Introduction

Canada saw record levels of investment in 2021. The Canadian Venture Capital & Private Equity Association (CVCA) 2021 Market Overview reported 752 deals totaling $14.7 billion in venture capital investments in emerging Canadian companies that year – more than double what was seen in 2019. In 2021, emerging companies, particularly in the technology sector, enjoyed increased valuations driven by greater competition among investors and greater access to capital.

Although record-breaking investments continued into the first quarter of 2022, it was clear this trend was beginning to slow as venture capital funds and investors altered their investment strategies in anticipation of changes in market conditions. Higher interest rates and a tightening of the credit markets, among other reasons, have driven these changes in market conditions.

In light of the changes in market conditions, emerging companies may find raising capital to be difficult due to a reduction in the availability of both equity and debt financing. Securing financing may also take longer than expected so emerging companies must consider scaling back spending to reduce their "burn rate".

With a softening in valuations, startups and emerging companies may also need to consider raising funds at the same valuation, known as a "flat round", or a lower valuation than their previous round, known as "down round" financing.

What is a "down round"?

Down rounds are often the result of numerous factors, which include the slowing of economic trends as we are currently seeing, the need for a company to reset or pivot, the emergence of a new competitor in the market or simply a shift in the market.

For founders of start-ups, down rounds can be a matter of survival whereby an immediate need for funding outweighs the possible negative connotations that a down round carries for the company. Down rounds are often seen as a last resort for growth companies. For venture capital investors, down rounds can reflect lower confidence in the company and a riskier investment.

Key terms in a down round

While down rounds can also be an opportunity for companies to reset and refocus, it is important to understand that the contractual terms of the financing will also likely shift, giving investors additional leverage to negotiate more favourable and protective terms. As such, founders and emerging companies must understand the types of deal protection measures that investors will likely be requesting. Negotiating unfavourable terms may not only negatively impact existing investors, but may also limit the company's ability to secure future financings.

Below is a summary of key issues startups and emerging companies should be aware of in down-round financings. For a more thorough analysis of these implications, it is important to consult your legal advisor.

Liquidation preferences

Preferred shares generally have priority over common shares upon the liquidation, dissolution or winding up of a company (a "Liquidation"). Before any distribution or payment can be made by the corporation to the holders of common shares or any other junior preferred shares, the holders of the class (or series) of preferred shares are entitled to be paid first.

In the event of a Liquidation, holders of preferred shares will receive the liquidation preference for each preferred share along with the payment of any accrued and unpaid dividends before any amounts are paid to the common shareholders, who are typically the founders. The Liquidation preference of each preferred share is typically the original purchase price the investor has paid for each preferred share. In riskier rounds, such as a down-round, the liquidation preference may be set as a multiple of the original purchase price. In addition to the liquidation preference, preferred shareholders may be entitled to an additional payment depending on if their preferred shares are participating or non-participating:

  • Non-participating – Once the liquidation preference is paid, the investor would not be entitled to any additional payments from the company. As such, any remaining assets of the company would then be distributed among the common shareholders and any junior preferred shareholders based on liquidation priority. Non-participating is the approach seen in the bulk of financings.
  • Participating – In addition to the liquidation preference, the investor also has the right to share in any remaining proceeds of the company with the common shareholders pro-rata on an as-converted basis.

Participating is also referred to as the 'double-dip' preference and could be considered a windfall gain depending on how the company is liquidated. Founders should be cautious when negotiating terms surrounding liquidation preference as the consideration they receive is typically "sweat equity" and they may receive salaries at below market.

In the event where the investor has negotiated a liquidation preference in which it would receive a multiple of the original purchase price, the investor may walk away with more than they have invested, whereas the founders, and other common shareholders, may end up with little or no payments. The risk is further compounded where the preferred shares are also participating because the investor would be entitled to share in any remaining proceeds of the company with the common shareholders pro-rata on an as-converted basis. Emerging companies should look to limit an investor's liquidation preference where possible. To balance the investor's desire to protect its investment with the emerging company's desire for a fair distribution of assets in the event of a Liquidation, the parties may also consider including a cap on the total amount the investor can receive in the event of a Liquidation. This may be a compromise that meets both parties' interests.

Anti-dilution protection

Investors in venture capital financings are typically issued preferred shares that are, at the option of the investor, convertible into common shares based on a predetermined formula. If certain events occur, such as a down round or a dilutive share issuance, the conversion ratio or price may be adjusted so that the number of common shares the investor will receive on the conversion of preferred shares would increase. There are two main types of calculation for this down-round protection: full-ratchet adjustment and weighted-average adjustment.

  • Full-ratchet – A full-ratchet anti-dilution provision leads to the greatest amount of adjustment and is not typically seen in venture capital financings. For a full ratchet, the conversion price of the preferred shares will be set at the lowest price for the company issued common shares (or shares convertible into common shares) following the investment no matter how many shares are sold at the lower price. For example, if the price per share in a future round goes down by 50%, then the conversion price at which the investor could convert all their preferred shares into common shares would be reduced by 50%. Full ratchet anti-dilution provisions are seen as punitive as they can be triggered by an insignificant issuance of shares.
  • Weighted-average – Weight-average adjustments may be calculated on a broad or narrow basis: Weighted-average anti-dilution provisions take into consideration the number of common shares (or shares convertible to common shares) that are subsequently issued at a lower price. Weight average adjustments lead to significantly smaller adjustments as they take into account the size and price of the down round in relation to the capitalization of the company immediately before the down round. Broad-based weighted-average adjustments are more commonly seen in venture capital financings.

Anti-dilution provisions can lead to unintended consequences and can be triggered by certain issuances that are unrelated to the economic condition of the company. Fortunately, certain types of issuances, such as shares issued upon the conversion of options issued under a stock option plan, are typically excluded from anti-dilution protections. However, emerging companies should carefully review what types of issuances are excluded to ensure that there are no unexpected consequences.

When considering conducting a financing at a lower valuation, emerging companies must consider the anti-dilution protection of existing investors to understand how these will impact the company's capitalization table. Companies can look to renegotiate anti-dilution provisions and other key terms with investors before conducting the financing so as to limit this dilution.

Cumulative dividends

Investors may also have a right to a distribution of the company's earnings by way of a dividend. Dividends may be either cumulative or non-cumulative. In most instances, dividends will be non-cumulative, i.e. paid only as declared by the company's board of directors. That said, in instances where the investor may deem the investment to be risky, the investor may insist on cumulative dividends. In contrast to non-cumulative dividends, cumulative dividends will accrue at a specified rate, regardless of whether or not the company actually declares dividends on those shares and generally carry a right to receive those accrued dividends in priority over any other shares ranked junior to such preferred shares. Emerging companies must carefully consider the impact of any cumulative dividends on future cash flows of the company along with their impact on distributions in the event of a Liquidation of the company.

Tranche financing

Where there are concerns about the company's performance, investors may agree to advance funds only when certain milestones are met. For example, investors may agree to advance a certain portion of their investment only after the successful accomplishment of a milestone, such as securing a key client. Where there are concerns about the future success of the emerging company, an investor may look to tranche financing to limit their exposure. Although this may seem like a balanced option, emerging companies must carefully consider the attainability of any milestones they set. Milestones should be specific and attainable. If the company fails to meet a milestone, then it will be in a weak bargaining position with the investor should it require any additional investment before meeting any specific milestone.

Conclusion

With rising interest rates and the possibility of a looming recession, emerging companies may need to make tough decisions when raising capital. Emerging companies must take steps to limit their cash burn to what is necessary to maximize their runway. Ensuring that emerging companies also understand the terms of any financing documents they agree to will help protect the interests of all stakeholders going forward. Before conducting a down round financing, companies should consider if there are any alternatives available, such as convertible debt or bridge financing. Venture debt may also be an option that could provide a much-needed injection of cash that could allow the company to meet its short-term objectives.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.