Cram Downs: Anatomy of a Round 'Cramming' Down the Prior Series of Preferred

Joseph W. Bartlett, Founder of VC


Historically, venture-backed companies are compelled, or elect, to pursue a multiple round strategy before arriving at an exit event. It is rare to find a firm which raises all the money it needs to get to liquidity in one round of financing. The reasons are varied: it can too expensive in terms of dilution to the founding entrepreneur to call down all the necessary capital at a time when the pre-money valuation of the company, because of its immaturity, is likely to be at its lowest; or, more probably, the entrepreneur cannot persuade the venture capitalist or other capital sources to put up the amount ultimately needed even if that need can be forecast with some precision at a time the journey is just commencing. The VCs recognize that money raised is money spent and they like to hold the founder's feet to the fire, keep expenses down at all stages, and particularly in the early stages, by rationing capital. Further, it is often difficult if not impossible to forecast how much money will ultimately be needed; business models change as the investee company and its management adapt to changing circumstances.

Given multiple rounds, the custom has been to arrange them in a lettered series of preferred stock and the early strategists fixed on dividing the rounds into preferred series rather than different classes of preferred because Delaware law is somewhat more flexible in dealing with a "series" versus a "class." The certificate typically demands that each class of stock be designated in the certificate so that, were one to divide the rounds into Class A, Class B, Class C, preferred the risk is that one would have to amend the certificate each time a class was identified and authorized. A series is a sub-set of a class and there is, therefore, less rigidity in how the series itself is drafted; the most prominent example is that, under the right circumstances, a vote of the entire class can alter the rights across the board of each series. See Delaware GCL Section 242(b)(2). An amendment to the constituent documents of a series, perhaps to correct an inadvertent error, is easier to formulate and effectuate.

The genesis of the term "cram down" or "burn out" or "wash out" in early stage finance was the dilutive effect of the Series A round valuation and deal terms … including antidilution protection, warrant coverage, liquidation preferences as a multiple of cost, diluting the common shareholders (typically the founder and the players in the friends and family round) from a significant to a trivial position in terms of their percentage ownership of the company. The justification for that brutal dilution is, first, that the company needs the money and no one else is willing to put it in, including the common shareholders; secondly, the common are invited to participate in the round in order to protect their percentage interests and, if they didn't "play," they will "pay" by suffering the dilution; and, finally, that the fault, if there was fault, can be laid at the feet of the founder and other managers for an indifferent performance in running the business, which in turn occasioned the "down round." The issue of fiduciary duty of controlling shareholders in a "down round" has been covered in some detail in this text. (See The Encyclopedia of Private Equity and Venture Capital: Book 11: Down Rounds) Of more recent origin is a controversy not between (i) the VCs, as the preferred stockholders, and (ii) the entrepreneur/founder, friends and family, as the common stockholders, but a bare knuckle fight among the VCs themselves, inter sese in legal jargon.

The paradigm case involves a company which has gone through several rounds of professional financing … the Series A through, say, the Series G. If those rounds were closed during the period leading up and during the salad days, pre-meltdown, they were generally "up rounds." The participants often, indeed usually, included one or two VCs which would participate in each round, plus new players … including perhaps entrepreneurs who had sold their company to the issuer in question, (let's call it Newco) in exchange for, say, some cash and preferred shares issued in, say, the Series C round. In a typical case the Series A and B would be controlled by that small cadre of VCs which had been supporting the company from its early stages the Series C might be controlled by at least over 51% by the entrepreneur who had sold his company to Newco in exchange for Series C shares and the Series D, E, F and G a mélange of VCs, perhaps an angel or two, and maybe even a strategic investor.

Assume the company needs more money; it still holds promise but valuations are considerably diminished (as one might imagine) and a Series H round is proposed, the dominant VCs planning to participate. The custom is that the Series H round is euphemistically relabeled as a Series AA and tendered to all the shareholders for their participation. Other than the fiduciary duty issues, mentioned below the treatment of the common is not an insuperable problem; those shareholders, if they have any money, "play," or, if not, they "pay" by virtue of the dilutive effect of the Series AA, the overall valuation of the company being established at a very low number. Assume the dominant VCs, the moving force in the H round, are the one or two firms which have participated in Newco in all of the prior series and control over 51 percent of the vote in all the prior series except, say, the C. These players are obviously in favor of, and plan to participate in the Series AA round. Assume further that those dominant VCs have been able to bring in an independent third party, a VC which has not participated in any of the prior rounds, to price the Series AA round, thereby lessening the opportunity of common shareholders alleging fiduciary duty breaches. In addition, assume that there are independent members of the board who approve the Series AA and that the company has spent a lot of time looking for better pricing and been unsuccessful (perhaps even hiring an agent). Accordingly, the fiduciary duty issue is not deemed to be a significant issue by counsel to the Series AA investors.

However, there are awkward provisions which have crept into the certificate of incorporation (or certificate of designation) of one or more of the prior rounds.[1] The Series C, for example, which is beyond the voting control of the dominant VCs, may have a negative covenant against the issuance of any securities with liquidation preferences on a par with or superior to the Series C. Moreover, the anti-dilution protection for each of the prior series might make the intended dilutive effect of the Series AA round (dilution intended to burn out most of the existing stockholders and leave on the table, say, 80 percent of Newco for the Series AA) difficult to achieve. Additionally, the aggregated liquidation preferences of all prior preferred rounds make it difficult to restore any equity ownership to continuing management by way of common stock options (the old trick in a down round). It is urgent, in short. somehow to rid Newco of the stranglehold that one or more of the prior series of preferred enjoy over Newco and its ability to obtain financing. The complexities of the balance sheet render Newco unfinancable and the shareholders equity line has to be cleaned up or there will not be a Series AA round, or, for that matter, any other road for Newco to survive.

It becomes necessary to obtain votes of each series to approve the issuance of the Series AA. Upon the issuance of the Series AA, Newco can achieve the disappearance of each of the prior series, either by compelling conversion of the series to common (which now is ordinarily close to worthless) or exchanging the same for shares of Series AA. Such a result is usually reached in two stages; first, the certificate of incorporation is amended to authorize the Series AA and provide for the mandatory conversion to common of all outstanding shares of the prior series of preferred at some future date, say, 30 days after the initial issuance of the Series AA; and second, by providing (typically in the purchase agreement) for the exchange of all shares of preferred stock held by existing stockholders who purchase some pre-determined threshold amount of Series AA shares prior to the expiration of that 30 day period. The attached "anatomy" is a road map for a preferred stock cram down, the necessary documents and forms. As a preliminary matter, please note, however, a complication, which is dealt with in the following commentary, reprinted from the VC Experts "Buzz of the Week."

Compulsory Aspects of the Preferred Cram Down: Del. G.C.L. § 242(b)(2)

It is no secret that the bulk of today's activity in the private equity sector is taken up with late rounds of financing. Typically, the VCs (i.e., private equity funds, including but not limited to funds which are the incumbent in a particular company's series of preferred shares) negotiate the terms of, let's call it, the Series D round … a so-called 'follow on' round. The D Round succeeds, in point of time, the initial issuance to the following investors: common stock to the founders, friends and family and sometimes angels, followed by Series A, B and C convertible preferred shares, to the professional investors. As VCs in the D round survey the balance sheet and capital structure, they note it is sufficiently cluttered that the company, unless it cleans up its capital structure, may be unfinanceable. And, while the majority of the holders of the A, B and C Series may be amenable to a new round of financing, the vote in favor of the term sheet suggested by the investors in the Series D round (often highly dilutive) may be less than one hundred percent. There is often an intractable, truculent holdout … someone or some institution who or which, for one reason or another, has entirely lost confidence in the company and its management, or is otherwise disaffected. Some of the holdouts may be impervious to the argument that, absent new financing, the company will fail. "Let it fail," may be their response … or, alternatively, "pay me extra baksheesh to persuade me to give up my blocking position."

I and other Encyclopedia editors have written extensively on this subject, see Buzz of the Week, "The Overhang Problem" (1/7/2001), and Book 11, plus Section 5.3, of The Encyclopedia of Private Equity and Venture Capital, which deal with the subject of 'down rounds' generally. The problem, in short, did not arise the day before yesterday; it has been around for years, with heightened interest since the dotcom meltdown a couple of years ago. And, the professionals in this business have naturally reacted to the issue in structuring private equity financings. Thus, the typical certificate of incorporation or designation establishing the terms of various series of preferred stock (and, for reasons described below, it almost always is a separate series versus a separate class), reads conventionally, until one gets to the automatic conversion provision … that section of the certificate which compels the entire series (say the Series A, B and C) to convert into common stock upon the occurrence of certain events.

In the Good Old Days, prior to the dotcom meltdown, that event was (and only was) the imminence of an initial public offering. The public markets do not like complex capital structures; and, since the IPO is almost always an accretive rather than a dilutive event, the preferred shareholders are happy to convert.

The provision now, however, routinely reads that there are two events compelling all holders to convert to common … the first being the IPO liquidity event and the second being the vote of the majority of the shares of the class (not Series by Series). It is easy to skip over the latter provision, and many professionals have done so, on the grounds that it is "boilerplate." As I put it to my various audiences, there is no such thing as "boilerplate." Every phrase in any binding legal document potentially has significant meaning: in fact, in an upcoming Buzz of the Week, I will give a horrible example to prove that point.

What that phrase can mean in this context is illustrated by the following hypothetical: The lead VC in the Series A, B and C rounds is Gorilla LP, the general partner of which is Gorilla LLC, acting in concert with a couple of VCs with which Gorilla is accustomed to syndicating investments. The lead group owns over fifty percent of each of the Series A, B and C. The minority includes a variety of investors, perhaps an angel or two, plus an individual who sold her company to the current issuer in exchange for, say, a minority interest in the Series B round. All of the minority investors in the A, B and C believed that they owned a convertible preferred stock, perhaps even a participating preferred with a juicy valuation preference … three x perhaps. Had the minority holders been represented, however, by me or, say, Carl Kaplan at Fulbright & Jaworski, they would have been informed that, in Kaplan's phrase (and Kaplan is the ultimate cynic, based on his long experience in this sector), "The best you own is common stock." And his, and to a lesser extent my, reasoning is as follows:

Say the company needs more money; the anticipated exit event, the IPO, has been indefinitely postponed. Otherwise things are on track, but the need for cash is severe.

Gorilla is ready to play in the round but, out of concern for fiduciary duty responsibilities (which I and others have talked about ad infinitum), Gorilla invites an unaffiliated VC, Chimpanzee, to come in and price the D round. Chimpanzee sees an opportunity and says: 'We will play but (i) only if the price is close to a 'burn out' price, diluting the incumbent shareholders significantly, and (ii) if and only if the A, B and C preference and special rights are out of the way.' The company, as is customary in these instances, invites all shareholders to play in the D round; but none of the common and only a few of the A, B and C, other than Gorilla et al., have the resources or the inclination. Gorilla licks its wounds, calculating that it can still retain a significant percentage of the company by playing in the down round, where: the liquidation preference is pegged at 4 x participating preferred and includes 100% warrants; the equivalent of a PIK dividend, etc. So Gorilla and its confederates convert the A, B and C into what is now deeply underwater common stock. If the minority complains, the answer is, first, you signed up for a specific security and are presumed to have read the provision which gave the majority the power to compel conversion without limit as to circumstances. Secondly, on the fiduciary duty issue, the round has been independently priced in an arm's length negotiation with an unaffiliated third party, Chimpanzee. That fact, plus the fact that you all were given a level chance to play in a Series D round, should (maybe) rebut the fiduciary duty issue if the company pulls a comeback.

The moral of the story is that, if you want a veto right over compulsory conversion, then specify a Series vote and set the bar high enough so that you (or perhaps you and one or two colleagues) can block the transaction and hold out for a better deal. You cannot count on common stockholders to protect you. The common stock majority is typically made up of the founder and current management, all of whom are likely to be key to the future success of the company and, therefore, can count on being made whole through a generous repricing of the stock options, plus additional grants. You may have assumed that Gorilla LLC would never do anything as self destructive as giving up the A, B and C liquidation preference. You fail to take into account, however, the fact that, by participating in a wash out Series D round, and cleaning up the capital structure in the bargain, Gorilla has every incentive to relegate the rest of the preferred holders to the common stock dust bin.

Parenthetically, there is an interesting side bar in these proceedings: Some companies are saddled with multiple series of preferred; and some of the early Series (say, the A holders in our hypothetical) own a security which does not contain in the then existing certificate, a provision for automatic conversion at the behest of the majority. Maybe the Series A was issued at a time prior to all of us thinking about these issues. If, however, the certificate of incorporation has been amended, after the Series A round is closed by a vote of the majority of the entire Class (the Series A, B and C being counted as a single Class), to provide that a majority of the Class may compel conversion, and despite the fact that the amendment to the certificate occurs after the issuance of the Series A (which certificate was silent on the question and, therefore, conferred no such explicit power on the majority of the class), counsel read Section 242(b)(2) of the Del. G.C.L. to provide that Series A is bound by the majority vote of the Class. The reasoning is that the amendment, which clearly alters "the powers, preferences or special rights of one or more series of any class so as to effect them adversely," is a valid change in the rights of the Series A because the amendment "affect[s] the entire class," including each Series.

Of course, it is always open to our truculent disgruntled minority holder to argue the fundamental unfairness of the transaction, claiming the authorizing amendment is a violation of the insiders' fiduciary duty ("fiduciary duty" being an equitable doctrine of imprecise meaning … a phrase I have suggested is synonymous, when appearing a court's opinion, with "recovery for the plaintiff.") Assuming, accordingly, that even though the votes in favor of converting the prior Series of preferred are based on the letter of the Delaware statute, some will argue the sponsors should pay attention to basic fairness principles.

And, of course, there are a variety of time tested and judicially honored methods for the insiders to follow in order to stake a claim to the 'business judgment rule' protection by following fair "procedures" … disinterested director committees, independent counsel thereto and other steps set out in the so-called "road map" cases in Delaware. The Encyclopedia, in sections earlier cited, goes through a number of those actions, to suggest possible prophylactic initiatives. One such method frequently encountered in today's environment deserves special mention. That is, the board affords the earlier preferred holders a triple opportunity … to play for fresh cash in the Series D round; to stand on the sidelines and see their shares converted to common; and/or to exchange preferred shares, using the liquidation preference/conversion price as currency, for Series D shares. In the latter case, the minority preferred holders can convert into the Series D without coming up with any fresh consideration. That tender is, of course, economically advantageous to Gorilla to the extent Gorilla owns A, B and C. Automatic conversion is, in effect, a form of play or pay. However, the triple offer (always subject to the 'facts and circumstances' qualification) could be effective in neutralizing the fiduciary duty claim of our truculent minority shareholder, at least as far as the prior preferred is concerned.

One holdout stockholder, for example, the entrepreneur who controls Newco's Series D, can thereafter prevent the amendment of the certificate and bring a halt to the entire transaction.

[1] There may indeed be awkward provisions in the stockholders agreements as well, although not if they have been well and presciently drafted.