Why Down-Round Financing?
Down-round financing occurs when stock of a company is sold at a lower price per share than it was sold during a previous financing. Although having to choose to do a down-round may not be an ideal outcome for a company, it is a tool that comes in handy when a company is seeking new investors in times of necessity, economic uncertainty or in a chilled fundraising environment. The legal aspects of a down-round can be challenging tactically and strategically for founders and investors.
Structuring a Down-Round
Regardless of a company’s reason for opting to sell stock at a lower price than in its previous financing rounds, once such a decision has been made, there are various legal issues that surface surrounding the structuring of the round. Many times, a down-round will involve a recapitalization of the company, which will require amending the company’s charter. An amendment of the charter can include conversion of stock, decreasing the amount of stock, limiting the economic and control rights of investors. One of the main challenges in structuring the down-round is obtaining proper approvals from key stakeholders and understanding the applicable legal formalities. Below are some of the main issues that we have seen come up in the last months.
Conversion of Stock
One way to structure a down-round is to convert the company’s preferred stock into common stock. This is done to entice the new investors by effectively getting rid of certain preferred rights of the old investors – mainly the liquidation preference overhang, which would otherwise prevent the new investors from benefiting from their investment at the occurrence of a liquidation event. The conversion can be achieved by (i) an auto-conversion of preferred shareholders’ (investors) shares into common stock shares or (ii) amending the company’s charter. The first method doesn’t require an amendment of the charter and the sole action is to give notice of the conversion to the company. The second method requires the vote of the majority of the class of shareholders or approval of the majority of multiple classes of shareholders depending on the protective provisions contained in the charter.
Another way to structure a down road is to, reclassify the the preferred stock into a different series of preferred, called “shadow series.” This way although the recapitalization will take place, certain preferential rights of the investors would be preserved going forward while limiting them in some areas. This method allows to differentiate between investors who hold the same series of preferred stock, which is important in the context of the pay-to-play provisions discussed below.
Reverse Stock Split
Another possible mechanism applied in the context of a down-round is the reversed stock split: a company may opt to amend its charter so as to decrease the number of its outstanding shares while maintaining the same ratio of equity between the shareholders. It is a useful mechanism where, due to multiple stakeholders and rounds of financing, the company has issued sometimes hundreds of millions of shares and the structure has lost transparency. Here, again, there would be a need to obtain the required votes of the shareholders to amend the charter and implement the reverse stock split.
Another tool negotiated in the context of a down-round are pay-to-play provisions. Quite often the investors willing to put up additional money require the other preferred holders to loyally participate in the financings. Pay-to-play are therefore provisions put in place to force existing preferred shareholders to participate in future rounds on a pro rata basis under the threat of having their shares converted into common stock or shadow series shall they decided to pass. Investors failing to meet the pay-to-play requirement would therefore lose part or all of their preferential rights, such as anti-dilution protection or certain voting rights. As with the conversion of stock, such provisions may be pre-existing or implemented contemporaneously with the financing.
A down-round may also trigger existing anti-dilution adjustments, located in the company’s charter. Such provisions allow for an adjustment of the price at which the preferred stock will convert into common stock, in order for the stockholder to maintain its percentage of ownership. In order to avoid the effects of anti-dilution, a waiver may be needed from the preferred shareholders or the charter may need to be amended. As in the previous cases, when amending the charter, votes of the relevant class or series will likely be involved.
Apart from the actual structuring of the financing, there are numerous other issues that a company should take into account in connection with a down-round financing. One issue involves proper disclosures of the financing details to minority shareholders in a series or class of preferred stock. It should be noted in this context that an amendment or modification of the series preferred in the charter, is usually made by the majority of a class, which, increases the risk of a potential lawsuits, by dissatisfied minority shareholders. Given the usually grim circumstances of down-rounds and high likelihood of rights diminution and resulting resentment it is crucial to keep all shareholders sufficiently informed about the shareholders meetings, resolutions adopted, and naturally the transaction itself as per, for instance, the Article 222 and 228e of Delaware General Corporate Law.
Fiduciary duties of directors
Another concern regards the fiduciary duties of the directors, especially directors chosen by the holders of preferred stock. Despite being chosen by a particular class of shareholders, each director owes fiduciary duties to all classes of shareholders. Thus, this may lead to conflicts of interest in the context of the financing, especially when certain classes of shareholders are benefitted more than others. An example of such a conflict would be a VC director who on one hand owes fiduciary duties to the company and on the other hand represents the interests of the VC in negotiating the share price and other favorable terms for the VC. In such a case, the company will want to obtain approvals of the disinterested stockholders or may opt to form an independent committee to evaluate the financing’s terms.
Employee Stock Option Plan
In the case of the employee stock option, a down-round may not lead to its decline in value. This is due to the fact that the value of the stock options is based on the value of the company’s common stock, as determined usually by an outside firm, rather than by an investor in a financing. Despite a round of funding in which the investors paid a lower amount for shares, the employee options would not decline in value unless the company’s value fell below the value set by the outside firm, rather than the one set by the investor. Furthermore, companies may undertake certain measures to mitigate the effects of down-round to protect the employees. They may bump up the stock plan and grant additional options with a newly established strike price to mitigate the dilutive impact. If the already granted options are underwater, the company can always restructure the options or allow their employees to cash out part of the options in exchange for their cancellation.
VCs and their LPs
Conducting a down-round financing can negatively affect investor accounting. Generally, a VC fund will account to partners based on the value of the stock of the company it is investing in. A down-round may result in a need to adjust the value of the fund’s holdings in financial statements, which in turn may hinder its fundraising efforts and trigger reporting to LPs.