01 Mar Tumble in Start-up Valuations May Lead to More Down Rounds
The last couple of years have been pretty good for entrepreneurs seeking venture capital. Valuations have been going up, and financing terms have been loosening up. Something like 150 so-called “Unicorns” – VC-backed private companies valued at $1 billion and up – have débuted. Alas over the last couple of months a handful of those Unicorns have seen their valuations plummet well below $1 billion. Conventional wisdom tells us the age of the Donkey is nigh.
The good news, for entrepreneurs in markets outside of the major venture capital centers (as for example Wisconsin), is that having not ridden the up cycle, in terms of valuation and financing terms, to the heights achieved by their Silicon Valley peers, the ride back down will probably not be as extreme either. If all you’ve climbed is a foothill, you can’t tumble down the mountain.
Still, the “down round,” a new round of financing priced lower than the last round, may crop up with more regularity than it has in the past couple of years. Entrepreneurs and investors should probably be prepared. Herewith a primer on the ins and (mostly) outs of down rounds.
The Down Round Problem and Players
In a down round, the earlier investors, and the holders of common equity and options to purchase common equity (including the founders) experience substantial dilution of their ownership stakes (as well as even greater paper losses in terms of the value of their holdings). How much depends on (i) just how “down” the new round valuation is from the previous valuation; (ii) the de jure rights of the various classes of stock outstanding when the down round takes place; and (iii) the negotiating positions and skills of the various folks who will be impacted by the final outcome of the drama.
The “top dog” in a down round drama is the new investor bringing in the new capital at the new, lower price. We’ll keep it simple and call her the “New Money.” Going into the negotiation, the New Money doesn’t have any de jure rights, but has something very powerful in her bag of tricks: The Golden Rule (business edition). Without the New Money, there is no deal and, presumably, no company.
The next key players are the prior investors – the folks who paid more for their shares than the New Money will be paying for hers. We’ll call them the “Old Money,” and they have the strongest de jure hand, commonly in the form of: (i) the power to veto any new investment on terms that are superior to the terms of their own investment; and (ii) some sort of “price protection” that would, when the New Money comes in, effectively re-price the financing(s) that the Old Money invested in to something between (usually) or even all the way down to (rarely) the price paid by the New Money. The Old Money looks well armed, but looks can be deceiving.
Next in the cast of characters are current and future employees that the New Money considers critical to the future performance of the business. We’ll call them the “Blessed.” They come to the drama with no real de jure leverage, but the critical role foreseen for them by the New Money gives them some serious de facto leverage.
Finally we come to those common shareholders who in the eyes of the New Money have no important role at the company after the closing of the down round. We’ll tag them the “Forsaken” and, as a matter of first impression, they have the look of presumptive road kill. None of the other players care about their fate, and they do not come to the drama with much obvious leverage. In point of fact, though, the Forsaken hold one trump card that, skillfully played, can return some value.
The Down Round Drama: Setting up a Case Study
Ok, let’s consider a down round scenario and see how it plays out (or doesn’t) if everyone “gets what they bargained for” in the transactions leading up to the down round.
Let’s start with some assumptions about the key players. We’ll assume that the New Money is the only potential new investor, and that absent her investment the company is likely going to crater and not be able to pay its debts. Let’s also assume that the Blessed and the Forsaken represent two groups of employees, each of which includes a co-founder. The New Money is not really sure how to allocate blame for the company’s problems between the two groups, but has concluded that going forward the Blessed are the group they want to run the company. Finally, while the Old Money is pretty much tapped out, it does have $100,000 currently earmarked for another portfolio company that it could reallocate to the company – at some risk to the other portfolio company’s prospects.
As for the financial situation, the Old Money previously bought one-half of the company for $4 million at a pre-money valuation of $4 million. To make the math simple we’ll assume they paid $1.00 per share for 4 million shares of Series A preferred stock. The terms of the Series A include “ratchet” price protection (so it will in effect be re-priced to the New Money price in a down round) and a protective provision giving it the right to block any new financing round on better terms than the Series A. We’ll also assume that the Forsaken and the Blessed each own 2 million fully vested shares of common stock.
At this point the New Money arrives at the table and offers $1 million of new capital in the form of Series B preferred stock at a pre-money valuation of $1 million. They are firm that the pre-money valuation is $1.0. The point here is not that price can’t be negotiated, but rather that whatever bottom line price the New Money settles on is inviolate. The pre-money valuation has to survive the actual transaction.
The Base Case: The Dilemma
Okay, on these facts we know that immediately before the down round closes there are 8 million shares outstanding (the Old Money has 4 million and each of the Blessed and the Forsaken have 2 million). We also know that the New Money will be getting 8 million shares (one-half ownership post closing) for it’s $1 million. That makes the price $0.125 per share. Post-closing, the New Money owns one-half of the company, the Old Money owns one-quarter of the company, and each of the Blessed and the Forsaken own one-eighth of the company.
Except, we forgot to factor in the Series A’s ratchet price protection. That’s because I assumed that the Old Money waived the price protection. Why? Because if it wasn’t waived, and the New Money came in at $0.125, the Series A would be effectively re-priced to $0.125. Which means 4 million shares of Series A would now be convertible into 32 million shares of common stock ($1.00/$0.125*4,000,000), and the post-closing ownership would be as follows: Old Money 32 million shares; New Money 8 million shares; and Forsaken and Blessed 2 million shares each. The New Money would thus own less than 18% of the company, which is to say it would effectively have paid more than four times the pre-money valuation the New Money was willing to pay. That violates the New Money’s requirement that it’s $1 million come in at a pre-money valuation of no more than $1.0 million.
A couple of things to note at this point. Any move by Series A to get any benefit at all from its ratchet price protection – even a small portion – is just an argument about valuation, which is a non-starter as the New Money has said it will not do the deal at a pre-money valuation north of $1 million. Note also that to the extent the Old Money gets any of its price protection rights, they would be squeezing the Forsaken and the Blessed, too. In the example, with full ratchet protection, the Forsaken and the Blessed would find their 25% ownership stakes pre-closing reduced to just 4.5% each post closing.
So what have we learned so far? Well, we know that the New Money will insist on 50% ownership for a $1 million investment. We can also be pretty confident that the Blessed will not stick around and work their sweat equity tails off post-closing if their carrot is less than 5% of the upside. So in addition to persuading the Old Money to waive its price protection, if there is going to be a deal the New Money must find a way to get the Blessed a bigger piece of the pie.
Addressing The Down Round Dilemma: Who Brings What to the Stage
With the above in mind, let’s play out the drama, starting with a review of what each player wants, and what leverage it has to get it.
The New Money. First and foremost the New Money has to own one-half of Newco post-closing. The New Money’s next priority is an adequate ownership upside for the Blessed, as the New Money considers them crucial to the company’s future success. The New Money has one more concern: minimize the risk of litigation by
the Forsaken (we’ll get to that possibility in due time). The New Money has one principal point of deal leverage: the capital the company needs to survive and fight on. That’s a lot of leverage.
The Old Money. The Old Money’s principal objective is minimizing its dilution. It comes to the table with at least one weapon: It can veto the deal. Typically, and in this case, it also has a price protection right. It may or may not have another weapon; capital that it could invest alongside the New Money, which would in effect buy it some anti-dilution protection by averaging down its price per share. In any event, the conundrum for the Old Money is that however bad the dilution proposed by the New Money might be, it’s investment will still be worth something after the down round closes. Which is better than the nothing its stake would be worth if the company cratered. The Old Money’s hand looks, perhaps, stronger than it really is.
The Blessed. The Blessed want a big enough piece of the company’s upside to make it worth their while to invest their time and energy in the deal. If they don’t get it, they will walk, just as the New Money will walk if they don’t get their bottom-line valuation. The Blessed have, perhaps, more leverage than you might think.
The Forsaken. Like the Old Money, the Forsaken want to minimize their dilution. Unfortunately, they have very little leverage. But they do have some. Most courts hold that directors, and in some cases controlling investors/shareholders, owe a fiduciary duty to act in the best interests of all of a company’s shareholders – including in this case the Forsaken. If the Old Money and the New Money solve all of their problems at the expense of the Forsaken, they could find themselves on the wrong side of a breach of fiduciary duties litigation. Predicting how a suit like that will turn out, or how much it will cost, is tricky. The uncertainty itself, though, is something the Old Money and the New Money want to minimize. The Forsaken, if they play their hand well, are not necessarily road kill in this drama.
The Down Round Dilemma: Alternative Scripts
The drama of the down round as set up by the above facts could play out any number of ways. In a fair number of these cases, the endpoint is no deal at all. We’ll assume a deal gets done, and consider several different ways that might happen.
Going into the negotiations we know one thing for sure: the pre-money valuation of the company is $1 million. We also know that the Blessed have to be taken care of, though we don’t know what that means with any precision. For our purposes, we will assume though that just as the New Money will not do the deal at a pre-money above $1 million, the Blessed will not do the deal unless they end up with 20% of the post-closing fully diluted equity.
The Base Case: The Old Money Sits the Round Out and Waives all Price Protection Rights. In this case, the Old Money just doesn’t have any dry powder available for the deal, and so sits on the sidelines. It also concludes that anything it is left with is better than nothing, and so completely waives its price protection rights. On these facts we know that post-closing the New Money will own 50% of the company, and the Blessed will own 20%. Which leaves 30% to be divided between the Old Money and the Forsaken.
That 30% could be divided a variety of ways, but in this setting – the Old Money staying on the sidelines and completely waiving its price protection rights – the Forsaken’s litigation trump card is of limited value. The New Money doesn’t owe any fiduciary duty to the Forsaken unless it can be tied to the fiduciary obligations of the Old Money, and since the Old Money is not getting any special benefit from the transaction (i.e. it is not getting any of the new, lower-priced shares, and is waiving all of its price protection rights) its pretty hard to see how there could be any conspiracy involving the New Money and the Old Money at the expense of the Forsaken. Chances are the Forsaken are going to be road kill in this scenario. Here’s how the deal probably goes down:
Price per share: $0.10*
Post Pre Change
New Money: 10,000,000 Shares 50% 0% +50%
Blessed: 4,000,000 Shares 20% 25% -05%
Old Money: 4,000,000 Shares 20% 50% -30%
Forsaken: 2,000,000 Shares 10% 25% -15%
* To keep the valuation at $1 million pre-money while also adding enough new shares to get the Blessed to 20% ownership post-closing we had to reduce the price per share from $0.125 to $0.10.
On the Base Case facts, this is the only realistic outcome. You can’t take shares from the Forsaken or the Old Money, and we assumed the New Money paid $1 million pre-money and the Blessed needed more shares to get to 20% ownership post-closing. Fiddling with the price per share is the only way to accommodate all of those outcomes. The key players in the drama on these facts are the Old Money and the Blessed. If the Old Money insists on ending up with a larger post-closing stake, the only way to get there is to raise the per share price and the only way to do that (without changing the $1 million pre-money valuation) is to reduce the post-closing stake of the Blessed.
Case Two: The Base Case Except the Old Money Insists on Partial Price Protection. In this case we will keep the above facts, except that the Old Money wants some of the benefit of its price protection rights. Specifically, the Old Money insists that its post-closing stake is 35%, or 15% more than it ended up with in Case One, though still 15% less than before the transaction. How does this deal come down?
It’s a trick question. This deal can’t happen. The math doesn’t add up. If the New Money gets 50% for $1 million, and the Blessed get 20%, there is only 30% left for the Old Money and the Forsaken to share. If you do give all 30% to the Old Money there would be nothing left for the Forsaken. And to do that you have to drive the price per share down to very close to $0.00.
Case two highlights the limited utility of price protection rights as a way to meaningfully insulate the Old Money from serious dilution in a significant down round. In this case, to get even one-third of the benefit of its price protection (i.e. to end up at close to 30% post-close ownership instead of 20%) it would have to approve a transaction that would leave the Forsaken with almost nothing. In that event, even if the Old Money thought in good faith that the Forsaken in fact didn’t deserve anything, there would likely be a significant risk that a jury would see it differently. Particularly as the litigation will likely only happen if the company succeeds and the Old Money ends up with a handsome return.
Case Three: The Base Case Except the Old Money Insists on Sufficient Price Protection so that the Old Money Has 25% (Instead of 20%) Post-Closing. We know from Case two that the Old Money’s price protection is of limited value: granting it enough of its price protection to save it from even one-half the dilution it would otherwise suffer is mathematically impossible within the other constraints of the deal. But let’s say the Old Money has a more modest goal; that it wants get enough of the benefit of its price protection to end up at 25% ownership post close, just 5% more than if it completely waived all price protection.
Price per share: $0.05*
Post Pre Change
New Money: 20,000,000 Shares 50% 0% +50%
Blessed: 8,000,000 Shares 20% 25% -05%
Old Money: 10,000,000 Shares 25% 50% -25%
Forsaken: 2,000,000 Shares 05% 25% -20%
* To keep the valuation at $1 million pre-money while also adding enough new shares to get the Blessed to 20% ownership post-closing and get the Old Money to 25% we had to reduce the price per share from $0.10 to $0.05.
This case further illustrates the great impact that giving the Old Money even a small portion of the benefit of its price protection rights will have on the end result. That extra 5% for the Old Money knocked the price 50%, to $.05. Note that the Old Money’s new 5% came entirely at the expense of the Forsaken, knocking them from 10% to 5% post-closing. Given the reduction in per share price, the value of their holdings went down 75% between the Base Case and this case.
From the perspective of the Forsaken, this looks like a situation where the Old Money and the New Money made a deal at the expense of the Forsaken. On our facts – we noted that the record was at least ambiguous as to who (the Forsaken or the Blessed), if anyone, was more responsible for Newco’s poor performance, this is a deal with a lot of litigation risk for both the Old Money and the New Money.
Case Four: Case Three Except the Old Money Invests $100,000 to Achieve its Objective of 25% Post-Close Ownership (and the New Money reduces it’s investment to $900.000). In this case, the Old Money looks to partially protect it’s ownership stake by investing alongside the New Money. This deal can certainly get done.
Price per share: $0.10*
Post Pre Change
New Money: 9,000,000 Shares 45% 0% +45%
Blessed: 4,000,000 Shares 20% 25% -05%
Old Money: 5,000,000 Shares 25% 50% -25%
Forsaken: 2,000,000 Shares 10% 25% -15%
* This is the Base Case except $100,000 of the capital in the round is provided by the Old Money. So price per share stays the same as the Base Case at $0.10 as does post close ownership of the Blessed and the Forsaken.
By investing $100,000 in the down round the Old Money achieved its objective of 25% post close ownership but without the massive dilution to the Forsaken of getting that position “for free” via its price protection right. Also, by investing $100,000, at a price set by a third party (the New Money), the Old Money further insulates itself (and the New Money) from claims by the Forsaken that it conspired with the New Money to reward itself at the expense of the Forsaken. In that sense, the $100,000 can be seen as an insurance policy. This deal would be easy to do.
The Down Round Drama: Closing Thoughts
This essay, including the examples, barely scratches the surface of the complications that can make down round financings so difficult, interesting and contentious. In general, though, there are a couple of important, points. First, the Old Money, while in perhaps the strongest position in a de jure sense, in fact has a very weak hand in practice, all the more so if it can’t or won’t participate in the down round. Second, while the Forsaken hold a pretty weak hand, in many scenarios they have some practical if hard to quantify leverage. Finally, the New Money, and the Blessed, lacking any de jure leverage, generally have the most practical leverage.
Within these confines, imagine how the dynamics would shift in the following scenarios:
1. Imagine if the Forsaken were clearly (or sort-of-clearly) the villains in the company’s poor performance, and thus variously unattractive plaintiffs in any lawsuit alleging breaches of fiduciary duty against the Old Money.
2. Imagine if the Old Money had enough dry powder to do the deal on its own? (In such event, might the Old Money still want to bring in a new investor to set the price?)
3. Imagine if, instead of doing a down round, the company could liquidate and return some portion of the Old Money’s capital – albeit they would have to pay some of that to some folks (which ones?) to stick around and manage the process.
4. Imagine that the New Money is fine with the Old Money investing in the down round, but only on top if its $1 million, not as part of it.
5. If you want to make the math really complex (without really changing the principles and lessons), imagine that the Old Money has the more typical weighted average formula, rather than ratchet, price protection rights.
6. Imagine that there are multiple earlier investors, some of whom paid (different) prices above and below the New Money price.
7. If you really want to let your imagination run wild, imagine that the co-founders are spouses (or ex-spouses), one part of the Forsaken and one part of the Blessed. Okay, maybe you shouldn’t go there. It would be the rare investor indeed who would walk into that trap.
In conclusion, if media speculation that the VC market is in the process of shifting from a seller’s market to a buyer’s market is correct, we will be seeing more down rounds, and not just in the rarefied world of the Unicorns. In that case, entrepreneurs and investors alike should brush up on the peculiar financial and psychological dynamics of down round financings.
Paul Jones is Of Counsel and Chair of the Venture Best group at Michael Best & Friedrich. His practice focuses on emerging technology entrepreneurs and businesses and their investors. Mr. Jones began his legal career in Silicon Valley in 1985. He moved to North Carolina in 1990 to co-found the second venture capital backed spin out from the Medical Center at Duke University, and over the following dozen years was a serial venture backed entrepreneur, angel investor and finally co-managing partner of a $26 million early stage venture capital fund. He returned to Wisconsin in 2003, where he continues to consult with and occasionally invest in Wisconsin technology driven start-ups. This post was originally published on in the Business Blog OnRamp.
The opinions expressed herein or statements made in the above column are solely those of the author, and do not necessarily reflect the views of WTN Media LLC. WTN accepts no legal liability or responsibility for any claims made or opinions expressed herein.