To seed investors and other parties who got in on the ground floor of a (once) promising startup, a down round of financing is not a welcome sight. In a down round, a private company offers shares for a lower price-per-share than was offered in the previous round of financing. In other words, the value of the company has decreased since the last round. To many people, a down round is a signal that the company is not performing as expected or hoped. The desired path for classic venture-backed startups is to shoot for exponential growth in order for venture capital investors to see returns on their investment.
Reasons for a Down Round
On the surface, a down round is simple: a startup company needs to raise money through additional rounds of financing to sustain operations. For whatever reason, the valuation of the company is less than it was immediately after the previous financing round. Some of the underlying reasons for a down round include:
Anti-Dilution Provisions
As much as the founders of a startup do not want to issue a down round, the ones most perturbed by a down round are the investors who put down money in previous financing rounds. Whenever multiple rounds of financing occur, existing shares are diluted. But, dilution occurs even in an “up” round, and more so in a “flat” round as well. However, in those latter scenarios, the thought is that the dilution is “a smaller piece of a bigger pie” and is more acceptable to investors. However, down rounds can significantly dilute ownership from previous shareholders if it were not for anti-dilution provisions. In this instance, it’s more like getting a “smaller piece of a smaller pie.”
However, it’s very likely that, in the first financing round, an investor obtained “anti-diluton” protection as part of the deal. There are generally two common types of anti-dilution provisions: “full ratchet” and “broad-based weighted average.” These provisions will become critical in a down round.
With a full ratchet provision, early-stage investors have the right to have their conversion price adjusted. The conversion price will determine the number of common shares issuable upon conversion of the investors’ preferred shares. For instance, if a seed investor who purchased 500,000 shares of Series A Preferred Stock for $1 per share, we would typically see the investors’ conversion price also being equal to $1 per share. In other words, if they convert to common stock (e.g., upon liquidation or an initial public offering, the investors would receive 500,000 shares of common stock in exchange for their 500,000 shares of Series A Preferred Stock.
If we assume that the Company enters into a subsequent financing where the price per share is, say, $0.50 per share (e.g., in a down round), then the Series A investors could exercise full ratchet protections and adjust the conversion price of their Series A Preferred Stock to $0.50 per share. As a result, each share of Series A Preferred Stock would convert into two shares of common stock (so the investor could not convert their 500,000 shares of Series A Preferred Stock into 1,000,000 shares of common stock). This is true even if the Company issues only 1 share of the newly issued stock at the $0.50 per share price.
In a broad-based weighted average anti-dilution provision, shares of preferred stock will still convert into additional shares of common stock. However, the amount of the adjustment will take into account the amount raised in subsequent rounds relative to the total number of shares of the startup.
For whatever it’s worth, in our experience it’s far more common to see early investors obtaining broad-based weighted average anti-dilution rights than full-ratchet anti-dilution rights.
Airbnb Example
A recent prominent example of a down round is Airbnb’s recent infusion of $1 billion from high-profile investors. Once some of the details of the investment were revealed, it became apparent that the company had closed the investment at a valuation of $26 billion, which was $5 billion less than its previous valuation. Many speculate that this decrease in valuation came as a result of COVID-19 pandemic and decrease in demand for Airbnb products and services. The company has not yet gone public.
Conclusion
While down rounds are not welcome for investors and entrepreneurs alike, companies must face reality and take actions to survive, despite the fact that they likely provided earlier VC investors with some form of anti-dilution protection. But, before an entrepreneur takes action on a down round, they should discuss the effects with their corporate counsel and make a plan.
Doida Law Group has extensive experience helping companies execute financing rounds; our overall mission is to help entrepreneurs reach their goals. We offer fee structures that are based on the scope of your projects, including fixed fees that provide certainty on price. Get in touch with our firm here through our website or call us at 720-306-1001.