The Q4 2017 Prime Unicorn Index Trend Report is an analysis of 85 components that comprised the Index in the last quarter of 2017. The Index includes both unicorns and “approaching unicorns,” which are private companies with a valuation of at least $500 million. Valuations for individual components are determined by an analysis of various documents, such as: Certificates of Incorporation, Employee-Plan Exemption Notices, Limited-Offering Exemption Notices, Annual Report filings, Form Ds, bankruptcy filings, and many more sources. Utilizing all sources, we can extract key Deal Terms, such as: Round of Financing, Round Direction, Liquidation Preference, Liquidation Multiple and Dividend Rate. The report analyzes the different trending deal terms for a more granular picture of the capitalization structures surrounding the Q4 2017 Index components.
Guest Post by: Dror Futter, Partner – McCarter & English LLP
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, firstname.lastname@example.org
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.
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.
Joseph W. Bartlett, Counsel, Reitler Kailas & Rosenblatt LLC
In December 2015, after intense lobbying by, e.g., the Angel Capital Association (“ACA”) and parties interested in the early stage / innovation economy in the U.S. the so-called PATH Act makes permanent the exclusion of 100 percent of the gain on the sale or exchange of qualified small business stock (QSBS) acquired after September 27, 2010 and held for more than five years. The PATH Act also permanently extends the rule that eliminates the 100 percent excluded QSBS gain as a preference item for Alternative Minimum Tax (AMT) purposes. In addition, QSBS gain excluded from income is not subject to 3.8 percent Obamacare tax on “Net Investment Income” from capital gains (and other investment income) on high-income taxpayers. 
As is often the case, this development was not treated as headline news, despite the fact that the effect on U.S. gazelles (David Birch’s nickname for startups seeking to journey “from the embryo to the IPO” my phrase) and subsequent job creation is likely to be huge.
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.
Guest post by Barry Moltz, Entrepreneur and Consultant
Sometimes I find that the company’s founder is so far ‘outside the box’ that they ‘stretch the envelope.’ As an angel investor, I review more than 500 business plans each year. Unfortunately, many are so riddled with economy lingo, business jargon and clichés, that they do not communicate any real business value. In my opinion, terminology, such as disintermediation, sweet spot, ASP, best of breed, and win-win should be outlawed for the next 100 years.
Guest post by Barry J. Kramer and Michael J. Patrick of Fenwick & West LLP
Fenwick & West LLP analyzed the terms of 166 venture financings closed in the second quarter of 2015 by companies headquartered in Silicon Valley.
Overview of Fenwick & West Results
Valuation results continued to be strong in 2Q15.
- Up rounds exceeded down rounds 83% to 8%, with 9% flat. This was essentially unchanged from 1Q15 when up rounds exceeded down rounds 83% to 9%, with 8% flat.
- The 75 point difference between up and down rounds was the largest since we began calculating up/down rounds in 1Q02. The last two quarters have had the highest percentages of up rounds since 1Q02 as well.
- The Fenwick & West Venture Capital BarometerTM showed an average price increase in 2Q15 of 107%, an increase over the 100% recorded in 1Q15.
- Series B financings have generally had higher Barometer results than other series over the course of our survey, and in 2Q15 Series B exceeded the next closest series by 81 percentage points, the largest amount in two years.
- The median price increase of financings in 2Q15 was 74%, an increase from the 62% registered in 1Q15.
- The software industry again had a very strong performance in 2Q15 with 50% of all deals and generally the second highest valuation results. The internet/digital media industry, with the highest valuation results, and the life science industry, with the second highest percentage of deals and also strong valuation results, also had very strong quarters. The hardware industry had very solid results also in the quarter, but lagged the other industries.