Think of “up” rounds and “down” rounds as the equivalent of “bull” markets and “bear” markets. When the economy is thriving (i.e., bull markets), companies tend to have more “up” rounds, but when it’s floundering (i.e., bear markets) you’ll see more “down” rounds.
A “down” round is a financing round at a lower post-money valuation than the company’s previous financing round. As market sentiment shifts, so does the balance of power between founders and venture capitalists. In bear markets, you can expect to see more “down” rounds and more economic terms intended to protect investors and offer them better downside protection, or at least terms that ensure some minimum rate of return.
5 Key Terms:
1. Anti-Dilution Protection: In a down round, anti-dilution protection will be triggered, which entitles the existing investors to an adjustment on their conversion price to offset some of the dilution they will experience because of the “down” round. However, anti-dilution protection can be waived in connection with a “down” round. Investors want to make money off their investments and while anti-dilution protection provides them with some additional upside, it doesn’t give them the outsized returns that their venture funds are looking for. They would much rather the company focus on becoming an ultra-successful unicorn than exercise their anti-dilution rights. After all, the investors’ shares won’t be worth anything if the company fails or has a lackluster exit. As a founder, the more transparent you are with your investors, the more likely they are to trust you and your company and waive their anti-dilution rights.
2. Liquidation Preference: As investors prepare for a bear market, they may try to negotiate higher multiples (i.e., 1.5x or 2x), participating liquidation preferences, or a liquidation “stack” to ensure some minimum rate of return. The overwhelming standard for liquidation preference is “1x, non-participating, pari passu” and as a founder, you need to understand how agreeing to these different liquidation preferences can affect your ultimate payout when you go public or are acquired. Higher multiples and liquidation “stacks” become more common in later stage companies, but if you are an early stage company navigating a “down” round, you should avoid these, if possible. Remember any term you offer to one set of investors, you will need to be prepared to offer to subsequent investors and the more upside investors capture by way of their liquidation preferences, the less there is to distribute to the company’s founders and employees. As best you can, try to keep all investors “pari passu” with one another.
3. Warrant Coverage: entitles investors to a preset number of warrants in exchange for their investment in the company. An example would be an investment amount of $7 million with 7% warrant coverage. The company would then issue the investor a warrant for $490,000 worth of shares. The warrant is typically tied to a set price per share such that if the price per share at a subsequent financing round is higher, the investor receives a discount on any purchased shares. If the company doesn’t raise at a higher price per share, the investor never has to exercise the warrants. Warrants can be a useful negotiating tool for founders, but just because they are not immediately dilutive does not mean you shouldn’t account for them when predicting future rounds of financing. You should also ensure that they have a reasonable expiry date such as 5-7 years and that they terminate in the event of a liquidity event.
4. Recapitalization (“recap”): can mean several things, but in the case of venture capital it often means that the old voting, equity, and capital structures are dissolved and replaced with a new structure. The new structure can be made of mostly debt, or reduce the number of shares that the company has outstanding. Recaps are a last resort and used: (i) when the company’s share price experiences a huge decline and a recap is necessary to stabilize the share price, (ii) to avoid bankruptcy, or (iii) to restructure the voting power of the company (i.e., give certain investors less / more control). If negotiating a recap, think about how it will affect control of your company. It may be the case that after the recap one investor holds the majority of the preferred stock so they will have a block right on all protective provisions (i.e., you can’t do certain things without their approval). If taking on additional debt as part of the recap, the lenders will likely want certain covenants in the documents or ask for a board seat.
5. “Pay-to-Play” Provision: requires the existing investors to purchase their pro rata portion of additional shares in connection with the financing round. If the investors do not “pay” into the next financing round then their equity is converted to common stock or they lose some rights (i.e., liquidation preferences, anti-dilution protection, or voting rights). If you get resistance on a pay-to-play provision, remember that the reasoning is that investors who do not support the company during a “down” round shouldn’t be entitled to the extra protections/ rights given to other investors. You may consider carving out angel investors or strategics that may not have the means to contribute additional capital or reducing the amount they must contribute.
“Down” rounds happen and aren’t all bad. The important thing is that you understand how to negotiate common “down” round terms so that you put your company in the best position to have a successful exit in the future.