Many companies and venture capital (VC) investors are encountering down rounds for the first time in a decade or longer. Given the long heritage of VC financing structures, we can look to previous downturns to identify investment terms and tools that are once again relevant. This insight provides a general summary of some techniques VCs and venture-backed companies can use to recalibrate risk, including the anatomy of a down round.

Bridge financings

Simple Agreements for Future Equity (SAFEs) have become a common tool for providing bridge financings, and are particularly appropriate when companies and investors are confident an equity financing will materialize. Distressed company bridge financings are different, in that they provide some protection if the company fails, and the “bridge” turns into a “pier”:

• Distressed bridge financings are generally structured as straight debt (i.e., non-convertible debt), a combination of debt and warrants, or convertible debt. Using debt provides downside protection in case the company fails or there is a “fire sale,” because the bridging investor will be repaid before the equity holders participate in the proceeds of the liquidation or sale. This type of financing can give companies additional runway.
• Straight debt can be the best tool to finance a company that has an immediate need for capital to meet its obligations (e.g., making payroll), because it is fast and simple. It also may be the only tool that is available if the company requires shareholder consent to complete a financing with an equity component, and the company anticipates delays or will be unable to obtain the necessary consent.
• Secured bridge debt provides additional protection for the investor, even though putting security in place is likely to take additional time, and may require the consent of the company’s existing lenders. In a situation where existing lenders have security in place, the bridging investor may be required to subordinate its security interest, particularly if the existing lenders are banks or other financial institutions. Depending on the circumstances, however, existing lenders that are not institutions may be asked to subordinate their own interests to the bridge lender. If the company has not granted security to existing lenders, there may be an opportunity to establish priority over certain valuable assets of the company. Desirable assets that investors may wish to take security over include tax refunds, refundable credits or other government financial assistance that will be payable to the company in the near future.
• A new debt facility, including bridge debt, will also give lenders the opportunity to add additional approval rights or controls that relate to any particular business and liquidity concerns.
• In addition to interest, bridge lenders may also consider including warrant coverage as part of the bridge financing terms. Warrants allows lenders to acquire equity on exercise, augmenting the rate of return over and above the interest rate accruing on the debt.

Equity financings

For a convertible preferred financing, an array of terms exist to provide downside protection to investors, which can be introduced either on an à-la-carte basis or as a full menu for very high-risk situations:

• Tranched / Milestone-based rounds: Financing can be provided in tranches conditional on the company achieving pre-determined product development or business milestones. If milestones are not achieved, the funding is not advanced (unless otherwise agreed by the investors) and/or a valuation adjustment might apply to funds already invested.
• Liquidation preferences: In recent years, sequential rounds of preferred shares often rank pari passu on liquidation (i.e., all investors holding preferred shares, regardless of which series they participated in, rank equally when it comes to liquidation proceeds). In lean times, a “last in, first out” ethos usually prevails, such that the last money takes priority in the waterfall before earlier series of preferred holders receive their proceeds. Also in recent years, participating preferred shares have been less common but we may see some return to this structure, plus liquidation multiples (see the next point).
• Liquidation multiples: During the financial crisis and early 2000s, it was common to see liquidation preferences of 1.5X, 2X and even greater (mainly for later rounds), as well as “participating preferred,” i.e., preferred holders receive their liquidation preference and participate with common shareholders in the distribution of remaining proceeds.
• Accruing dividends: An accruing dividend of 6% to 8% can be in addition to, or as an alternative to, a liquidation multiple. In recent years, where accrued dividends are negotiated, they often disappear on conversion of preferred to common. In difficult times, accruing dividends may also convert to common, or may be required to be paid out in cash on conversion.
• Redemption: Preferred shares may be redeemable after a fixed amount of time, with five to seven years historically being the most common period. The redemption price may also be set as the greater of the liquidation amount (including any accrued dividends), or fair market value. Use of redemption rights can have adverse tax and accounting consequences, and if investors want to avoid those consequences, pressure to obtain liquidity can be achieved by investor rights to control the company’s board and/or mandate the sale of the company after a certain period of time.
• Full ratchet price protection and “SAFE-like” price adjustments: In recent years, broad-based weighted average price protection has become the norm. Given the ongoing correction of tech company valuations, we expect to see movement to return to full ratchet price protection. Full ratchet price protection automatically adjusts the conversion price of the preferred shares to the lowest price at which the company raises financing, and can be a powerful protection if the company pursues a future down round, where shares are issued below the prior round per share price. In addition, we are starting to see convertible preferred deals with SAFE-like price adjustments (i.e., the lesser of a valuation cap or discount) used in situations where the investor wants issued shares but with price / valuation floating until fixed by a future financing or commercial milestone.
• Tougher / enhanced veto rights: Investor veto rights should be tightened up to ensure that downside protections that are established are not easily unwound in future financing rounds.
• Pay-to-play penalties: If investors want co-investors to be committed to continuing to support the company through future rounds of financing, they might consider imposing penalties over and above the dilutive impact of not participating, if co-investors fail to take up their pro rata share in the next round. Penalties may include automatic conversion of their preferred shares into common shares (either on a one-for-one basis or at a punitive ratio), or the loss of board seats or other investor rights.
• Voting drags: Investors may wish to incorporate voting drags that go beyond the usual requirement that all shareholders must support the sale of a company (or other exit) if approved by the holders of a minimum specified percentage of the issued and outstanding shares. With a broader voting drag, all shareholders can also be required to vote in favour of other fundamental changes if supported by the investors (or some other specified shareholder group). This can be a powerful tool where, for example, a company is required to embark on a down round to attract fresh capital.

Of course, there is no substitute for setting an appropriate valuation for new financing rounds, to reflect the adjusted risk profile for the company.

Anatomy of a down round

A down round is generically described as any round where the pre-money valuation is less than the post-money valuation of the preceding round. However, when it comes to terms and implementation, one down round can look quite different from another. Before embarking on a down round, it is critical to consider and understand the following:

• Are existing investors entitled to a price protection (anti-dilution) adjustment? Most convertible preferred shares terms include price protection clauses that increase the conversion ratio of existing convertible preferred if new securities are issued at a lower price per share than the original purchase price of the convertible preferred shares.
• Do existing investors that make up a “Preferred Majority” plan to participate in or otherwise support the down round financing, so that necessary investor consents can be obtained?
• For a company incorporated in Canada, are class or series voting rights and dissent rights under the corporate statute intact such that they will come into play?

Down rounds can fall along a range:

• A down round in which existing investors do not have the benefit of price protection, or are willing to waive a price protection adjustment, can look much like an up round from the standpoint of legal terms and implementation.
• A down round in which existing investors will receive price protection on a weighted average basis can result in a negotiation as to the number of shares that should be included in the company’s pre-money capitalization (i.e., should the increased number of common shares issuable on the conversion of prior-round shares as a result of the price protection adjustment be excluded or included). Sometimes the additional dilution from the price protection adjustment will be trivial so this is a non-issue, but a large down round at a materially reduced valuation will be more difficult to address.
• A down round in which existing investors are entitled to price protection on a full-ratchet basis is more complex. Full ratchets create a more pressing circularity problem in determining an appropriate pre-money capitalization number, which ideally should be addressed to the satisfaction of both existing and new investors.
• A down round may include a “cram,” where existing investors who fail to invest their pro rata share will experience a consequence that may include: the conversion of their existing preferred shares into a more junior class of preferred shares, or into common shares, or – most punitive – into a smaller number of common shares (e.g., 1 common share for 10 convertible preferred shares). While it is quite aggressive, in some scenarios remaining common shares can be “consolidated away” to entirely remove a non-participating investor from the cap table. Failure to “pay-to-play” may result in other consequences, including the loss of pre-emptive rights, ROFRs, co-sale rights and/or registration rights.
• A pay-to-play can be implemented retroactively (vs. being “pre-agreed” by earlier round investors), if participating investors control the requisite majority of the shares. For Canadian companies, this is generally achieved by participating investors using their majority voting power to force the conversion of all existing convertible preferred shares into common shares, and then purchasing new convertible preferred shares that sit at the top of the liquidation stack. This can be most readily achieved if the participating investors (or other supportive shareholders) control a “Preferred Majority” as that term is defined in the company’s existing financing documents, plus 66 2/3% of all voting shares, plus 66 2/3% of each class or series of shares. This is a complex transaction from a corporate law standpoint, and consideration must be given to the impact of dissent rights, statutory provisions regulating “squeeze-out” transactions and the oppression remedy. In a future sale of the company, a buyer can be expected to require indemnification from selling shareholders to defend the resulting cap table.

Financing structures that erode the equity of minority shareholders are not immune to challenge. For example, a court will focus not just on how a cram or pay to play is implemented, but on the overall factual context. From a company and majority shareholder perspective, there are a number of “best practices” that will help a court to reach a favorable decision that a pay-to-play should be enforced. These include allowing all shareholders an opportunity to participate in a financing (regardless of whether they have pre-emptive rights), submitting the transaction to the approval of “independent directors,” obtaining a third-party valuation or fairness opinion, providing all shareholders with full disclosure of the transaction, and establishing that all alternatives to the financing have been thoroughly investigated.

Stock option top-ups and founder carve-outs

Down rounds can discourage founders who are already under operational and economic pressures, as their equity can get stranded at the bottom of the liquidation waterfall. If the company has a view to a potential liquidity event, it may be desirable to either top-up the stock option pool and make fresh option grants, or negotiate a special carve out for the benefit of founders where they receive a portion of the proceeds of a future sale of the company. Founders can put themselves in a better negotiating position to ask for equity top-ups if they also agree to a salary reduction to reduce cash burn.

A few additional thoughts and takeaways for VCs

If a VC has a director on the board of any of its portfolio companies, now is an appropriate time to audit the company’s director and officer insurance to ensure necessary protections are in place in the event of the company’s insolvency. It is also desirable to ensure that the companies are on top of employee withholdings and other payments that can result in personal director liability. Directors who anticipate pursuing more aggressive financing structures should be mindful of their duties as well as conflict-of-interest provisions in Canadian corporate statutes. A director owes a fiduciary duty to act in the best interests of the company and respect the reasonable expectations of the company’s stakeholders, and cannot simply consider the impact of a financing on the director represents on the board. It is often a best practice to have a representative of the investor other than the director nominee sign documents and otherwise represents the interests of the investor in connection with the financing. Directors should also be familiar with the terms of the company’s D&O insurance policy which may exclude coverage for claims by certain shareholders of the company, such as minority shareholders who are adversely affected by a down round.

Additionally, as portfolio companies pivot to adapt to a changing climate they may end up competing with other companies in the VC’s portfolio. VCs should review competitive overlap and be thoughtful about whether new conflicts require them to change their nominee directors or leave board seats vacant.

The VC investors we know prefer investing in a vibrant economic environment without driving terms that, until recently, would be seen as harsh. However, VCs are under their own pressures from limited partners. We can take comfort that these financing techniques have in the past been reliable approaches to successfully realign interests among limited partners, VCs, companies and their founders.

For more information, please contact Andrea Johnson or any member of Dentons’ Venture Technology and Emerging Growth Companies group.