The COVID-19 pandemic has abruptly slowed-if not upended-the bull run in venture capital of the past decade. As valuations for companies affected by COVID-19 decline, those who were often price makers pre-COVID-19 may find themselves becoming price takers in a new preferred share financing round. For some companies raising money in subsequent rounds, this may result in a "down round."

A down round financing occurs when a company is raising money at a price per share that is less than the price per share paid by investors in a previous financing round. Companies will often explore alternative avenues-cutting expenses, selling non-critical assets, or bridge note financing-before engaging in a down round. But if a down round is unavoidable, companies would be well served to be mindful of key issues and terms that may arise in this context.

1. Antidilution protection

In the event of a down round, everyone's mind will first turn to the existing antidilution provision that likely exists from prior rounds of funding (typically a broad-based weighted average formulation, as set out below). This is a standard and fundamental protection in venture capital deals which gives investors some price protection in case the company later issues new shares at a lower price (subject to certain standard exceptions, such as shares issued under the option plan). If the antidilution protection is triggered, the conversion ratio is changed, so that each affected preferred share is convertible into more than one common share. In a situation where the company never does a down round, the conversion ratio is typically one for one. The exact common share to preferred share conversion ratio is normally calculated based on a broad-based weighted average formula, which factors in (among other things) the amount raised and per share price of the previous rounds, compared to the amount raised and per share price in the down round.

The conversion price adjustment is important for two main reasons. First, preferred shareholders vote on an as-converted basis-if one preferred share converts into 1.2 common shares, then the preferred share carries 1.2 votes. Second, and most importantly, it impacts the company's fully-diluted capitalization. The additional common shares issuable upon conversion of the preferred are considered part of the company's capitalization, so these additional shares can be highly dilutive to existing shareholders.

If a company is raising money from new investors, those investors may insist that the existing preferred shareholders waive their antidilution rights as a condition to investment (the voting threshold for waiving antidilution protection is typically set out in the company's Articles of Incorporation). Depending on the full context, existing investors may be motivated to concede this point. Even if this is not a condition to the new investment (or if it is an inside-only round), a company may persuade its existing investors to waive this right in light of the potentially highly dilutive impact of the dilution adjustment, which can be very de-motivating to employees.

One related point is that while existing investors likely have broad-based weighted average dilution protection (as set out above), new investors-who fear market uncertainty and may not be confident in the accuracy of the agreed-upon valuation-may request full-ratchet antidilution protection. This formula is much more punitive to the existing shareholders as it does not account for the amount raised at the new lower price. Rather, the adjustment is made in full even if the company subsequently raises a very small amount at the new lower price.

2. Liquidation preference

The liquidation preference sets a return hurdle in connection with a sale of the company. It is the threshold amount of proceeds that must be returned to preferred shareholders before proceeds are distributed to the common shareholders.

In a down round financing, a company may need to negotiate two aspects of the liquidation preference. The first is only relevant where a new lower valuation approaches or exceeds the total liquidation preference payable to preferred shareholders. This is called the "liquidation preference overhang." For example, if the liquidation preference payable is $50M but the company's value is $60M, investors would be hard pressed to invest-especially anything above $10M-because they would not have confidence that they would at least get their money back upon the company's sale or liquidation. Investors in a down round may therefore negotiate for a liquidation preference that is senior to all other existing preferred shares such that the new money is paid out first (as opposed to the more standard pari passu formulation). Alternatively, in a more extreme scenario, new investors may require that all existing preferred shares are converted to common shares before the new financing round-that way, the new investors make up the entire liquidation preference. Both of these options affect the various stakeholders differently and will need to be negotiated carefully.

Second, a company may find investors asking for more aggressive liquidation preference terms. The market liquidation preference in a good fundraising environment is 1x the original investment amount, non-participating. This means that upon a sale or liquidation event, investors can either take their 1x liquidation preference, or forgo this and convert to common shares, thereby participating in the transaction proceeds based on their percentage ownership of the company. However, investors might ask for more as downside protection in the current economic climate. For example, investors may ask for (i) a higher multiple liquidation preference (2x or 3x), and/or (ii) a participation feature (with or without a cap), such that investors take their liquidation preference off the top of the proceeds and then convert into common shares to participate based on their percentage ownership of the company (this is referred to as "double dipping"). The punitive effects of liquidation multiples greater than 1x and participating preferred shares are most felt by the common shareholders, as this potentially (at certain deal values) leaves little if any residual proceeds for the common shareholders upon a liquidity event or sale of the company. This is particularly difficult for employees whose compensation packages are typically heavily skewed toward equity. That is why the aforementioned terms are not market during normal times, but might be subject to renegotiation in the current climate.

3. Management carveout plans and employee incentives

The common shareholders of venture-backed companies are largely comprised of members of management and employees. If the effects of a down round are such that the common shareholders are highly diluted (as outlined above) and/or the valuation of the company is so low that the team may receive little, if any, upside benefit upon an eventual sale of the company, then the ultimate result is a highly unmotivated management team and workforce. To avoid this scenario, a company and its board of directors may want to consider a few incentivization tools. Typical options are to (i) adjust the incentives (equity or cash) granted to employees, and (ii) create a management carveout plan.

Equity or cash incentives

Equity incentives can be adjusted in two ways. First, the company can simply make additional equity awards (usually in the form of stock options) to the team after the new financing round closes. This helps ensure that the team owns a larger percentage of the company. It is important to note that this is only a useful tool to the extent that the board of directors and management team believe there is real value in the common equity upon a sale of the company. Second, the company can consider repricing existing stock options to reflect the new lower value of the common shares. To the extent the exercise price is lower, there is more potential upside upon an eventual sale of the company. Like the grant of additional equity outlined above, this tool is only useful if the board of directors and management team believe there is real value in the common equity upon a sale of the company. There can be tax and accounting issues to consider in adopting a repricing program, so companies should work with their legal counsel and advisors to ensure the repricing is done properly.

Management carveout plan

Lastly, if a company sale is on the horizon, and the concern is that there will be little or no value for the common shareholders in such a transaction, then a management carveout plan can be a useful motivation tool to ensure the team stays engaged and sees the company through the sale transaction. This plan carves out a certain percentage of the deal proceeds (typically around 10%) to be payable to the key management team. It provides an incentive for management to grow a struggling company by allowing them to participate in the upside of a liquidity event or sale when they otherwise would not as a result of the aggregate liquidation preference. There are many permutations and combinations of management carveout plans, and a number of terms to be considered, so companies should again ensure they work with experienced advisors when putting a management carveout plan in place.

4. Pay-to-play

In a situation where certain existing investors are prepared to lead a new round of funding for a company, they may insist that other existing investors "pay to play", i.e., participate in the financing. If a pay-to-play structure is adopted, investors who do not participate in the financing are penalized (typically to their full pro rata). There are many variations of pay-to-play transactions, but typically those investors who do not participate in the financing transaction will have their existing preferred shares converted to common shares, thereby losing the rights and privileges they have as preferred shareholders (e.g., liquidation preference, antidilution protection, etc.). Pay-to-play transactions (which often accompany down rounds) raise complicated corporate governance issues.

The above issues are just a few of the salient deal issues likely to arise in a down round. In this fundraising environment, companies can generally expect investors to want to de-risk their investment and look to take more control of the company in various scenarios. Companies should navigate the situation with great care, including understanding the impact of various terms on both existing investors and common shareholders, and engage experienced and reliable advisors to guide them through the process. Transparency and regular communication with the board of directors and all investors is paramount to arriving at effective solutions in this current environment.

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Originally published June 16, 2020

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