Managing Down Rounds in Venture Capital Fundraising

There is a global recession presently that has made fundraising a difficult task. Investors are looking to support their existing portfolio. Fresh capital deployment is scarce. There is real pressure on valuations. Many young businesses that have taken venture capital are running out of runway, need to raise more, but now face the dreaded down round. Pádraig Walsh from the Technology practice group of Tanner De Witt reviews and assesses the implications of down rounds for founders.

A down round occurs when a company raises capital at a price per share that is less than the price per share for previously completed investment rounds. It is important to know how this affects founders and existing investors. Often existing investors have rights that will entitle them to additional shares in a down round, which will have the effect of diluting founders.  Founders need to know the consequences of this before they start seeking fresh capital.

No business would wish to raise capital at a lower valuation than previously. The ideal scenario is for each investment round to be at a higher price per share, and indicating a higher valuation. We are presently living in extreme economic times. The current reality is that higher valuations may not be possible. Also, a holding pattern may not be possible. Capital is being burned.  Revenue is decreasing. Survival is becoming a pressing, even critical, issue for many businesses. Fresh capital may be needed to help the business to grow, and eventually become self-sustaining. So, if this is the circumstance a business finds itself in, and it goes to market for fresh capital, the prospects of a lower valuation are high. It may be the only basis on which investors will participate in these difficult times.

The consequence of a down round for existing investors could be that they find themselves with a smaller slice of a smaller pie. The size of the pie has reduced because of the lower valuation. The slice of the pie is reduced because of the dilution caused by new investors contributing fresh capital. The perspective of existing investors is that this outcome is unfair. They have invested in the expectation of a particular valuation. That valuation has not been retained. They should then have a bigger slice of the smaller pie. This is the basis on which investors seek anti-dilution protection.

The key concept in anti-dilution protection is that the investor seeks to protect the quality (or value) of his investment in circumstances where the value of that investment deteriorates.  It can be distinguished from pre-emption rights on new share issuances, which are focused on protecting the quantity (or equity percentage) of his investment.

There are three different types of anti-dilution protection:

Full ratchet: Full ratchet protection allows an investor to apply the lower valuation to the amount of his original investment, and receive additional shares or additional exit proceeds (now or in the future) based on that lower valuation. The key feature is the calculation of that right does not take any account of the number of shares issued or the amount of fresh capital contributed in the new investment round. Theoretically, the protection is triggered if only one share is issued at the lower valuation.

Narrow based weighted average: This form of anti-dilution protection does take into account the number of shares issued in the down round, by applying a weighted average to the calculation. The narrow base of the calculation is that the calculation is performed by reference to shares that are actually issued, and is not conducted on a fully diluted basis taking into account convertible rights or ESOP allocations. So a narrow based weighted average is more fair than full ratchet, but there is another calculation method that is even more fair.

Broad based weighted average: The broad base of this calculation is conducted on a fully diluted basis, and takes into account convertible rights and other option rights under ESOP allocations.  If founders decide to agree to grant investors anti-dilution protection, then broad based weighted average protection is the most fair choice available to them (and is generally agreeable to investors also).

Recommendations

Founders should avoid granting anti-dilution protection to investors, if possible. Increasingly, though, investors will insist, and founders that need capital may agree. If so, founders should only consider granting a broad based weighted average anti-dilution right.

If founders are raising fresh capital at a valuation that represents a down round, then founders must check their existing investor rights. Read the Shareholder Agreement, Investor Rights Agreement and Articles of Association of the company, and check to see if existing investors have anti-dilution protection. These are technical provisions. We are often asked to help interpret and advise on the provisions. Founders may feel they need to take legal advice to assist them in the analysis.

If existing investors have anti-dilution protection, then perform simulated calculations based on the amount of capital the company is seeking to raise. Appraise the pre- and post-capitalisation table to see the effect the anti-dilution protection will have on the dilution of founders and other shareholders.

Founders should factor the information gleaned from that analysis into their negotiation and fundraising strategy.  Forewarned is forearmed.  Approaching investors for capital to weather these difficult times now should not leave founders in troubled waters even after this storm has passed.

Pádraig Walsh

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Disclaimer: This publication is general in nature and is not intended to constitute legal advice. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.