Founder Series: Top Tips on Navigating a Down Round Financing

Orrick's Founder Series offers monthly top tips for UK startups on key considerations at each stage of their lifecycle, from incorporating a company through to possible exit strategies. The Series is written by members of our market-leading London Technology Companies Group (TCG), with contributions from other practice members. Our Band 1 ranked London TCG team closed over 320 growth financings and tech M&A deals totalling US$9.76bn in 2022 and has dominated the European venture capital tech market for 29 consecutive quarters (PitchBook, Q1 2023). View previous series instalments here.

With a decline in amounts invested, deal volume and valuations so far in 2023, whilst deal terms have generally continued to be relatively company-friendly we have seen a slight uptick in down rounds. So, what is a down round? In the fourteenth instalment of Orrick's Founder Series, our Technology Companies Group offers key guidance for UK founders on what they should be thinking about when considering a down round.

1. What is a down round? When a company undertakes a financing round in which it issues new shares to investors at a price per share that is less than the price per share paid up on a previous financing round, this is colloquially known as a “down round”.

While sentiment towards a down round is generally negative, founders should remember that they are driven by the broader macro-economic environment that impacts company valuations, rather than being a sign that a company’s business is less attractive.

Where there is limited deployment of late-stage capital, a restrictive IPO market and a prior period of inflated valuations, you can expect to see more companies going being subject to down rounds. 

2. What is the impact of a down round?

• Signalling. High growth technology companies, while typically unprofitable and illiquid, are driven to showcase growth to attract investors and top-tier talent. When a company seeks to raise new capital at a lower price per share than a previous round, this drives negative signalling of the company both internally and externally, impacting employee morale and wider market confidence.
• Dilution. With a lower price per share than a previous financing round, a company is required to issue more shares than it otherwise might have needed to on a flat round or higher priced round to receive the same level of capital. As a result of a down round, existing shareholders will take a greater dilutive hit. The impact of this can sometimes be exacerbated if investors seek to rely on existing anti-dilution provisions.
• Venture portfolio values. Investors will need to re-evaluate and account for the declined value of their portfolio companies following a down round, which may impact future fundraising efforts and distributions following any respective write downs, which investors will have to explain to existing and prospective limited partners.

3. Alternatives to a down round (terms). There are several levers a founder can pull when faced with a down round. Founders should consider the implications of each option:

• Waive or negotiate? It may be appropriate and commercial for investors to look to waive existing anti-dilution rights or renegotiate them on the proposed down round (either by reducing, adjusting or removing them entirely) to avoid disincentivising the company’s employees and consultants.
• Other investor-friendly terms. Founders can also consider terms which provide greater upside protection to enable new investors to manage downside risk, including:
  • Increasing the liquidation preference return (moving away from the 1x non-participating preference which has dominated the market over the past few years, and providing a participating preference or more than a 1x return).
  • Issuing warrant shares.
  • Providing super pro rata rights.

  Founders should carefully balance such terms against their overall impact on existing share classes. See our Deal Flow 3.0 report or speak to us directly for insights into which terms are considered more / less commonplace in the market. 

• Reduce burn. To the extent founders are able to do so, reducing the business’ costs and increasing runway can help postpone the requirement for further financing until the company is able to obtain a better valuation.

4. Alternatives to a down round (structures). During challenging macro-economic climates, other structures offer alternatives to raising a down round:

• Alternative transaction structures. Mergers, asset sales, joint ventures or strategic partnerships may provide appropriate alternative structures to avoid the need for raising a down round. They also may instil confidence and a higher business value in the minds of existing shareholders.
• Bridge financing. To avoid triggering the dilutive impact of a down round on your existing cap table, consider whether short-term bridge financing may more appropriately address concerns with the company’s valuation in the current market. Common bridge instruments include advance subscription agreements, simple agreements for future equity (SAFEs) or convertible loan notes, where capital invested converts on the company’s next financing round, typically at a discount to the round price. See instalment ten of the Founder Series for more information on Raising Bridge Financing.
• Alternative investors. The company can explore other investors who may provide more favourable terms at an increased or flat valuation to the previous round.

5. What is anti-dilution? Anti-dilution rights enable investors, holding shares with such rights, to avoid being diluted in a down round.

Anti-dilution provisions are commonly implemented using one of two methods:

• Issuing additional shares, by way of a bonus issue of shares.
• Effectively adjusting the conversion rate of preference shares that have a right to convert into ordinary shares, resulting in those investors holding more ordinary shares on a future conversion.

The most common method of the two is the bonus issue. It has the advantage of providing immediate certainty as to the dilutive impact and capitalisation of the company following a down round. By contrast, the conversion rate method doesn’t provide such certainty to shareholders until a future conversion event (which may, for example, be triggered by an election by the relevant shareholder or automatically on an IPO).

6. Impact of different anti-dilution constructs. The extent to which the anti-dilution ratchet avoids dilution of investors’ shareholdings will vary depending on whether the full ratchet, broad-based or narrow-based weighted average ratchet is used. Such ratchets will result in a different number of bonus shares being issued to investors who have the benefit of the anti-dilution right, and any dilution will flow to and impact shareholders who do not have such a right.  

• Full ratchet. The most draconian of the ratchets from the company’s perspective (and one which is therefore rarely used or accepted), is the full ratchet. Under a full ratchet, the investor will receive a bonus issue of shares in such number as it would have received had the original subscription price per share been paid at the down round price.
• Broad-based weighted average. The most common of the three mechanisms is the broad-based weighted average. This calculates an adjustment to the original subscription price paid up on an investor’s shares, taking into account the number of new shares issued in the proposed down round, the down round price and the fully diluted share capital position of the company immediately prior to the down round.
• Narrow-based weighted average. Similar to the broad-based ratchet, this mechanism adjusts the original subscription price paid up on an investor’s shares. However, instead of using the fully diluted share capital of the company, it considers the number of new shares issued compared to the number of shares in issue, prior to the down round.

7. Will investors waive down round protections? Anti-dilution rights represent percentage ownership protection for investors benefiting from them, rather than price protection. Accordingly, you should consider whether greater upside protection could be provided to the relevant investors as sweeteners for a waiver of such rights. A waiver of anti-dilution rights will ultimately protect the future signalling of the company and the investors’ existing investments.

8. Key considerations when negotiating anti-dilution provisions. At the outset (during term sheet negotiations), consider whether anti-dilution rights are appropriate – pessimistic investors often use anti-dilution provisions to protect against an overreaching and optimistic valuation. Accordingly, ensure that your valuation is realistic when you’re negotiating your financing round. This should mitigate against the impact of anti-dilution rights and other downside protection mechanisms used by investors on future rounds. Other considerations include:

• Impact on Founders / Key Employees. Remember that much of the value attributed to an early-stage, high-growth company sits with its founding team. By exercising anti-dilution provisions (which substantially dilute founders and senior key employees), investors prevent those individuals from being duly incentivised to grow the company in which they have invested which, in turn, impacts the overall value being returned to those investors. It is therefore in an investor’s interest to consider and negotiate anti-dilution provisions in this context.
• Pay-to-play. When negotiating anti-dilution protections with investors, consider whether you should include pay-to-play mechanisms to ensure investors follow their money on subsequent financing rounds to maintain their anti-dilution protection. If an investor fails to purchase its pro-rata entitlement on a subsequent investment round, they are penalised by the removal of their anti-dilution protection. In such a scenario, a non-participating investor’s preference shares will typically be converted into another class of preference shares that rank pari passui with their existing preference shares, but without the benefit of anti-dilution protection.
• Interplay with other provisions in the constitutional documents. Many companies unintentionally impact the economics of a financing round when including anti-dilution rights in articles of association using the bonus issue method. In one such example, the preference amount used when calculating the liquidation preference waterfall is a hard-wired subscription price. In this scenario, if bonus shares are issued under the anti-dilution regime, they will have the effect of increasing the preference amount owing to an investor. Also consider redemption rights and preferred dividends, which should similarly not ameliorate an investor’s economic position. Ensure that anti-dilution shares are issued as ordinary shares (rather than the preferred class of shares that have the right) or build into the articles an adjustment mechanism to the liquidation preference waterfall, redemption rights and preferred dividend mechanism.
• Modelling the anti-dilution impact. While it may be difficult, to ascertain the number of bonus shares a company may need to issue to investors on a future round, it is a useful exercise to model out the impact of down rounds (at varying down valuations) on your cap table. Once modelled out, consider whether any specific thresholds attaching to consent rights or board appointment rights will be impacted by future dilution in these scenarios and protect those rights, where necessary or desirable, in your investment documents.
• Clear intentions. Given the sensitivities and complexities involved with anti-dilution rights, any term sheet you negotiate should state explicitly the form of anti-dilution protection being offered and the company’s articles of association should be carefully drafted to ensure there are no unintended consequences of the mechanism being used.

9. Ensuring good corporate governance. A company that proceeds with a down round must practice good corporate governance. Appropriate corporate authorities should be put in place and the board should manage investor relationships to ensure such corporate authorities can be duly passed by the requisite number of shareholders to enable the down round to proceed.

 The board also should document that it has explored all viable alternatives before authorising the down round, noting the factors that have driven the company to undertake a down round (for example, the fundraising conditions, broader macro-economic environment, etc.).

Directors must be mindful of their statutory duties prescribed in the Companies Act 2006 and ensure they can document that they have acted in the best interests of the company and discharged their other duties. See the eleventh instalment of the Founder Series for more information around Complying with Directors’ Duties.

10. The last resort. Liquidation may be the company’s only viable option if it is unable to raise financing, faces pushback from investors who are no longer willing to back the business and if all other alternatives have been exhausted. See the ninth instalment of the Founder Series for more detail on what founders should consider when Steering a Company Through Financial Difficulties.

Our London TCG practice reflects London’s role as one of the world’s leading financial markets and a centre for international commerce. Nothing inspires us more than helping tech companies develop novel strategies and push boundaries. Through our extensive client portfolio, deal volume, and relationships in the tech ecosystem, we provide commercial and legal insight to each company’s strategy. We work with tech companies on all aspects of their business plans, financing strategies, protecting intellectual assets, retaining talent, securing and monetising data, and advocating for innovation-friendly public policy.

If you would like more details on any of the issues above, please contact Jamie Moore.