[This is the first of a series of posts on down round and dilutive financings.]
I don’t want to add to the “sky is falling” in Silicon Valley theme that I’ve read on various blogs, but given recent economic conditions, a review of how venture financing deal terms may change seems warranted.
Existing investors generally want new investors to set valuations and deal terms in subsequent rounds of financing for a company. However, these deal terms typically become more investor favorable as raising money becomes more difficult. In many cases, existing investors are left to fund the company as new investors are unwilling to invest.
Unlike conventional, “up-round” financings which have a fairly predictable range of terms, the structures and terms of down round financings are variable. A “down round” financing typically occurs when a company issues securities to investors at a purchase price less than that paid by prior investors. Absent anti-dilution protection, a down round financing will dilute both the economic and voting interests of the prior stockholders. A “washout” or highly dilutive financing, is an extreme form of down round financing that significantly reduces the percentage ownership of prior stockholders.
Below are some features of down round and highly dilutive financings.
- Valuation. Obviously, valuations may decrease as the financing environment becomes more difficult.
- Liquidation preference. Liquidation preferences are also typically more investor favorable than previous rounds. These financings may involve the issuance of participating preferred stock with senior liquidation preferences at multiples of the purchase price. Please keep in mind that the liquidation preference may be the most important right of the preferred stock, as the percentage ownership that the preferred stock represents upon conversion into common may become meaningless from a practical perspective if the common stock is worthless (see below).
- Full ratchet anti-dilution protection. Investors in risky financings may request full ratchet anti-dilution protection to protect against future down round financings.
- Aggressive convertible debt terms. Many investors in highly risky financings will prefer senior secured convertible debt over equity securities in the event the company has to file for bankruptcy. These financings may involve the issuance of secured convertible debt (sometimes coupled with warrants) senior to other debt with a payment of a multiple of the principal amount on a sale of company (or conversion into equity securities at a multiple of the principal amount). 5x multiples were not shocking during the post-dot com bust 2001 era. In these situations, voting control, as reflected by percentage ownership and affected by valuation, is a secondary concern to the return on a sale of company and protection in bankruptcy.
- Milestone-based or tranched financings. Investors may be reluctant to invest large amounts of money in a risky financing. Instead, they may provide enough money for a company to find someone willing to buy them or achieve a particular milestone that decreases investment risk. These “IV drip” bridge financings may provide a couple to a few months of operating cash and are typically structured as secured convertible debt with a multiple X return upon a sale of company.
- Conversion of preferred stock. Some financings involve a conversion of previous series of preferred stock into common stock in order to decrease the aggregate liquidation preference. In some companies, previous financings may have resulted in an aggregate amount of liquidation preferences that may render the common stock worthless. For example, due to multiple X liquidation preferences or raising multiple rounds of financing, a company that has raised $50M in financing may have $100M in liquidation preferences. However, the company may realistically have a problem getting sold for greater than $100M in poor economic conditions where company valuations are low.
- Pay to play. Many dilutive financings implement a pay to play mechanism where stockholders not participating in the financing are penalized by being forced to convert into common stock. Absent a pay to play mechanism, stockholders may not have an incentive to risk additional investment into a company due to a free rider problem.
- Enhanced rights for participating investors. In some financings, existing stockholders that participate in the financing may receive additional benefits over non-participating stockholders. This is similar to pay to play provisions that penalize existing stockholders for not participating in the financing. For example, existing stockholders that participate in a financing may have their preferred stock repriced via an adjustment to the conversion ratio, which would effectively give them the benefit of a lower valuation for their original investment. Alternatively, participating stockholders may have the opportunity to exchange their existing preferred stock for new preferred stock with more favorable rights, such as a senior liquidation preference.
- Expanded investor protections. Some investors may request more extensive representations and warranties, broader indemnification protection, D&O insurance, and other similar investor-favorable protections.
- Drag-along rights. Investors may require drag-along provisions that require existing investors to vote in favor of a future sale of company or an amendment of the certificate of incorporation to create a new series of preferred stock to facilitate a future financing (even before the terms of the preferred stock have been established).
- Employee retention plans. Some financings may involve large stock option grants to offset the dilutive effects of the financing to employees. In some companies, aggregate liquidation preferences or multiple X returns on convertible debt may render the common stock worthless. In these situations, stock options may not be adequate to hire and retain employees. Instead, companies may implement retention plans where employees receive a certain percentage of sale proceeds upon a sale of company.