Confronting a Down Round

Guest Post by:  Dror Futter, Partner – 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, dfutter@mccarter.com

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. Previously, he was a partner and General Counsel of renowned venture capital fund New Venture Partners LLC. While there, he helped to form funds, and advised multiple start-ups and corporate spin-offs in the information technology and telecommunications industries, as well as serving as the venture fund’s legal counsel. He also advised portfolio companies with respect to commercial, mergers and acquisitions, employment, Internet/ecommerce and intellectual property law matters.

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.

Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from McCarter & English LLP. This work reflects the law at the time of writing in September 2016.

Deal Terms: The Missing Piece of the Valuation Puzzle

The following is an excerpt from VC Experts Reference

There has been a good deal of elegant work done on the valuation of private equity securities and the issuers thereof – chiefly securities issued by early stage firms. The challenges are significant since the usual indicia of value are often not in place (e.g. revenues and net after tax earnings), particularly on a historical basis. Valuation is key to the pricing of various rounds of financing of an emerging growth company. The pre-money valuation, given the amount of the financing, yields the post-money valuation and, based thereon, the percentage of the company the investors in the round wind up owning. Thus, a pre-money valuation of $3 million and a $1 million investment equals a post-money valuation of $4 million, with the investors owning 25% ($1 million ÷ $4 million) of the company. The issue is how to arrive at the $3 million pre-money valuation.

The “venture capital method” entails ignoring the negative start-up cash flows, and estimating a hypothetical future terminal value for the company as of several (usually five) years in the future and discounting backwards, using a significant discount factor to take into account the unusual risks involved in early stage finance. The trick is to derive reliable projections based on some currently ascertainable indicia and evidence. The process aims to minimize the pure guesswork as much as possible, but is very difficult, given the lack of information. There is also future guesswork involved when one factors in the dilutive effect of future financings and speculates on the amount of dilution those financings will entail.

There are also other methods that VCs use to value early stage companies. The Discounted Cash Flow (“DCF”) method improves on the venture capital method by including all relevant cash flows for the company, and estimating a true cost of capital for the company. Comparators are often used, but perfectly comparable companies are hard to find, as are detailed financials, in the private equity space. A somewhat more sophisticated model involves the “option method”. The idea is that an early stage financing represents, in effect, payment for a call on future values. If the company fails (as many do), then the call is worthless, similar to a publicly traded option that expires out of the money. On the other hand the profit from a successful investment can be spectacularly well beyond anything a DCF analysis would suggest.

This article seeks to illustrate and highlight a significant oversight, in all the current methods–a piece of the equation that is routinely left out of conventional valuation discussions.

Take a typical conversation at the outset of the negotiation of a Series A Round financing. The discussion starts out with the issue of valuation. The entrepreneur and his or her advisors lay on the table a number, based on art as much as science, and suggest that the venture capitalist agree with it as the basis for further discussions. There may be, depending on the investment climate, a certain amount of discipline applied to the pricing of the deal if there is more than one potential investor. In such a case, the market sets the price of the security … i.e., the pre-money valuation. The fact is, however, that there is not much of an auction market for Series A Round securities. In fact, if a knowledgeable venture capitalist smells an auction, he or she will ordinarily pass and go on to the next opportunity, or team up with the competitor and make a consolidated bid.

The price, in other words, is usually left to naked negotiations between the buy and the sell side. The negotiation starts with the entrepreneur’s number, a different number comes from the VC, and the price settles somewhere in the middle. The final result is usually closest to the VC’s number since most VCs have a relatively good handle on what is going on the marketplace, what other firms are paying for investment opportunities. Moreover, ordinarily, there are fewer buyers than there are sellers and more deals than money. The parties agree on a price and then the negotiation segues to a discussion of deal terms. When the deal is finalized, the entrepreneur reports to his or her current shareholders that a pre-money valuation of X dollars has been secured.

My point is that this process, as described, puts the cart before the horse. The entrepreneur and the angels cannot understand the valuation number until they fully understand deal terms. Thus, the term sheet may recite a pre-money valuation of $10 million and, from the entrepreneur’s standpoint that may appear to be favorable. However, the $10 million stands up only if the new investors are buying common stock with their $1 million and standing pari passu with the existing shareholders. And, that is hardly ever the case.

Let us assume that the new investment is a convertible preferred stock. The new investors get their money back plus accrued dividends before the common shareholders i.e., the entrepreneur et al., get anything. And, let us assume there is at least a fifty-fifty chance the company will be sold for less than its post-money valuationi.e., $2 million vs. $4 million. Without doing the precise math, it is clear that the valuation, given that scenario, is not $3 million pre-money. Further, let us say that accrued but unpaid dividends are tacked on to the liquidation preference for purposes of the conversion calculation. If that dividend is 10% and the liquidation event is assumed to be four years away, the common shareholders are being diluted (even under a favorable scenario) automatically by 2.5% a year (the 10%dividend times the 25% interest with which the VCs start out).

Assume the VCs impose restrictions on the transfer of the entrepreneur’s shares, perhaps even reverse vesting. Under classic valuation theory, those restrictions eat into the current value of the common shares. Also assume the convertible preferred is in fact a convertible participating preferred, meaning that the VCs get their money back first and then they share in the proceeds as if they had converted. In most scenarios, i.e., those not involving a terminal value in the stratosphere, the participating preferred deal term negatively impacts the entrepreneur’s value significantly.

All this, of course, is well known. Savage Deal Terms in favor of the VCs have an individual and cumulative negative impact on both the pre- and post-money valuation of the company. What is remarkable is how little quantification work has been done on the impact of deal terms on notional valuations. It is true that the outcome of the valuation negotiation in a Series A Round gets underway does not ipso facto determine the outcomes of the parties. The parties do not see their investment posted on the score sheet until the liquidity event occurs, the price of that event matched with each participant’s percentage and, if applicable, the effect of various deal terms factored in. All relevant items determine the ultimate return on investment. If the company is sold or goes public, for instance, at a valuation of $500 million, the fact that the Series A investors get their $1 million back first is not a major factor one way or the other; if the terminal value is $5 million, on the other hand, the reverse is true.

In the above sense, the question of pre-money valuation has no definitive significance. However, since valuation determines the parties’ relative percentages, it is a critical number. And there is no reason why, under a variety of likely scenarios, the players should not have all the material information at their fingertips when the negotiations go forward.

Restructuring Liquidation Preferences

Guest Post by Eric Hanson-WilmerHale

Job candidates may choose to work for a startup to help build something new, to work in an environment that fosters and rewards creativity, or to get the thrill of climbing aboard a “rocket ship.” New employees rarely, if ever, guide the rocket ship’s trajectory, even though they often directly help determine it. And startup employees’ incentives usually skew heavily toward equity in the company’s option plan—rather than salary—even though these employees usually have no say in how the company’s fundraising activities will impact the eventual value and payout of the common stock held by the employees.

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Savage Deal Terms

Joseph W. Bartlett – Special Counsel, Reitler Kailas & Rosenblatt LLC

Some of the financings in ugly investment climates are typically proposed by venture capitalists on deal terms that approach the punitive. By that I mean a Series A Round (or any professional round) which contemplates a “participating preferred” with anywhere from a ‘2X’ to a ‘3X’ return to the holder. What those abbreviated terms mean numerically is the following:

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Valuation and Pricing of an Enterprise

Joseph W. Bartlett, Council, Reitler Kailas & Rosenblatt LLC

When a founder determines it is worth his while to attempt to raise money for his concept, the basic issue becomes one of price. If, for example, the business needs $500,000 to get started, how much of the equity in that company should $500,000 in fresh cash command? A brief summary of common terminology will help illuminate the subsequent discussion.

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What Do Those Deal Terms Mean?

In today’s venture financing environment, knowledge of the venture financing process is vital to ensuring fair business practice between entrepreneurs and investors. Many times, deal terms are often agreed to by entrepreneurs without a clear and concise understanding of what the terms actually mean to their company.

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