The Case For A Down Round Financing
A “down-round” occurs when a company raises new capital according to a valuation lower than that had been used in the previous financing. While this might be seen as a last resort, it becomes less unusual and actually useful in a turbulent economic landscape like the current one. In fact, when a “down-round” is justified by factors that are outside of a company’s control, such as the current concurrence of a pandemic-induced crisis and inflation shocks, it should not affect the reputation of the company. On the other hand, as long as the fundamentals of the company are positive, it is a great opportunity for a clean restart when the economy bounces back.
One of the items to carefully review before conducting a “down-round” is whether the subscription agreements of the investors who participated in the previous rounds contain “anti-dilution” provisions triggered in the event of the company raising capital at a lower valuation. These clauses imply that other parties (founders and often employees) would be diluted, thus causing a shift of control and a reduction of the economic incentives. In these cases, it is advisable to try renegotiating some of the terms with the investors. Surprisingly, many of them might be willing to give up some of their protections to ensure a rosy future to the project they are invested in.
If a company wants to avoid a “down-round” financing, a popular alternative is seeking a “bridge-financing” solution. The most common option in similar situations is to use convertible notes, which are short-term loans that might convert into equity if a specified event occurs (typically future financing round at a pre-established valuation).
The decision to conduct “down-round” financing needs to be properly justified and documented by the directors. Clearly, some disgruntled existing shareholders might look into starting a derivative lawsuit against them alleging a breach of fiduciary duties. To reduce these risks, directors should consider that all the alternative options have been evaluated and that the “down-round” financing has been approved by a board resolution as a last resort.
At Cea Legal, we assist directors, new investors, and current shareholders, helping each of these categories evaluate all the solutions available based on the specific contingencies. Often, our flexibility and deal-making attitude allow us to be in a unique position to propose a solution that satisfies all the parties.
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