Down Rounds: What You Don't Know Can Cost You in Equity (or in Court)

Michael Halloran and Tom Gump, Pillsbury Winthrop


After a decade of unprecedented increases in venture capital funding made available to new business ventures, the beginning of the new century witnessed an almost equally dramatic drop in both the total dollar volume committed and number of new investments made. [1] Moreover, those companies able to attract funding commonly found themselves able to do so only at valuations that were substantially diminished from prior financing rounds. [2] Often known as "down-rounds" or, if sufficiently severe, "washout financings," [3] these transactions forced venture capital investors to confront many business and legal issues for the very first time. In this excerpt of Venture Capital & Public Offering Negotiation, Michael Halloran and Tom Gump provide an overview of common characteristics of securities issued in such "down-round" financings.

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The current economic climate has led to the increase of investor favorable terms as venture capitalists seek to improve their potential returns and reduce their risk exposure. Increasingly, as the terms become market practice, companies have less leverage to negotiate with their investors. Some examples of common terms and conditions of down-round financings, as well as common consequences of such financings, are discussed below.

A. Lowered Valuation

down-rounds are by definition consummated based on a lower valuation than the valuation in previous financings. Without the guidance afforded by an active public market in a company's stock, investors in down-rounds consummated by private companies look to stock prices of similar companies trading in the public markets or the valuations of comparable private companies. Against the backdrop of the currently depressed public and private markets, the relative valuations investors are willing to agree to have decreased. This decrease also results from the fact that venture capital investors currently expect longer maturation periods for their investments and assume that companies will take longer to reach profitability and/or liquidity events (such as a sale of the company or an initial public offering of its stock).

By offering new investors the opportunity to buy large stakes of an enterprise for less consideration per unit of investment than was paid by investors in prior rounds, down-rounds have the potential to significantly dilute (or even "washout") the shareholdings of existing investors. In financings where the valuation represents a step-up from the valuation used in prior rounds, shareholders often accept significant dilution because the increased value of the enterprise on an aggregate basis has made their ownership stake more valuable. In contrast, however, down-rounds commonly result in significant reductions in the ownership and voting percentages of prior investors as well as the value of their ownership stake. [1] Moreover, existing shareholders of the company often find that the investors in the down financing require significant changes to the equity stakes of existing shareholders. These may include, among others, the conversion of existing shares of preferred stock to common stock (i.e., a "reset"), a reduction of the liquidation preferences applicable to their preferred shares, or a reverse stock split which reduces the number of preferred and/or common shares prior to consummation of the down financing. Needless to say, such results often create dissatisfaction among the issuer's existing shareholder base, as stockholders who financed the company during its earliest, and arguably riskiest, phases wind up holding only a de minimis stake in the enterprise. [2]

B. Staggered Financing

Lead investors in venture capital financings typically are expected to add to their initial investments in companies in subsequent funding rounds. Because such issuances take place at a more advanced stage in a company's development, such "follow-on" investments are often made voluntarily at higher valuations (and not as a matter of contractual obligation). Recently, however, the economic climate has led to a trend for staggered financings, with the result that the entire investment for a financing is split into tranches based upon the same valuation with investors advancing additional funds only when and if the company meets predetermined targets or milestones. These milestones are negotiated by the parties prior to the initial round of financing and are commonly based on financial and operational projections in the company's business plan. Such staggered financings help venture capitalists manage their risks by allowing them to make investments in smaller increments while offering the chance to improve returns by securing the opportunity to make additional investments at the lower valuation. At the same time, staggered financings can create significant uncertainty for the issuer, as it must meet the predetermined milestones to receive the additional tranches. As a result, staggered financings can result in significant distractions for the top management of an issuer, as such managers must deal with constant pressure to raise funds.

C. Increased Liquidation Preferences

Liquidation preferences are a common feature of convertible preferred stock financings in development stage companies that enable investors to receive a negotiated amount prior to and in preference to the holders of junior securities (whether preferred or common stock) in the event of a liquidation, merger, consolidation, change of control, or other liquidity event. [3] Thus, liquidation preference provisions allow investors to achieve a return of their capital (perhaps with the payment of a dividend as well) before distributions are made to other stockholders. In today's down-round market, many venture capitalists demand enhanced liquidation preferences (i.e., multiples of the original investment amount, in some cases even three or four times the original investment amount) as the price for consummating a new financing. The practical effect of such increased liquidation preferences is often to render other classes of stock (usually common stock issued to founders or upon the exercise of employee stock options) worthless unless substantial increases in the company's valuation are achieved. In other words, high-multiple liquidation preferences sometimes consume the entire proceeds of a liquidity event (other than an IPO) before other investors, employees, and founders of the company receive any payments on their stock.

Perhaps even more serious, onerous liquidation preference entitlements often create incentives for an issuer's management, technology officers, and other employees (who usually own only common stock or rights to acquire common stock) to seek other employment. Take, for example, the simplified case of an issuer who has the following capital structure and financing history:

HighTech Corp

Capitalization History

Issue Date Security Pre-Money Valuation Amount Raised Shares Issued Liquidation Preference [4] Aggregate Liquidation Preference
January 2000 Common Stock n.a. sweat equity 10,000,000 none none
February 2002 Junior Series A Preferred $10,000,000 $5,000,000 5,000,000 at $1.00 per share $1 per share (1x) $5,000,000
September 2002 Senior Series B Preferred $5,000,000 $5,000,000 15,000,000 at $.33 per share $1.65 per share (5x) $25,000,000

In the case set forth in the table above, the issuer would have to be sold for over $30 million (i.e., at in excess of 600% of the Series B round valuation) before the holders of the issuer's common stock would share in any part of the sale proceeds, as the first $25 million distributed would pay liquidation preferences due the senior Series B Preferred Stock and the next $5 million would pay liquidation preferences due the Series A Preferred Stock.[5] In practice, down-round financings that would involve a high liquidation preference hurdle to be overcome before the common stock shares in sale proceeds (such as the $30 million hurdle in the example set forth above) have resulted in situations where management, technologists, and employees (who hold the common stock) threaten to terminate their employment with the company in response to the proposed deal terms.[6] Although issuers often seek to mitigate the effects of high liquidation preference entitlements by increasing the size of the company's option pool to increase the aggregate percentage ownership of employees, this tactic works imperfectly at best as the employees still begin to participate in the proceeds of a sale of the company only after the high liquidation preference hurdle of the investors' preferred stock has been passed. In fact, in those cases where the issuer cannot easily find replacements for the departed or dissatisfied employees, the venture capitalists leading the down-round will commonly lower their liquidation preference requirements (e.g., from 4x to 2x) or otherwise take steps to carve out meaningful equity participation for the remaining employees to ensure that the company's talent pool remains intact.[7]

D. Participating Preferred Stock

Holders of a participating preferred stock are entitled to participate in the distribution of the remaining proceeds of a liquidity event on a pro rata basis with the holders of common stock after all liquidation preference entitlements of the holders of the preferred stock have been satisfied.[8] In effect, a shareholder who owns participating preferred stock enjoys the upside of converting to common stock upon a liquidation event without having to actually convert and give up the right to a liquidation preference payment. Investors, of course, seek participating preferred stock as a means to increase their expected returns. At the same time, participation features can contribute to the same employee dissatisfaction and disincentives discussed above as they further reduce the potential upside of founders, employees and other common stockholders. As a result, issuers attempt to mitigate the harsh effects of participating preferred stock (measured in terms of the reallocation of the proceeds of a liquidity event to the preferred stockholder) by capping the participation component of the preferred shares at a given level (usually some multiple of the original investment amount) or by setting a dollar valuation or amount at which the participating preferred holders will lose the right to participate (or further participate) without actually converting.

E. Anti-Dilution Provisions

Investors commonly seek protection from the dilutive effects of subsequent issuances of preferred stock or other convertible securities made at reduced valuations. Typically, such protection is provided by contractual provisions that adjust the conversion price of an investor's securities in order to maintain the investor's relative percentage interest in the company, or at least minimize the dilutive impact of, a down-round. The principal point of negotiation with respect to anti-dilution protection is the formula used to adjust the conversion price of the investor's securities. Although there are many variations, typically two types of formulas are used: weighted average and full ratchet.[9]

In a weighted-average adjustment formula, the conversion price is adjusted to the weighted-average of the purchase price of the previously outstanding and the newly issued shares. Weighted-average adjustment formulae can be either "broad-based" or "narrow-based." In a "broad-based" weighted-average formula all outstanding common stock is taken into consideration, as well as all outstanding or authorized warrants, options, and other securities that are convertible into common stock. Because the dilutive effect is apportioned among the greatest possible number of securities, the severity of the price adjustment is less than that resulting from a "narrow-based" weighted-average formula, which usually considers a smaller portion of the issuer's fully diluted shares.[10]

"Full ratchet" anti-dilution provisions operate by reducing the conversion price of previously issued shares of preferred stock to match the price of new shares in the dilutive issuance. From a company's point of view, full ratchet provisions are problematic in that prospective investors may be dissuaded from participating in future down-rounds because of the increase in the ownership stake of prior investors triggered by application of the ratchet.[11] With a full ratchet adjustment, the ownership and control of the investors who benefit from the provision's application in a down-round increases and causes substantial dilution of common stockholders and other stockholders who do not benefit from the same full ratchet protection. For this reason, issuers typically expend significant effort attempting to negotiate away full ratchet provisions requested by investors. However, in the current financing environment, such provisions are more common as struggling companies are forced to face the realities created by the scarce supply of venture capital financing.

F. Redemption Rights

Redemption rights provisions allow investors to require a company to cash out their investments, usually for the greater of the original purchase price of the shares plus any accrued and unpaid dividends or the fair market value of the shares. In some cases a fixed rate of return may be factored into the redemption price, or if dividends are cumulative, the investors receive a premium over their original investment. Acting as a kind of safety net, these rights theoretically ensure that investors have an exit when a company fails to achieve a liquidity event as quickly as expected or the investment is otherwise performing in an unsatisfactory manner. The trigger time for redemption is often targeted to the time (or period after that time) at which, in accordance with the company's business plan, a liquidity event is supposed to occur. In a healthy investment climate, venture capitalists often forego redemption rights as their portfolio companies have less trouble reaching liquidity events. Not surprisingly, however, redemption rights are more common in more recent venture capital transactions. This may not be solely because of their safety net protections; instead, many investors use the threat of an exercise of redemption rights to obtain additional concessions, such as board control, warrants for additional shares or other valued consideration, or to force the company into a liquidity event.[12]

G. Dividends

In a healthy investment climate, investors in venture capital financings are often able to negotiate only "non-cumulative" dividend entitlements. Such dividends do not represent firm entitlements; instead, such dividends are paid only "when and if declared by the board." In the down-round context, however, investors will often require that they receive a firm (cumulative) dividend entitlement as a means to increase their prospective returns. While most commonly payable in cash,[13] such dividends can also be payable through the issuance of additional shares to such investors or by the adjustment of the conversion rights for such investors' original shares, particularly if the company does not have a legal source for the payment of such dividends.[14] While it improves the prospective returns of investors, the obligation to pay a cumulative dividend can often put a strain on the issuer's cash flow and hinder the enterprise's development.

H. Protective Provisions

Venture capital investors in almost any business climate insist on a measure of input or veto power over some level of significant company actions. Typically, the power is obtained by granting consent rights to a class or series of stock that limit the company's ability to take certain actions without the approval of those stockholders. These consent rights may be found in a stockholders agreement between the company and all or part of its shareholders or, as is typically preferred by investors, in the publicly filed certificate or articles of incorporation of the issuer. Examples of company actions investors often seek to be able to influence are the issuance of securities on parity or senior to the preferred stock issued in the down-round, the declaration of dividends, and the amendment of the company's charter or by-laws.[15] In today's market, the range of company actions investors are seeking to control is broader. Many of the actions over which control is now sought have traditionally required only board approval, such as incurring new debt, expanding option pools, approving accelerated vesting schedules for existing options, making changes in management, creating new subsidiaries, and entering into transactions outside of the ordinary course of business. Although issuers are often concerned that placing this sort of veto power in the hands of investors hinders the day-to-day operation and growth of the company and, in some cases, puts all of the issuer's shareholders at the mercy of a small group of investors, venture capitalists will argue that they are merely seeking the ability to protect their investments by limiting the ability of their portfolio companies to take extraordinary action. The parties will, of course, differ on whether or not such protections are needed, particularly where investors already have board representation. However, due to their relative advantage in bargaining power, contemporary investors are demanding and receiving minority shareholder protections well above and beyond those afforded investors in healthier funding environments.

Careful drafting of protective provisions is essential to ensure that the investors in a preferred stock financing attain their intended objectives, a fact which was recently reaffirmed by the Delaware Chancery Court's decision in Benchmark Capital Partners IV, LP. v. Vague, et al.[16] The case focused on the plan of an issuer and its lead venture capitalist, the Canadian Imperial Bank of Commerce ("CIBC"), to consummate a down-round against the wishes of one of its preferred stockholders, Benchmark Capital IV, L.P. ("Benchmark"). The down-round was to be consummated by the merger of the issuer with another entity followed by the sale of a new Series D Preferred Stock to CIBC. Benchmark, along with other holders of the issuer's Series A Preferred Stock and Series B Preferred Stock, generally had a consent right with respect to any corporate action that would "[m]aterially adversely change the rights, preferences and privileges of the Series A Preferred [and Series B] Preferred Stock."[17] While the breadth of this consent right may appear plain to the untutored eye, the Delaware court opined that the language of such consent rights must always be read against the background overlay of Delaware corporate law. In looking at such law, the court concluded that the choice by the parties of language that parallels language used in Delaware General Corporation Law provisions respecting charter amendments required that, despite the breadth of plain meaning of the language it the consent right applied only to changes to stockholder rights effected by charter amendment. Because the down-round at issue in the case effected a change to Benchmark's rights, not through a charter amendment but via a merger, the court concluded that the consent right negotiated by Benchmark was not implicated by the transaction. To protect itself, the court said, Benchmark would have had to negotiate a consent right that applied with specificity to a change to its rights, preferences, and privileges in the context of a merger.[18] This decision, which resulted in a "washout" of Benchmark's prior investment in the issuer, reaffirmed the need for careful drafting of consent rights and examination of the impact that applicable law has on the ability of the parties to enforce such rights.

I. Directors and Management

During periods wherein the valuations of a developing stage company rise, members of an issuer's management team often find that financing for the enterprise can be more expeditiously arranged as investors demonstrate their eagerness to participate in a business venture that is perceived as successful or likely to be successful. In contrast, down-rounds often give rise to greater scrutiny of the issuer from both existing and potential investors, as existing shareholders evaluate whether they should cut their losses with respect to the venture by declining to participate in the down-round and new investors look more critically at the enterprise's potential for success. Consequently, down-rounds often take much longer periods of time to arrange, with the result that management is often distracted from focusing on the operation of the business and improving its results for prolonged periods.[19]

As is the case with an issuer's management, the prolonged periods of time necessary to arrange many down-rounds results in significant distraction to the issuer's board of directors. The issuer's board of directors is thus unable to focus on the strategic and operational aspects of the business at precisely the time such focus is most needed. While such distraction is obviously undesirable, down-rounds can under some circumstances also result in potential liability for both interested and disinterested directors, as discussed in greater detail below. As a result, directors of an issuer involved in down financing need to spend adequate time to minimize the prospects of such potential liability.[20]

Reprinted by permission. © 2003 Aspen Publishers. Please note that this work is part of a larger work, Venture Capital & Public Offering Negotiation, by Michael Halloran et al., Aspen Publishers.

[1] Prior preferred stock investors may have anti-dilution protections in their preferred stock terms, but are most often asked to waive such protections in the down-round context. Founders most frequently hold common stock without any anti-dilution rights at all and often find that, after consummation of a down-round, they are left with a mere residual stake in an enterprise created from their original vision and sweat equity.

[2] In structuring a down-round, venture capitalists should take care to examine what stockholders consents are required to consummate the transaction. Specifically, if the down-round has the effect of "washing out" the holdings of a class or series of the corporation's stockholders whose consent is required, such stockholders often have little, if any, incentive to approve the deal, with the result that the transaction cannot be consummated as originally contemplated.

[3]A sample down-round liquidation preference provision is included in Exhibit A-1.

[4] The Liquidation Preference is usually determined as some multiple of the per share price of the securities offered in the financing.

[5] Down-rounds can also have devastating effects on the rights of earlier purchasers of an issuer's preferred stock as well. In the example set forth in the table, both the purchasers of the Series A Preferred Stock and the Series B Preferred Stock invested the same amount in the company (i.e., $5 million), but the Series B Preferred Stock's senior "5x" liquidation preference entitles it to receive all of the fast $25 million in proceeds of the sale of the company (compared with a junior entitlement of only $5 million held by the Series A Preferred Stock).

[6] Take, for example, the case of San Francisco-based Livemind Inc., whose chief backer required a "4x" return as a condition of providing a bridge loan. When Livemind's employees learned that the value of their shares would be significantly reduced as a result of the financing, they threatened not to return to work. Livemind has since gone out of business. See Junk Bonds Were a Farce Welcome to 2001, The Industry Standard (June 13, 2001),

[7] Such employee carve-outs can be accomplished by granting contractual rights to participate in the proceeds of a "liquidity event" to the employee group the issuer seeks to incent.

[8] See Exhibit A-11 for a sample down-round participating preferred stock provision.

[9] See Exhibit A-IV for a form of Full Ratchet Anti-Dilution Provision.

[10] For example, a narrow-based weighted average formula might exclude options or outstanding but unexercised warrants with the intention of providing the investors with greater conversion price adjustments from dilutive issuances.See Exhibit B for sample calculations which demonstrate the potential impacts on an issuer's capitalization of weighted-average and full ratchet anti-dilution protection.

[11] As a result, prior round investors are often required to waive any benefits of the application of their anti-dilution protections by subsequent investors as a condition of their making the investment.

[12] Issuers rarely have sufficient cash on hand to meet their redemption obligations in full. As such, the threat of exercise of redemption rights can give investors significant leverage in subsequent negotiations with an issuer.

[13] See § 170 of the Delaware General Corporation Law which establishes limits on a corporation's ability to pay dividends to its stockholders.

[14] Commonly referred to as a "PIK" or "Payment-in-Kind" dividend.

[15] See Exhibit A-III, "Down-Round Protective Provisions," for additional examples.

[16] Benchmark Capital Partners IV, LP. v. Vague, el al., No. 19719, 2002 Del. Ch. LEXIS 90 (July 15, 2002; revised July 17, 2002).

[17] Id. slip op. at 10.

[18] Id. slip op. at 22.

[19] As a result, bridge financings are often required to fund the company until the down financing itself can be consummated.See discussion of the role of bridge financings in Part 3.F, infra.

[20] See discussion in Part 4, infra.