WHAT'S UP WITH DOWN ROUNDS?
The down round has become part of the venture capital landscape
in 2001. Most follow-on financings being done these days in all but
a few business segments are priced at a premoney valuation which is
significantly lower than the previous financing round's post-money
valuation. It is now common to see financings that are completed at
a price per share that is only a small fraction of the price in the
most recent round. These depressed valuations do not appear to be
sector specific (although some sectors are suffering more than
others), but instead derive from the overall malaise of the markets
and the global economy. Nor are the low valuations apparently
confined to any geographic area. This price pressure is being seen
in European, North American, Australian and Asian deals. Investors
have lost a lot of money, the IPO market is dry, and most venture
capitalists are concentrating on managing and funding their
existing portfolio companies. Relatively few new deals are being
done.
This change has affected even the terminology that people use
when conducting business. During the heady days of a year or two
ago, it used to be said that a rising tide lifts all boats, but now
it is plain that a lowering tide can lower all boats. It is now
more appropriate to say that to succeed, you must survive. A filing
used to mean a filing of an IPO with the SEC, a round used to mean
another financing (usually at a higher price per share), and ROI
(return on investment) used to pepper speeches and product
presentations. Now a filing might refer to a bankruptcy or
insolvency filing, a round might refer to another round of layoffs,
and the use of RIF (reduction in force or layoffs) is more common
than ROI.
When planning and implementing a down round, it is important to
plan for success. At a time when a company is just trying to
survive, it is easy to become impatient with legal documents and
processes. And yet, imagine what might happen if a company goes
through a down round, the nonparticipating stockholders are
severely diluted, sometimes to the point of being washed out
completely, the appropriate legal processes are not followed, and
then the company ultimately becomes a raging success. At that
point, there would be an asset (the company) worth arguing over,
and those nonparticipating stockholders have everything to gain and
nothing to lose by asserting whatever creative legal claims they
can think of. Such claims might range from highly technical
procedural irregularities to broad gauge breach of fiduciary duty
claims.
Unfortunately for those stockholders who do not participate in a
down round involving their company, down rounds usually involve
many onerous terms and conditions in addition to a low price per
share. Examples include:
- a higher dividend accrual rate;
- allowing an accrued dividend to be paid in cash or in more
shares, at the option of the investors;
- a participating (double dip) or even super-participating
(triple dip) preferred stock whereby the investor is assured of
a priority payment of one, two or even three times its
investment plus participation on an as-converted basis in the
remaining value of the company;
- warrants to purchase more shares in the future, and at an
advantageous price;
- an upgrade of old stock, permitting it to be exchanged for
new stock with its more advantageous terms;
- extensive special veto powers for new investors, and
termination of special veto powers by prior investors;
- seniority of new money over old money in any liquidity or
liquidation event. Sometimes this is accomplished by
structuring the investment as a form of convertible debt;
- implementing full rachet antidilution protection for the
new money, and forcing nonparticipating stockholders to waive
or compromise their existing antidilution rights;
- redemption rights, having the ability to force the company
to repurchase shares on a future event; and
- pay-to-play provisions, which deny an investor certain
rights if it does not participate in additional funding for the
company.
THE DRAMA OF ANTIDILUTION – WHEN IS LESS MORE?
Apart from the dramatic decline in valuations, the next most
dramatic change in the structuring of such deals may be the now
very common insistence on full rachet protection for new money.
Little more than a year ago, it had been the norm for years that
venture money was protected from subsequent value-dilutive events
via so-called weighted average antidilution clauses. Such clauses
would modify the preferred stock's conversion price (having the
effect of increasing the number of shares of common into which the
preferred became convertible) by employing a formula that took into
account the number of new shares being issued and the amount of
aggregate consideration. The modification would be small if only a
few shares were issued for not much aggregate money; and the
converse was true as well.
Now, however, investors frequently require that the conversion
price of the new preferred stock be automatically adjusted to the
same level as the per share price of new stock that is issued in
the future, regardless of how many new shares are issued and
regardless of how large that future deal might be. For example, if
$10 million of new stock is issued today at $10 per share (with a
conversion price of $10, so that each preferred share is
convertible into one share of common), and if $250,000 of stock is
issued eight months from today at a price of $5 per share, then the
conversion price of today's preferred stock would be lowered to $5,
so that each share of today's preferred would be convertible into
two shares of common.
Not surprisingly, nonparticipating stockholders are uneasy about
full rachet protection being given to the new money. Typically,
they argue that everyone in the company should bear the risk of
future declines in value, and that it is unfair to penalize the
early investors in the company.
PROTECTING THE MANAGEMENT CROWN JEWELS
New investors are not typically very sympathetic toward the old
investors. The new investors will point out that "the market is the
market" and that pre-existing "sunk costs" by old investors have no
relevance to the pricing of a new round. In contrast, however, new
investors are quite concerned about management's reaction to the
down round and frequently make sure that management is spared from
at least some of the dilutive effect of a down round. After all, in
most venture funded companies, the enthusiasm of the management
team and the company's ability to attract top talent are the sine
qua non of success. Consequently, most investors in down rounds
will pay early attention to the employee option pool and to the
terms of options and other elements in the management's
compensation package.
Examples of steps to protect management from dilution include
increasing the size of the employee option pool, accelerating
vesting of old options and granting new options at a much lower
price than options were granted before the down round. These kind
of adjustments must be implemented extremely carefully, being
mindful of both accounting and tax rules. One of the most important
issues to recognize is variable accounting. This is when rather
than the customary accounting effect of employee options (that is,
that there is no hit to the P&L at all), the company is
required to take a compensation expense to its P&L at the end
of every accounting period for the life of the option, equal to the
difference between the exercise price and the then value of the
shares. Not a desirable result, but one that will be caused, if,
for example, a company merely reprices its old options by lowering
the exercise price per share.
LEGAL ISSUES – PRUDENCE, PATIENCE AND INDEPENDENCE.
Down rounds frequently raise at least three issues under
Delaware law, all of which relate to process and procedure —
namely, whether the directors have complied with their duty of
care, whether they have complied with their duty of loyalty, and
whether they have obtained the proper approvals in order to
implement the down round. And, although the Delaware legal
terminology may be different from that used in other states and
countries, the basic legal principles tend to be similar from
jurisdiction to jurisdiction. Directors who are too impatient and
do not take the time to deal with these issues are exposing
themselves to potential liability. Patience can be a difficult
virtue at a time when a company is running out of money, people are
being laid off, and problems seem to be around every corner for a
company.
A director who complies with his/her duty of care will
reasonably believe that the down round and its structure are in the
company's best interest. A director has the obligation to ensure
that adequate information is available to the board and has been
evaluated in a reasonable fashion. This means being careful to
thoroughly consider the terms of a proposed financing round and to
understand its significance for the company (and especially for
those stockholders who are not participating in the down round
itself). The directors should also endeavor to find independent
data points that support the valuation and other terms of the
round. For example, they might obtain comparables (information
about companies that are somewhat comparable to the company and
which have undergone down rounds), and might even obtain an
investment banker's fairness opinion. In our experience, however,
most IBs are unwilling to provide such opinions on a schedule or at
a price that venture funded companies find acceptable. The
directors should also press the company to explore all reasonable
alternatives to the down round. For example, could the company
factor its receivables, or could it obtain capital from someone
other than the insiders, or could it make its existing cash last
longer by implementing cutbacks so as to avoid the need for a down
round?
Complying with the duty of loyalty requires managing the
often-inevitable conflicts of interest that can lead to
self-dealing. These conflicts typically arise in venture-financed
companies, because the boards of directors in such companies
typically include individuals who are employees or partners of
existing investors, and because such existing investors are often
the only sources of new money when a company is struggling
financially. In short, the existing investors are in a position to
potentially control the company's decision on how to structure the
down round. Typically, such conflicts are managed by having the
round approved by an informed majority of the disinterested
directors or disinterested stockholders or by being able to
demonstrate that the round is fair to the company, which usually
entails a fairness opinion from an independent third party.
Examples of techniques that support compliance with this duty
would include ensuring that all directors are informed about each
other's financial interests and how the down round would hurt or
help them, taking adequate time to evaluate the proposed financing
terms and encouraging a robust and clear debate about possible
alternatives, extending the offer to participate in the round to
other stockholders, attempting to persuade third parties to invest
in the round (and in particular, to state at what price they would
be willing to invest), circulating a written description to all
stockholders of the capital structure with a side-by-side
comparison to the proposed down round capital structure, obtaining
information on comparable transactions, documenting discussions in
well-kept minutes, and encouraging a tone of debate at the board
level which emphasizes the fiduciary duty to all stockholders.
Another common trap for the unwary in down round financings is
the de facto veto power that some parties might have over a down
round. For example, if a down round requires an increase in the
number of shares of a class or series of stock, or if the down
round has an adverse effect on the special rights of such class or
series, then the company cannot implement that increase or adverse
effect without the approval of a certain majority of the affected
class or series. Also, even a single stockholder can block a down
round if the round depends on implementing an amendment to the
stockholders agreement, unless the original agreement contains a
provision expressly permitting amendments by less than unanimous
consent. Obviously, from the investor's point of view, the best
solution to these types of veto problems is forward planning during
the up round that precedes the down round, eg to make sure that the
stockholders agreement can be amended without 100% approval.
Finally, one must plan for non-obvious issues as well as obvious
issues such as veto rights. For example, a down round could be
blocked, in effect, by now industry-standard provisions in most US
certificates of incorporation (and in many other deal documents,
such as executive level employment agreements) that give someone a
substantially increased financial return (or that trigger a forced
payment of assets) when more than 50% of the voting control changes
hands. As many down rounds involve that degree of change of
control, this is a real problem which one can easily overlook in
the tight timelines and intensity of a down round.
So, if you have been "down so long that everything now looks up
to you," it could be that the business you rescued during that last
down round is finally moving up the hockey stick of valuation. You
survived, and now you can succeed. That's both the good news . . .
and the bad news, unless you had done your legal homework during
the earlier down round and set the stage for good legal defenses
now that there's some real assets for disgruntled stakeholders to
fight about.
Edwards & Angell LLP
101 Federal Street
Boston, MA 2110
Tel: 1 617 439 4444
Fax: 1 617 439 4170
Website:
www.ealaw.com