Globally, we saw record levels of investment in 2021. In 2021, emerging companies, particularly in the technology sector, enjoyed increased valuations driven by greater competition among investors and greater access to capital.
Although record-breaking investments continued into the first quarter of 2022, it was clear this trend was beginning to slow as venture capital funds and investors altered their investment strategies in anticipation of changes in market conditions. Higher interest rates and a tightening of the credit markets, among other reasons, have driven these changes in market conditions.
In light of the changes, emerging companies may find raising capital difficult due to a reduction in the availability of both equity and debt financing. Securing financing may also take longer than expected, so emerging companies must consider scaling back spending to reduce their “burn rate.”
With a softening in valuations, startups and emerging companies may also need to consider raising funds at the same valuation, known as a “flat round,” or a lower valuation than their previous round, known as “down round” financing.
What Is a "Down Round"?
Down rounds are often the result of numerous factors, which include the slowing of economic trends as we are currently seeing, the need for a company to reset or pivot, the emergence of a new competitor in the market, or simply a shift in the market.
For founders of start-ups, down rounds can be a matter of survival whereby an immediate need for funding outweighs the possible negative connotations that a down round carries for the company. Down rounds are often seen as a last resort for growth companies. For venture capital investors, down rounds can reflect lower confidence in the company and a riskier investment.
Key Terms in a Down Round
While down rounds can also be an opportunity for companies to reset and refocus, it is important to understand that the contractual terms of the financing will also likely shift, giving investors additional leverage to negotiate more favorable and protective terms. As such, founders and emerging companies must understand the types of deal protection measures that investors will likely be requesting. Negotiating unfavorable terms may not only negatively impact existing investors, but may also limit the company’s ability to secure future financings.
Below is a summary of key issues startups and emerging companies should be aware of in down-round financings. For a more thorough analysis of these implications, it is important to consult your legal advisor.
Generally, preferred shares have priority over common shares upon the liquidation, dissolution, or winding up of a company (each of these events is referred to as a “Deemed Liquidation Event”). Before any distribution or payment can be made by the corporation to the holders of common shares or any other junior preferred shares, the holders of the class (or series) of preferred shares are entitled to be paid first.
In the event of a Deemed Liquidation Event, holders of preferred shares will receive the liquidation preference for each preferred share along with the payment of any accrued and unpaid dividends before any amounts are paid to the common shareholders, who are typically the founders. The liquidation preference of each preferred share is typically the original purchase price the investor has paid for each preferred share. In riskier rounds, such as a down round, the liquidation preference may be set as a multiple of the original purchase price. In addition to the liquidation preference, preferred shareholders may be entitled to an additional payment depending on if their preferred shares are participating or non-participating:
- Non-participating – Once the liquidation preference is paid, the investor would not be entitled to any additional payments from the company. As such, any remaining assets of the company would then be distributed among the common shareholders and any junior preferred shareholders based on liquidation priority. Non-participating is the approach seen in the bulk of financings.
- Participating – In addition to the liquidation preference, the investor also has the right to share in any remaining proceeds of the company with the common shareholders pro rata on an as-converted basis.
Participating is also referred to as the “double-dip” preference and could be considered a windfall gain depending on how the company is liquidated. Founders should be cautious when negotiating terms surrounding liquidation preference as the consideration they receive is typically sweat equity, and they may receive salaries at below market.
In the event that the investor has negotiated a liquidation preference in which it would receive a multiple of the original purchase price, the investor may walk away with more than they have invested, whereas the founders, and other common shareholders, may end up with little or no payments. The risk is further compounded where the preferred shares are also participating because the investor would be entitled to share in any remaining proceeds of the company with the common shareholders pro rata on an as-converted basis. Emerging companies should look to limit an investor’s liquidation preference where possible. To balance the investor’s desire to protect its investment with the emerging company’s desire for a fair distribution of assets in the event of a Deemed Liquidation Event, the parties may also consider including a cap on the total amount the investor can receive in the event of a Deemed Liquidation Event. This may be a compromise that meets both parties’ interests.