Down Round Basics

by Jed Weiner

A down round is a financing round in which the company’s valuation is lower than the prior round valuation. Down rounds may cause significant dilution to founders and other preexisting investors’ equity ownership. Venture capital funds invested in a company which completed a down round may need to “write down” the value of their investment, affecting the fund’s performance.

Early Preferred Stock Investors

Preferred stock investors, which include venture capital funds, can protect themselves from down rounds by negotiating anti-dilution protections when investing in companies. Common anti-dilution protections for down rounds include full ratchet anti-dilution rights and weighted-average anti-dilution rights.

Under a full ratchet anti-dilution provision, existing preferred investors maintain the same percentage of equity ownership after a down round. A weighted average anti-dilution provision reduces the conversion price of preferred stock to common stock to the weighted average price per common share at which the company has sold its securities, including the securities sold in the down round issuance triggering the anti-dilution protection. The weighted average price per common share is based on the number of shares of common stock of the company then outstanding valued at the price used in the investor's original financing (as adjusted by any prior anti-dilution events) and the number of shares of common stock issued in the down round issuance valued at the price for that investment.

Walking Back Anti-Dilution Protections

Founders and other common stockholders may be unwilling to accept anti-dilution protections previously agreed with venture capital funds and other preferred stockholders as a fait accompli. Founders and other common stockholder and new preferred stock investors may pressure existing preferred investors to waive anti-dilution rights to enable a new round of financing required for the business’ survival. Moreover, preferred stockholders may be inclined to waive anti-dilution protections to keep management, which generally owns common stock or option to purchase common stock, incentivized.

Fiduciary Duties

While investors face economic challenges in down rounds, the threat to directors and controlling shareholders may be legal exposure for breach of fiduciary duties. A down round may present directors who are founders or appointed by controlling shareholders with a conflict of interest. Founders and controlling shareholders’ economic incentives may be at odds with the economic interests of minority stockholders, who may not participate in the down round and may suffer from substantial dilution.

To address this heightened risk, the board of directors should meticulously comply with the duties of care, loyalty and candor, each mandated by state law, in conducting down rounds. For one, this means establishing a thorough and transparent decision-making process. In some cases, the board of directors should establish a special committee, obtain consents from non-participating stockholders, or engage a financial advisor to provide a fairness option.

For more information about down round strategy, contact Jed Weiner, Head of Corporate at Mei & Mark LLP at jweiner@meimark.com.