Confronting a Down Round

Guest post by Dror Futter – McCarter & English LLP

The last few years have witnessed Unicorns become common and down rounds become scarce. Now the venture market is returning to a more normal state, which means more down rounds and fewer Unicorns.

If your venture is confronting a down round, you should not wear it as a badge of shame. In normal times, few ventures make an uninterrupted march up and to the right on the valuation curve. More importantly, if you are doing a down round, it still means you were able to raise capital. Although a down round will dilute your economics, no venture has ever died from excess dilution, the same cannot be said for lack of funds.

What is a “Down Round”

Simply stated, a “down round” is a round in which the pre-money valuation of a company is below the post-money valuation of its last round. As result, shares in the company purchased in a down round will be less expensive than those bought in the last round. Down rounds are never fun. To existing shareholders, it means the value of their investment has dropped and they will absorb additional dilution to raise the same amount of money. To venture investors, who report their illiquid holdings to their limited partners based on “mark-to-market” principles, it almost inevitably means a write-down of the carrying value of the investment. As a result, reported fund returns drop.

Down rounds are most common when a new investor enters the scene or most existing investors are not funding their pro rata. In addition to a lower valuation, funding terms of a down round are usually more investor friendly. Often shares sold in a down round will have a senior liquidation preference (i.e. they will sit above prior classes of shares in terms of priority for getting a return at exit), a participating preferred return (i.e. investor gets its investment back and sometimes a multiple of its investment back and then participates with common), dividends that are accruing and at a higher rate, and class-specific veto rights on multiple corporate decisions.

Why Do Down Rounds Occur?

There are several reasons why your company may be subject to a down round, including:

  • Your company failed to reach the financial and operational goals it set for itself the last time it raised money;
  • You did a particularly good job of selling your company at the last round and received financing at a favorable valuation. The down round may just be reversion to a more conservative valuation; or
  • Overall valuations have dropped in your sector or market-wide.

A down round, therefore, is not always a sign of a struggling company. However, even if your down round result from broad market forces, you will subject to the valuation drop, and likely many of the same unfavorable deal terms, as a struggling company.

What Can You Do to Prepare?

There are a few things a company can do that will help its down round proceed more smoothly.

1. Review the Corporate Charter and financing documents from prior rounds. Make sure you understand the rights of existing shareholders in a down round and have identified any relevant supermajority voting requirements and pay-to-play obligations. Also, identify all pre-emptive rights that existing shareholders have and the timetables they have to exercise. Down rounds are often Eleventh Hour fire drills and you do not want to be stymied by a multi-day notice period for pre-emptive rights.

2. If your shareholders have anti-dilution rights, make sure you have assembled a spreadsheet that will allow you to determine the impact of financings at various price points on the existing cap table. This will be essential information for the new investors as they determine the new pre-money valuation of the company. In some cases, new investors may require existing investors to waive their anti-dilution right as a condition of funding.

3. Down rounds are risky events for a company’s Board of Directors. This is especially true for a Board that does not have independent directors to provide an unbiased view on the fairness of the reduced share price in a down round. Shareholders who do not participate in the new financing and are significantly diluted may bring an action against the Board. To reduce this risk, the Board should shop financings to multiple investors and should document these efforts in writing. Also, the Board should conduct market research to fully understand market terms. If possible, the Board should seek to obtain the approval of non-participating shareholders and at a minimum, such shareholder should routinely be updated on attempts to find financing and findings on current market terms. The Board should also consider doing a “Rights Offering” where each existing shareholder is offered the opportunity to purchase its pro-rata piece the financing at the down round price, even those shareholders who do not have the benefit of a contractual pre-emptive right. Finally, a down round is a good time to make sure that D&O insurance is in place and includes adequate coverage.

4. Develop a communications plan for employees. Despite your best efforts, this is the type of information that often can get out there. Decide how you will position the down round to your employees. Since the dilution of a down round will also impact their options, consider whether some star performers should get option refreshes (i.e. a supplemental option grant to reduce the economic impact of the dilution).

One Final Word

Success lifts many boats. As a result, when a company is doing well and experiencing a string of “up rounds,” it is easy to gloss over different interests among shareholders and directors. A down round can create two or more classes of investors with very different economics. In the wake of a down round, it is important to be sensitive to this change, factor it into decision making, and develop a communications plan that addresses the potentially divergent interests of these shareholders.


Dror Futter, Partner- McCarter & English LLP

Dror Futter is a partner of the firm who brings more than 20 years of high tech and intellectual property legal and business experience to McCarter and its clients. Dror joined the firm as part of McCarter’s combination with SorinRand. Prior to joining SorinRand in February 2013, Dror was General Counsel to Vidyo, Inc., one of the nation’s top 50 venture-backed companies, where, among other things, he negotiated and documented sales agreements for both direct and indirect channels, purchase agreements, software licenses, service agreements, and strategic agreements in the US, Asia and Europe.

Biography

McCarter & English LLP

McCarter & English, LLP is a firm of approximately 400 lawyers with offices in Boston, Hartford, Stamford, New York, Newark, East Brunswick, Philadelphia, Wilmington and Washington, DC. In continuous business for more than 170 years, we are among the oldest and largest law firms in America.

Various Ways to Raise Capital

Guest post by Daniel DeWolf, Megan Gates, and Kaoru Suzuki – Mintz, Levin, Cohn, Ferris, Glovsky, and Popeo PC

The world of raising capital has been evolving over the last several years.  Offerings of securities generally used to fall into two main buckets: (i) private placements under the old Rule 506 or (ii) a public offering. With the implementation of various provisions of the JOBS Act now mostly complete, the array of choices has increased exponentially and include crowd funding, crowd sourcing by general solicitation for accredited investors, IPO light under the new Reg A+ rules, and confidentially submitted initial public offerings.  No one size fits all and issuers, bankers, and legal counsel should look carefully as to the context of the situation to determine which format makes the most sense for a particular offering.  We thought it might be helpful to provide a chart of the various alternatives for offerings now available.

Click on the chart to see full size.

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Daniel I. DeWolf, Member Chair, Technology Practice Group, Co-Chair, Venture Capital and Emerging Companies

Daniel is Co-chair of the firm’s Venture Capital & Emerging Companies Practice Group and Chair of our Technology Practice Group. In addition to his active legal practice, he is an adjunct professor of law at the NYU Law School and he has a wealth of experience in private equity and venture capital, having co-founded Dawntreader Ventures, an early stage venture capital firm based in New York.

Biography

Megan N. Gates, Member

Megan is a member of the Firm’s Policy Committee and Co-chair of the Securities & Capital Markets Practice Group. She concentrates her practice on providing counsel to public companies with respect to public and private equity financings, merger and acquisition transactions, and compliance and disclosure obligations under the Securities Exchange Act of 1934.

Biography

Kaoru Suzki, Associate

Kaoru’s practice focuses on representing public and private clients on general corporate and securities matters, including mergers and acquisitions, venture capital, private equity, and securities transactions. He also counsels his clients on compliance with federal and state securities laws. Kaoru represents both funds and companies across various industries, including energy and clean technology, life sciences, high tech and information technology.

Biography

mintzedge

‘Get Out of Jail Free’ Card

Joseph W. Bartlett, Co-Founder of VCExperts.com

Various attacks are mounted against the boards and managers of U.S. publicly held companies based on alleged deficiencies in the disclosure of financial results, the prosecution’s case buttressed by a emails discovered in the cloud from disgruntled insiders. The legal issues have been analyzed ad infinitum by the media and legal commentators. There is no effort from this corner to add to that enhanced commentary.

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Beware the Non-Disclosure Agreement

Joseph W. Bartlett, Co-Founder of VCExperts

Any number of private equity transactions begin with the execution of a confidentiality or non-disclosure agreement (“NDA”). Assume a venture capitalist is investing in the private equity of an early stage firm, or two venture-backed companies are discussing a merger. The usual protocol insists that, before due diligence commences, each of the parties (in the case of a merger, particularly if stock is the consideration) or the issuer (in the case of a venture investment) seek to protect their confidential information by requesting the other party to execute an NDA.

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9 Reasons Your Start-Up Needs Patents

Guest post by Jim Cleary and Rob Latta – Mintz, Levin, Cohn, Ferris, Glovsky, and Popeo PC

1.  Patents Get Venture Capital.

Venture capitalists want to see patents.  67% of venture-backed startups report that patents were vital for them in securing investment.[1]  In a 2010 study, only 40% of startups held patents, 80% of startups that received venture capital owned patents.[2]

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How Venture Capitalists Talk

Joseph W. Bartlett, Co-Founder, VCExperts.com

This post reviews basic terminology commonly used in the venture world. First, the entities into which capital sources are aggregated for purposes of making investments are usually referred to as “funds,” “venture companies,” or “venture partnerships.” They resemble mutual funds in a sense but are not, with rare exceptions (AR&D was one), registered under the Investment Company Act of 1940 because they are not publicly held and do not offer to redeem their shares frequently or at all. The paradigmatic venture fund is an outgrowth of the Greylock model, a partnership with a limited group of investors, or limited partners, and an even more limited group of managers who act as general partners, the managers enjoying a so-called carried interest, entitling them to a share in the profits of the partnership in ratios disproportionate to their capital contributions. Venture funds include federally assisted Small Business Investment Companies (which can be either corporations or partnerships) and, on occasion, a publicly held corporation along the AR&D model, styled since 1980 as “business development corporations.” This book, following common usage, will refer to any managed pool of capital as a “fund” or “partnership.”

Once a fund makes an investment in an operating entity, the fund or group of funds doing the investing are the “investors.” A company newly organized to exploit an idea is usually called a “start up,” founded by an individual sometimes referred to as the “entrepreneur” or the “founder.” Any newly organized company, particularly in the context of a leveraged buyout (LBO), is routinely labeled “Newco.” The stock issued by a founder to himself (and his key associates) is usually sold for nominal consideration and those shares are labeled “founders stock.” (The use of the male gender is used throughout for ease of reference only.) The founder, as he pushes his concept, attracts professional management, usually known as the “key employees.” If his concept holds particular promise he may seek from others (versus providing himself) the capital required to prove that the concept works—that is, the capital invested prior to the production of a working model or prototype. This is called “seed investment” and the tranche is called the “seed round.” Each financing in the venture process is referred to as a “round” and given a name or number: “seed” round, “first venture” round, “second” round, “mezzanine” round, and so forth.

Once the prototype has been proven in the lab, the next task ordinarily is to place it in the hands of a customer for testing—called the “beta test” (the test coming after the lab, or “alpha,” test). At a beta test site(s), the machine or process will be installed free and customers will use and debug it over a period of several weeks or months. While the product is being beta tested, capital is often raised to develop and implement a sales and marketing strategy, the financing required at this stage being, as indicated above, “the first venture round.”

The next (and occasionally the last) round is a financing calculated to bring the company to cash break-even. Whenever a robust market exists for initial public offerings this round is often financed by investors willing to pay a relatively high price for the security on the theory that their investment will soon be followed by a sale of the entire company or an initial public offering. Hence, this round is often called the “mezzanine round.” A caution at this juncture: The term “mezzanine” has at least two meanings in venture-capital phraseology. It also appears as a label for junior debt in leveraged buyouts. In either event, it means something right next to or immediately anterior to something else. As used in venture finance, the financing is next to the occasion on which the founder and investors become liquid—an initial public offering (IPO) or sale of the entire company. As indicated earlier, the measures taken to get liquid are categorized as the “exit strategies.”

One of the critical elements in venture investing is the rate at which a firm incurs expenses, since most financings occur at a time when the business has insufficient income to cover expenses. The monthly expense burden indicates how long the company can exist until the next financing, and that figure is colorfully known as the “burn rate.”