What is a Down Round Financing?
Tech start-ups and VCs often work with the assumption that the price of the shares sold in a later financing round will be higher than the price of shares sold in an earlier round. But this is not always the case and sometimes, the reverse may be the case. We are seeing stricter price discipline on the part of VCs who are now asking for lesser valuations. No doubt, venture-backed start-ups now increasingly face the prospect of a down round. In this update, we share some insights around what a down round financing is and on how a down round financing will impact investors and founders.
Breaking Down a Down Round Financing
A down round financing is a type of equity financing round where a tech start-up sells its shares at a price per share that is less than the price per share for which it sold its shares, in an earlier financing. To illustrate, let’s assume you raise a Series A financing at a price of $6 per share. 18 months down the line, you are doing a Series B financing but your investors are only happy deal at say, $5 per share; that would be a down round. In other words, the pre-money valuation of your current fundraising round is lower than the post-money valuation of a previous round.
Perhaps, the most recent example of a down round is that of Buy Now Pay Later start-up Klarna. In July 2022, Klarna raised $800m at a valuation of $6.7billion, a valuation amount that represents an 85% valuation cut from the $45.6 billion valuation at its last round .
For all the negative rap associated with down round financings, a down round can, in many ways, be a lifeline for tech start-ups and can make all the difference for a start-up whose only other option would have been to close shop. However, with a down round financing, there are going to be implications and everyone eventually takes a hit.
How Will a Down Round Financing Impact Tech Investors?
Venture capital funds are valued on the basis of the value of their portfolio companies and in terms of the most recent pricing of their portfolio companies. A couple of down rounds in a VC’s portfolio, can affect a VC’s ability to raise another fund, if, for instance, that VC has a limited partnership obligation to disclose and write down the value of their existing holdings, as an accounting matter.
There could also be legal implications for VCs under Delaware’s corporate law, in a down round. Under Delaware corporate law, directors are fiduciaries meaning that directors have a duty of care and a duty of loyalty to the Company. Directors are expected to always act in the best interests of the company where they are directors and must not use their position as directors to advance their own interest. Within the context of a down round financing, these legal duties are often tested and can easily be breached. More importantly, controlling shareholders of a Delaware company have fiduciary duties to their fellow/minority shareholders. In the case of Sterling v. Mayflower Hotel Corp., 93 A.2d 107, 109-10 (Del. 1952), the court noted that “[W]hen a shareholder presumes to exercise control over a corporation, to direct its actions, that shareholder assumes a fiduciary duty of the same kind as that owed by a director. Against this background, it would be prudent for VC directors and “controlling” VC shareholders, to bear these corporate law rules in mind when deciding to vote for or against a down round and to seek legal advice when unsure about the legal effect of an intended course of action.
How Will a Down Round Financing Impact Tech Founders?
VCs are generally okay with some level of dilution created by a round of financing provided that, a new/subsequent round of financing increases the value of their investments. However, where a new round does not increase the value of an investment, as would be in a down round, there can be no commercial reason to welcome a share dilution. In practice, sophisticated VCs will make you sign up to an anti-dilution clause, which would be clearly stated in your term sheet. If your new round is a down round, the anti-dilution clause is triggered. An anti-dilution clause, can be a full ratchet anti-dilution clause, a broad-based weighted average formula or a narrow-based weighted average formula.
The big issue that founders should be concerned with in a down round financing is share dilution, because the design and effect of an anti-dilution clause is to protect your investors (holders of preferred equity) from a dilution of there shares, (which would be the effect of a down round), by issuing them additional shares in your company.
How much shares are we talking about? This depends largely on the type of anti-dilution clause you signed up to.
A typical Series A broad-based weighted average formula will look something like this:
With the weighted average price formula, you are simply trying to get to a conversion price that is a function of how the company’s capitalisation ( item A, in the formula above) is defined. If the company’s capitalization is defined more broadly, as to be fully-diluted and covering all shares that are already subject to issuance, you are signing up to a broad based weighted average formula. With a narrowed-based weighted formula, the definition of capitalization is narrower as it does not include “reserved but unissued” shares in your company, resulting in a higher conversion price and less dilution.
With a full ratchet anti-dilution clause, your investors will have the right to convert their preferred stock into a number of shares of common stock that is equal to the amount invested by investors divided by the price per share in the current down round. If, for instance, I invested $10,000 for 1000 shares in your company at $10 per share, I would be entitled to additional 2000 shares of common stock in a down round financing
It is not unusual for the shareholding of founders to be reduced significantly in a down round. More than any other round of financing, founders and their VCs, are going to need the support of an experienced venture capital counsel, to help with negotiating the economic and governance structure of a down round financing, which is often tightly skewed towards preserving the value of the new money.
You may want to read our previous article which summarises some of the options Founders can explore before considering a down round financing
We welcome inquiries around startup fundraising and venture capital investments in Africa. Please reach out to your usual Balogun Harold contact or via support@balogunharold.com
