Raising a Down Round and How to Be Prepared

Transcript

Max:
Hey everyone, I'm Max Cantor. I'm a partner at Orrick in our Tech Companies Group based in the New York office.

Samir:
Hi everybody, I'm Samir Bakhru. I'm also a partner in our Tech Companies Group and also based in our New York office. And today we're here to spend a few minutes with you just talking about down rounds.

So Max, as markets have shifted, we've naturally seen a number of down rounds occur. It's many times part of a company's life cycle. Can you tell us what a down round is? And maybe why it's not as bad as some might perceive it to be?

Max:
Yeah, sure. So I think, you know, down rounds fundamentally are any round in which the valuation is less than it was in the prior round. So the new stock is being sold at a price per share that's lower than it was in the prior round. In terms of why, our view is that in many cases down rounds are not as bad as the market might perceive them or many people might think that they are. I think there's sort of two answers to that question. The first is that they have become very common. And the result of that is that the market perception of a down round does not mean it's necessarily the end of times or the ultimate doom loop for a company. What it fundamentally means at this point is just that the company's valuation has been reset due to factors in the market. And now we're resetting the valuation of the company. Fundamentally, they've become more common. The result of that is that investors have become more familiar with them. The market generally has become more familiar with them. And so they don't have this horrible perception around them and they don't mean the end of times for a company. And then on the other hand, the other key piece is that in many down rounds or potentially most down rounds, the impact on the existing shareholders and the founders is not actually as bad as most people might assume. You really don't have this sort of complete wipeout in many cases. And Samir, we can talk a little more about how that's actually structured and what the actual impact is for the cap table.

Samir:
Absolutely. And I think you might agree with this in most cases. For many of the companies we've worked with over the years, those companies fundamentally have broad based weighted average, which is a form of an anti-dilution adjustment that's built into your charter or your governing documents as a tech company. Max, can you tell us a little bit about in a normal plain vanilla down round with a company that has broad based weighted average, how does that really play out and what happens on the cap table when we actually implement that broad based weighted average?

Max:
Right. So as Samir said, broad based weighted average is a form of anti-dilution protection that is attached to preferred stock that investors purchase in a venture financing. The way it works in a sort of simplistic way of saying it is that it adjusts the conversion price, i.e. the price at which the preferred stock converts into common stock, based on a formula that takes into account the new price and the amount of stock sold. The formula is a bit complicated. We don't need to run through it right now. But fundamentally, a key thing to understand and you'll have to model it out. Each company is going to be different. Is that the impact and the additional dilution is often just not nearly as significant as many people might assume, even when the valuation is, for example, being cut in half.

Samir:
That's right. And I think when we take a step back, a lot of people have a misconception around the down round that all of a sudden it means that the prior round is fully repriced down. Everybody gets a whole bunch of extra stock on the cap table. And that's just in most cases simply not true. And as Max just explained, you're not giving an investor in a down round under most circumstances extra liquidation preference. You're not issuing them more stock. All you're doing is adjusting their conversion price so that they essentially have more upside in the business as the company performs well. And the formula that you use to get there is going to weight how much money you actually raise. And so if you don't raise a lot of money in a down round, the impact is typically very small.

Max:
Yeah, that's right. And of course, what we're talking about right now is what we'll call sort of a vanilla down round or your average down round. There are, of course, and not uncommon forms of sort of more painful down rounds that will just generally refer to as recapitalizations. We'll call them recaps for short. Are rounds in which we're fully in many cases fully resetting the cap table by converting some or all of these existing preferred stock down into common stock, thereby wiping out the liquidation preference and putting everybody on an even basis. This is beneficial for a number of reasons. But one key piece is it allows the company to then reinsert a new class of preferred, whatever is being raised in that financing, that is not adding on to a very large existing stack of liquidation preference, which would further push down the common. And therefore, the chances that the founders, the management team and other holders of common stock would ultimately ever be able to make money in an exit.

Samir:
And let's double down on that a little bit. Why do investors and companies actually engage in a recap? Why wipe out the liquidation preference? Why reset? What are the drivers behind that if you're a founder?

Max Cantor:
Good question. There's a number of reasons to do a recap, right? Let me give an example, I think, which might be a better way of understanding it. But imagine a company that's raised $100 million over a number of rounds. And the most recent valuation was, say, $300 million. Market shift, company's growth slows. Suddenly, the company's market value may be closer to $50 million or $100 million. If we were to raise, say, an additional $20 million of preferred stock and just add that to the existing liquidation preference, the result would be that you'd have $120 million of liquidation preference on a company that's only worth 50 or 100 million dollars. What that means is, practically speaking, you've made the common stock really not worth much and made it very difficult for the founders, for the employees to ever really participate in the upside of an exit. De-incentivizing continued work, de-incentivizing further innovation, and generally not a good outcome for the common or for the investors.

Samir:
That's right. And I think the way a lot of new money investors would think about it in that scenario too is, hey, this business is pivoting, it's changing, it's not worth as much. I am not going to risk my new capital side by side with, let's say, in Max's example, $100 million that's already been spent on the business in its prior form. So usually, new investors and the management team are aligned in engaging in that recap to breathe new life into the company and give everyone a chance to profit.

Max:
Yeah, and fundamentally, it's a key point. You really have to have alignment amongst all your stakeholders, or it's very difficult to do a down round that is structured as a recap. In most cases, while you might not need everybody's consent to do the round, you are going to need sufficient majorities of different classes of stock, and you're really going to need full buy-in from a number of stakeholders, both to reduce risk, but also just to get your basic approvals to get the round done.

Samir:
So you mentioned recaps. Let's talk also a little bit about some of the other flavors of a down round. We've heard these terms like full ratchet. We've heard these things like push up, pull down. We've heard about refresh option pools. Tell us a little bit about that and how those terms can sometimes come into play in down rounds that are not plain vanilla.

Max Cantor:
Yeah, I think we'll riff off this vanilla example. Down rounds are very much a full ice cream store with a thousand flavors and a thousand different options. You could put sprinkles on them. You could put full ratchet on it. There's a lot of choices. And so it's difficult to say, you know, all down rounds look like this or all down rounds look like that. There's a lot of features to choose from, and they're highly customized. They're very different from, let's say, your typical series seed financing in which, you know, subject to adjustments and particulars for each deal, there's a lot of commonality. In down rounds, it's very much customized to the particulars of a company to achieve whatever the board has decided the ultimate goal of the deal is and whatever the new investor believes. So I think, you know, you see a lot of different terms that are added in. A number of those we can touch on quickly would be full ratchet, right, which is an alternative to the broad base weighted average anti-dilution we talked about earlier. Why don't you just run through what that is?

Samir:
So similar to broad base weighted average, a full ratchet also adjusts the conversion price of an existing investor's preferred stock. But what it actually does is it really does push the price all the way down to the new valuation. So, you know, I recently had a company that had raised a few years ago at a $1.5 billion valuation large company, you know, similar to Max's example, growth slowed, company had to pivot, change business models, reset. The new investor came in and said, hey, the company's only worth, you know, 500 million right now. And they needed a lot of existing insider participation to get the deal done. And in that scenario, the existing insider said, hey, we'll participate, but you need to bring our $1.5 billion down all the way to 500 million, irrespective of how much you raise. So what that means is it just gives it treats it as if that investor invested at 500 million. So their conversion price was basically 3X.

Max:
Right. Right. And the key thing to understand here when we're talking about these terms, these are going to be terms that apply to the new preferred stock that sold in the deal in the down round. And the reason why full ratchet may make more sense or the investor may believe it makes more sense in a down round versus your typical up round is it's very difficult to price a company that is in a down round situation. There's not necessarily a lot of market competition. There's not a number of term sheets coming in. And so there's not necessarily a readily discernible price, growth has changed. It doesn't fit into everybody's valuation models. So that full ratchet is really price based protection for those investors who can't necessarily exactly pinpoint the valuation like they may be able to do in your typical up round series A or series B.

Samir:
So we've heard this term push down pull up. What is that? How does that come into play in a down round or a recap?

Max:
Right. So push down, pull up fundamentally is just the way in which we effectuate a recap. Right. It's pretty simple. The words are pretty catchy. Right. What it means is we're pushing down all existing preferred stock into common stock and then we are pulling up common stock back up into the previous preferred for those investors who participate in the financing. Typically on a pro rata based formula that is going to be a little different than your typical pro rata. Usually a percentage of the round itself. So it encourages participation. It eliminates some preference and again gets the company the money it needs because investors need to participate if they want to retain their rights, their liquidation preferences, whatever other rights may have been attached to that previously existing preferred.

Samir:
So in a sense it basically is a form of a pay to play.

Max:
That's right. It is fundamentally a pay to play. Right. In order to continue playing in the company sandbox you have to pay. And what you're paying for is both new preferred stock and the right to have their prior preferred that was just pushed down into common, pulled back up so you can continue to retain those rights.

Samir:
Now what are some of the other kind of economic terms that we see in these down rounds. We've also heard about management refresh grants and big, you know, big option pools. How do you think about that as a founder when you're—

Max:
Right. So there's a number of terms right. Like I mentioned there's 50 thousand flavors and you got to pick the ones that work. Founder refresh grants and other forms of incentives for existing employees and founders are often pretty key in a down round scenario. The reason being the dilution is less friendly than in typical round. And it may be the case that there's been fairly severe dilution for the common stock.

Samir:
In a really bad down round.

Max:
In a really bad recap style down round. And the result is that you need to re-incentivize founders to continue participating in the company to continue building and to continue shooting for that big exit. So we'll often see very large option pools that will be put into place to really get the founders trued back up to potentially right where they were before the financing to make up for that dilution, as well as in some cases other sort of alternative option pool structures which will often come management incentive plans which are really forms of phantom equity, i.e. cash bonuses that pay out in a sale and those are used more often when the common stock is so diluted that it really doesn't make any sense to add additional pool or because there's so much liquidation preference left that even adding pool is still not going to create the value we need to continue incentivizing your key team.

Samir:
So one of my takeaways here is that as a founder you really want to hire someone who's been through a down round and who can guide you through it and talk you through these terms and knows how to help you see around the corners on these financings.

Max:
Yeah and I think the key is not just that you hire somebody who knows what they're doing but that you do it early in the process. Down rounds, and I'll defer to you to sort of talk through some of the process points, but down rounds are fraught with a lot of risks. There's a lot of conflict issues. There's a lot of fiduciary duties issues that come into play given what is happening potentially to some of the stockholders equity and therefore you really need to get counsel involved deep in the process early so that you maybe can put things in place like a special committee which we can talk more about and otherwise just make sure you're running a very clean process understanding that the risk that there is scrutiny and potential litigation around a down round financing is much more significant than it would be in a vanilla up round.

Samir:
Yeah I think that's right. Let's pause and talk about process for a bit and how you know boards should think about approaching a down round. I think one of the key takeaways based on what Max said and to take that a bit further is that if you are going to need to go through a down round you want to start planning early and you want to start talking to your board around what that down round might look like, how much capital the company needs. And as a board if the down round is going to be led by an existing insider as opposed to an outside investor a board really needs to think very very hard about potentially creating a committee of disinterested directors to look at that financing, go to market, run a process, make sure that they've sort of explored all the alternatives before settling on that down round financing because as Max said if you end up in a litigation these facts get looked at. People look at what process the board ran and it's going to be instrumental that the board can show through its records that hey we ran a process we got the best price we got the best deal that we could and then we executed, we didn't just pick the first term sheet that came to us.

Max:
Right. I mean the board's job fundamentally is to exercise its duties to do what's in the best interest of the company and its stockholders. In order to do that you have to get the best deal possible. If the down round is not the best deal possible or you can't prove it's the best deal possible because you didn't actually go to market, you didn't solicit alternative bids and you didn't really run it to ground you're opening yourself up to substantial risk and potential litigation down the road.

Samir:
And what's another I think you know we've also heard this term rights offering but how does a rights offering play into that when a board is going and doing a down round. How do they sort of protect themselves further by doing a rights offering?

Max:
Yeah so rights offering sort of ties back to the pay to play concept, right. So when we talk about a push down, pull up and a recap with a pay to play, that pay to play is really put into place via what we call a rights offering. A rights offering is a formal offering to the existing holders of preferred stock to participate in the round. It involves sending out an information statement or you know explanatory cover letter that's really detailing all the terms and what's happening in the deal and giving the investors the right to participate in order to pull back up their stock or stop themselves from being converted down into common.

Samir:
And I think you would agree that a big reason to do it is from a fairness standpoint and to ensure that if you are doing a rights offering that's led by an existing inside investor that you're giving the same opportunity to all of your stockholders that are being diluted. So they get treated the same as an insider which further insulates the board.

Max:
That's right. And you know fairness is one piece of it. But ultimately what we're really talking about is the underlying Delaware corporate law. Right. And Delaware case law and the Delaware courts have been fairly clear over the years that a rights offering is a key component of a financing recap that's structured like this because you really don't want to just force everybody down and punish existing investors to the benefit of the new one without giving those existing investors the ability to save themselves or continue to participate on the same terms as the new folks. So it really does help sort of reduce risk profile of an overall transaction and generally also just going to make your existing investors a little happier if at least they have the right or the choice of whether they want to continue to put money in the company and continue to participate in its growth.

Samir:
And I think you would also agree that as part of the process of doing a down round it's important to be communicating with your stockholders early and often. Right.

Max:
That's right.

Samir:
This is a difficult thing for some stockholders to accept. It, in some ways, can cause some trauma for them. Right. And so I think not sort of foisting this on them at the last minute when the company is running out of capital and communicating with them early and often will go a long way to having a smooth process.

Max:
Yeah that's right. And I think you know every cap table is different. The benefit of the down market that's occurred over the last couple of years is that more investors are familiar with down rounds. Almost every major fund has been through multiple down rounds in the last couple of years. If they haven't please let me know where I can invest in them. I'd love to. But that's generally probably not going to be the case. So investors who are sophisticated institutional investors are generally going to be fairly familiar with down round structures or their counsel certainly will be. So they may take it a little better than others but angels or friends and family those can be a little more difficult because they may never have seen one. They may view it as more punishing than it actually is. And that communication early often will really help both get the deal ultimately approved but also sort of ease some of the tension and prevent reactionary litigation or reactionary anger or just general disruptions that cause problems in your financing.

Samir:
So in summary Max it sounds like some of the best practices for a down round are involve your counsel early and often and hire somebody that's been through the process because down rounds do have many flavors to them. It also sounds like it's important to be communicating with your stockholders early and often so they're aware of what's happening. They're not caught off guard and it ensures a smooth closing for you throughout the deal. And you know perhaps most importantly it's important to get your board involved early and have them run a full fair and thorough process to get the best deal for the company so that they're protected from a fiduciary duty perspective.

Max:
Yeah you don't want to negotiate in a vacuum right. You really want to get out there and see what the market has to offer and make sure you're running down every available alternative for the round and that you're taking the best one. But you know I think one last takeaway would just be that down round is not a bad word. They come in many flavors. Some of them are pretty painful. Some of them are not nearly as painful. And it's just important to keep in mind that just because your company may have done a down round or a company that you're looking at going to work for has done a down round does not mean it's a bad company. It fundamentally means that their valuation dropped and that could easily be due to general macro factors. Right. And so just keep in mind that not all down rounds are necessarily bad.

Samir:
Well thank you for joining us today for this conversation on down rounds. If you have any questions please don't hesitate to reach out.

Max:
Thanks so much.