Current State of the Market and Down Rounds
According to the Wall Street Journal, two-thirds of economists at the large financial institutions said there will be a recession this year. The main culprit is the Fed raising interest rates.[i]
Even if we do not see a recession, the capital raising market is shifting because we are transitioning from a decade plus long stretch of low interest rates (due to the last Great Recession)—where money was almost free—to an environment of relatively high interest rates. In other words, money is becoming more expensive, companies that thrived in the low interest environment are being tested, and investors are less incentivized to put their capital in high-risk venture when they can get stable returns in low-risk vehicles such as bonds and the like.
The Venture Capital market is already seeing the effects, as deal activity has been on a downward trend. In the first quarter of 2022, there were roughly 5,000 deals. That number dropped down to around 3,000 in the last quarter of 2022.[ii] Many companies are seeing their valuations shrink[iii] and others are burning through cash, running out of runway, and will soon need a cash injection. That said, the news isn’t all bad.
Seed stage company valuations grew relative to 2021 partly because of the large number of micro-funds, and nontraditional and crossover investors.[iv] But early-stage companies are also vulnerable if an economic downturn occurs. And there is some evidence that any windfalls gained from a strong micro fund market will retreat, as micro-fund closings have fallen back to pre-pandemic levels.[v] Nontraditional investors, who have also fueled the early-stage venture capital market, have also been slower to deploy capital as well.[vi]
Additionally, investors are seeing less returns from their VC investments, and, as such, are not as eager to deploy their capital. This has led to the lowest level of deal value in three years. Following that, exit activity dipped to the lowest level since 2016, $71.4B.[vii] Though VCs are still sitting on around $300 billion of undeployed capital, aka dry powder.[viii]
But if an economic downturn occurs, or if the Fed keeps on raising rates and companies need cash, they likely will be raising money in what is called a down round.[ix] A down round is where a company that previously raised money at one valuation is now raising money again but at a lower valuation. This is undesirable for many companies because it tends to signal to investors that the company is not performing well. In addition, previous investors often are unhappy if new investors are able to buy shares of the company at a relative discount rate compared to the previous investors.
In this type of environment, the leverage when negotiating deals will shift to the investor.[x] As such, founders should be keen to protect their equity and watch out for are two provisions in their legal documents: liquidation preference and antidilution.
Liquidation Preference
Simply put, liquidation preference refers to who gets paid first in the event there is a liquidation event, such as a sale of the company, a merger, or a winddown of operations. In such an event, investors will usually want to be made whole before another else gets paid for their investment. So, depending on where you stand in “line”, even though you technically may own say 35% of your company, because you get paid last, you might not see 35% of the payout when the Company is sold.
Over the past years, a 1x non-participating preference has been typically, meaning that the investors would get their money back before any founders received their cut or they can forego that option and decide to participate as a regular shareholder on a pro-rata basis.[xi] Aggressive investors may ask for a preference of 2x or so in a down market, meaning that they would require that they double their investment before founders could receive their cut.[xii]
There is also a second part of liquidation preference: participation. Participation preference means, in addition to getting a preferred return or first-in-line spot when everyone gets paid, investors also will be able to share in the overall cut as well after they already received their initial investment back. In a down market, expect investors to be aggressive on both these parts of liquidation preference arguing that after receiving their initial investment back, they should also share in the upside of the liquidation event pro rata, reducing the amount of money that goes to you the founder.
A common way to limit the dilutive effects of a participating liquidation preference is to impose a cap on the participation of the investor in the remaining proceeds. In that case, the investor will receive all the benefits of the participating preferred shares as mentioned above, but his or her overall return is capped.[xiii]
Also keep in mind that giving any investor friendly terms has a lasting impact, as future investors will likely expect to receive the same terms, along with seniority in liquidation preference.
Anti-Dilution Provisions
As mentioned earlier, a down round also upsets investors because they likely will not appreciate that new investors receive shares of your company at a lower price than they paid. As such, investors ask for anti-dilution provisions. Due to these provisions, if you raise a new round at a lower valuation, past investors will be able to force you to renegotiate your previous deal to reflect the new, lower valuation of your stock.
The burden to make the old investors whole will fall onto common shareholders—in other words you, the founder[xiv], further diluting your equity or ownership in the company.
In general, an anti-dilution provision can be either full ratchet or weighted average.
Full ratchet anti-dilution is the most investor friendly type of protection. If an investor receives this provision, they will be put in the position as if they had invested at the new, lower issue price. This completely preserves the value of their initial investment in a down round and can cause significant dilution of the value of the shares held by the shareholders that are not protected against price-based dilution.[xv]
Weighted average anti-dilution protection considers the proportional relevance of the subscription price paid in the down round and the subscription price paid in the previous round. It will not bring the old price down to the new price of the down round but will “ratchet down” or bring down the new price to a weighted average of both prices. For the new price, the weighting factor is the number of shares issued in the dilutive financing round. For the old price, the factor is either (i) the total number of common shares outstanding prior to the dilutive financing round on an “as if converted and fully diluted” basis (broad based weighted average) or (ii) part of the shares outstanding prior to the dilutive financing round as specified in the term sheet (narrow based weighted average).
That said, in today’s market, there doesn’t seem to be any full ratchet provisions. But it should still be something you all are aware of.[xvi] In general, fight for weighted average.
Another alternative is to place a time limit or share price floor on the full ratchet right.[xvii] Additionally, instead of using the down round alone as reference for the anti-dilution compensation, founders may include future rounds in the calculation of the dilution. That way, the full ratchet or weight average protection is then based on a new price calculated as the weighted average price of all future rounds. This will limit the dilution when one down round is followed by other “up” rounds.
Lastly, another tool companies can use to combat anti-dilution provisions is adding pay-to-play provisions, requiring investors to invest their pro-rata share in later rounds if they want to preserve their anti-dilution protection.[xviii][xix]
Alternatives to a Down Round: Debt
Venture Debt:
During times of economic uncertainty, companies tend to turn to debt to raise capital. As such, venture debt or any other debt financing may be an attractive alternative to raising capital via a priced round or selling equity in your company.
Venture debt is a type of loan offered by banks and nonbank lenders that is designed specifically for early stage, high-growth companies with venture capital backing. Venture debt follows an equity round, as venture lenders use venture capital support as a source of validation and the primary yardstick for underwriting a loan. Terms and conditions depend on context.
In my opinion, in general, if you can qualify for debt financing, I encourage it over selling shares of your company.
Convertible Debt:
Convertible debt is a bridge loan that is meant to convert to equity. With convertible debt, though you do not need to debate valuation, you likely will need to agree on valuation cap, which essentially is the equity valuation that the loan will convert at. Moreover, in exchange for granting the loan, investors generally gain a discount in the next equity raise. Thus, an investor may still benefit from the leverage he has in a down market.
[i] David Rabouin, Big Banks Predict Recession, Fed Pivot in 2023, Wall Street Journal, Jan. 2, 2023, https://www.wsj.com/articles/big-banks-predict-recession-fed-pivot-in-2023-11672618563.
[ii] See Pitchbook et al., Pitchbook | NVCA Venture Monitor Q4 2022, Pitchbook, pg. 5, https://pitchbook.com/news/reports/q4-2022-pitchbook-nvca-venture-monitor.
[iii] Cynthia Clarfield Hess & Mark Leahy, Silicon Valley Venture Capital Survey Fourth Quarter 2022, Fenwick & West, Feb. 15, 2023, pg. 6, https://www.fenwick.com/insights/publications/silicon-valley-venture-capital-survey-fourth-quarter-2022. “From the beginning to the end of 2022, the average percentage change between the price per share at which companies raised funds in a quarter and the price per share at which the companies raised funds in their prior round of financing dropped 87%, with Series B rounds being most affected.”
[iv] It seems that in the current environment, early-stage companies are actually seeing an advantage as in Q4 58% of the VC financing was for early-stage companies. See Hess at 12. And deal value went up YoY for early-stage companies due to a robust pre-seed market, expansion of seed-stage investor participation, and the prolonged time between startup funding and seed rounds giving rise to more mature startups. That said, the amount of the deals did decrease. See Pitchbook at 8.
[v] Pitchbook at 39.
[vi] Id. at 33.
[vii] Id. at 5.
[viii]Id. at 33.
[ix] Flat rounds and down rounds were up 23% from Q4 of 2021 to Q4 of 2022. See Hess at 5. Later stage companies are most affected. Id. at 4.
[x] Deals across all stages of companies are becoming more investor friendly. See Pitchbook at 6.
[xi] Sifted, What Founder Need to Know About Term Sheets in a Downturn, Sept. 9, 2022, https://sifted.eu/articles/founders-vc-term-sheets-downturn-brnd.
[xii] From Q3 of 2022 to Q4 of 2022, senior liquidation preference has risen 25% percent, meaning that the investors in later rounds are asking to liquidation preference ahead of former investors. And the percentage of financings with a senior liquidation preference that included a multiple greater than one rose 11 percent. However, they still haven’t gone pass 2x. See Hess at 14-15.
[xiii] De Vries et al., Venture Capital Deal Terms: A Guide to Negotiating and Structuring Venture Capital Transactions, HMS Media Vof, pg. 89.
[xiv] When anti-dilution protection is triggered, the protected investors obtain the right to receive additional shares. This right may be exercised either by adjusting the conversion ratio of the preferred shares into common shares, or by directly issuing additional shares to the investors. One of the advantages of the first mechanism is that the investors do not have to pay for their additional shares. But, they will have to ensure that they can vote in the shareholders’ meeting as if they had converted their preferred shares into common shares. Id. at 73.
[xv] De Vries at 75.
[xvi] Hess at 18.
[xvii] De Vries at 77.
[xviii]Id. at 78.
[xix] Dividends can drive additional dilution if it is paid out in stock. This can be especially material in downside cases. Id. at 92. Make sure that any dividends need approval of a majority – if not supermajority – of the board of directors. Investors may also increase their preferred repayment amount via accrued and unpaid dividends or by applying multiple pay-put instruments. Id. at 90. By increasing the liquidation preference with the amount of accrued and unpaid cumulative dividends, investors can increase their ROI once a liquidation event occurs.
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