Venture capital investment in United States startups is projected to decline in 2022 by over one-third from 2021 levels 1. And while down rounds remain infrequent relative to historical trends, there has been a notable upward tick in their occurrence, particularly in the fourth quarter of 2022 2. In light of this slowing market, companies that have already secured venture capital funding are increasingly resorting to extension rounds as a means of obtaining additional capital in an attempt to avoid a down round financing and extend their runway until the fundraising environment improves. Extension rounds involve the infusion of additional funding from existing or new investors under the same terms as the previous financing round. In some cases, extension rounds are being used to keep funding open on rounds that were closed more than a year ago 3.
Extension rounds can provide several strategic benefits for startups, including:
- Provision of additional capital: In a market where fundraising is challenging, extension rounds offer startups the opportunity to raise additional capital to support their operations and growth initiatives.
- Preservation of valuation: Extension rounds can protect the startup's valuation by pricing shares at the same rate as the previous round and allow them to extend their runway until the funding environment improves.
- Streamlined process: Extension rounds generally involve similar terms as the initial round, thus simplifying and expediting the administrative process of fundraising. This can also result in significant cost savings in documenting the new financing.
- Credibility enhancement: Extension rounds can be viewed as a positive endorsement by outside investors, which can increase the startup's credibility and lend validation to the company.
While the potential benefits of extension rounds for startup companies are relatively straightforward-investors must necessarily take a more circumspect approach. It is critically important that investors carefully consider whether existing terms remain favorable under evolving market conditions, warranting their extension for another round. Some of the most important contract provisions for investors to pay particular attention to include:
- Voting thresholds: Investors should carefully evaluate the implications of extension rounds on existing voting thresholds, specifically in regards to any provision that may grant a single investor the ability to make unilateral decisions. If an existing or new investor obtains sufficient ownership such that they can unilaterally approve significant transactions such as additional financings or a sale transaction, existing investors should evaluate the thresholds and make appropriate changes. This evaluation is crucial in ensuring the preservation of the investors' rights and interests in the company.
- Blocking rights: Similarly, investors should also carefully evaluate the potential impact of the extension round on investor's blocking rights. An existing investor who had determined that their vote would be required to approve certain transactions under the terms of the existing round prior to the extension may find that their ownership is no longer sufficient to prevent an unfavorable transaction from happening and other investors may be able to proceed without that investor's approval..
- Amendment provisions: It is imperative for investors to carefully review and consider the impact of the extension round on the amendment provisions in the existing financing documentation. This includes assessing whether these provisions continue to effectively protect their rights and interests, and determining whether the extension round would alter any of these protections. Additionally, it is important for investors to also consider whether current amendment provisions should be modified to provide additional safeguards and protections.
While extension rounds may seem straightforward on the surface, it is important to note that they involve a number of critical considerations. Given the complexity of the matter, it is strongly recommended that investors consult with legal counsel to ensure that their rights and interests are adequately protected.
1. CB Insights, State of Venture Q4 2022 Report (January 11, 2023)
2. Pitchbook, Flurry of Down Rounds Hints at Valuation Resets Ahead (December 14, 2022)
3. WSJ, Risks from Falling Valuations Prompt More Startups to Extend Funding Rounds (August 08, 2022)
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