is unfair to penalise the early investors in the company.

Protecting the management crown jewels

New investors are not typically very sympathetic toward the old investors.  The new investors will point out that ‘the market is the market' and that pre-existing ‘sunk costs' by old investors have no relevance to the pricing of a new round.  In contrast, however, new investors are quite concerned about management's reaction to the down round and frequently make sure that management is spared from at least some of the dilutive effect of a down round.  After all, in most venture funded companies, the enthusiasm of the management team and the company's ability to attract top talent are the sine qua non of success.  Consequently, most wise investors in down rounds will pay early attention to the employee option pool and to the terms of options and other elements in the management's compensation package.

Examples of steps to protect management from dilution include increasing the size of the employee option pool, accelerating vesting of old options and granting new options at a much lower price than options were granted before the down round.  These kind of adjustments must be implemented carefully, being mindful of both accounting and tax rules.  One of the important issues to recognise is variable accounting, in which rather than the customary accounting effect of employee options (that is, that there is no hit to the P&L at all), the company is required to take a compensation expense on its P&L at the end of every accounting period for the life of the option, equal to the difference between the exercise price and the then value of the shares.  Not a desirable result, but one that will be caused, if, for example, a company merely reprices its old options by lowering the exercise price per share.

Legal issues - prudence, patience and independence

Down rounds frequently raise at least three issues under Delaware law, all of which relate to process and procedure - namely, whether the directors have complied with their duty of care, whether they have complied with their duty of loyalty, and whether they have obtained the proper approvals in order to implement the down round.  And, although the Delaware legal terminology may be different than that used in other states and countries, the basic legal principles tend to be similar from jurisdiction to jurisdiction.  Directors who are too impatient and do not take the time to deal with these issues are exposing themselves to potential liability.  Patience can be a difficult virtue at a time when a company is running out of money, people are being laid off, and problems seem to be around every corner for a company.

A director who complies with his/her duty of care will reasonably believe that the down round and its structure are in the company's best interest.  A director has the obligation to ensure that adequate information is available to the board and has been evaluated in a reasonable fashion.  This means being careful to thoroughly consider the terms of a proposed financing round and to understand its significance for the company (and especially for those stockholders who are not participating in the down round itself).  The directors should also endeavour to find independent data points that support the valuation and other terms of the round.  For example, they might obtain ‘comparables' (information about companies that are somewhat comparable to the company and which have undergone down rounds), and might even obtain an investment banker's fairness opinion.  In our experience, however, most IBs are unwilling to provide such opinions on a schedule or at a price that venture funded companies find acceptable.  The directors should also press the company to explore all reasonable alternatives to the down round.  For example, could the company factor its receivables, or could it obtain capital from someone other than the insiders, or could it make its existing cash last longer by implementing cutbacks so as to avoid the need for a down round?

Complying with the duty of loyalty requires managing the often-inevitable conflicts of interest that can lead to self-dealing.  These conflicts typically arise in venture-financed companies, because the boards of directors in such companies typically include individuals who are employees or partners of existing investors, and because such existing investors are often the only sources of new money when a company is struggling financially.  In short, the existing investors are in a position to potentially control the company's decision on how to structure the down round.  Typically, such conflicts are managed by having the round approved by an informed majority of the disinterested directors or disinterested stockholders or by being able to demonstrate that the round is fair to the company, which usually entails a fairness opinion from an independent third party.

Examples of techniques that support compliance with this duty would include ensuring that all directors are informed about each other's financial interests and how the down round would hurt or help them, taking adequate time to evaluate the proposed financing terms and encouraging a robust and clear debate about possible alternatives, extending the offer to participate in the round to other stockholders, attempting to persuade third parties to invest in the round (and in particular, to state at what price they would be willing to invest), circulating a written description to all stockholders of the current capital structure with a side-by-side comparison to the proposed down round capital structure, obtaining information on comparable transactions, documenting discussions in well-kept minutes, and encouraging a tone of debate at the board level which emphasises the fiduciary duty to all stockholders.

Another common trap for the unwary in down round financings is the de facto veto power that some parties might have over a down round.  For example, if a down round requires an increase in the number of shares of a class or series of stock or if the down round has an adverse effect on the special rights of such class or series, then the company cannot implement that increase or adverse effect without the approval of a certain majority of the affected class or series. Also, even a single stockholder can block a down round if the round depends on implementing an amendment to the stockholders agreement, unless the original agreement contains a provision expressly permitting amendments by less than unanimous consent. Obviously, from the investor's point of view, the best solution to these types of veto problems is forward planning during the up round that precedes the down round, eg, to make sure that the stockholders agreement can be amended without 100 per cent approval.

Finally, one must plan for non-obvious issues as well as obvious issues such as veto rights.   For example, a down round could be blocked, in effect, by now industry-standard provisions in most US certificates of incorporation (and in many other deal documents, such as executive level employment agreements) that give someone a substantially increased financial return (or that trigger a forced payment of assets) when more than 50 per cent of the voting control changes hands. As many down rounds involve that degree of change of control, this is a real problem which one can easily overlook in the tight timelines and intensity of a down round. 

So, if you have been ‘down so long that everything now looks up to you' it could be that the business you rescued during that last down round is finally moving up the hockey stick of valuation. You survived, and now you can succeed. That's both the good news . . . and the bad news, unless you had done your legal homework during the earlier down round and set the stage for good legal defenses now that there's some real assets for disgruntled stakeholders to fight about.

Copyright 2002 Edwards & Angell LLP

Albert L Sokol, Richard G Small, Stephen O Meredith and Jonathan E Cole are all partners with Edwards & Angell LLP.

Edwards & Angell is a full service law firm focusing on financial services, private equity, and technology.  With more than 270 attorneys, the firm has seven US offices in the New England and New York areas, as well as Florida. For more information please visit www.ealaw.com

The above article has also been published in Private Equity and Venture Capital 2002 and in The Journal of BioLaw & Business (2002).