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Down Rounds: What Emerging Companies Should Consider When Raising In A Slowing Economy – Shareholders


Introduction

Canada saw record levels of investment in 2021. The Canadian
Venture Capital & Private Equity Association (CVCA) 2021 Market Overview reported 752 deals
totaling $14.7 billion in venture capital investments in emerging
Canadian companies that year – more than double what was seen
in 2019. 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 in market conditions, emerging companies
may find raising capital to be 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 favourable and
protective terms. As such, founders and emerging companies must
understand the types of deal protection measures that investors
will likely be requesting. Negotiating unfavourable 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.

Liquidation preferences

Preferred shares generally have priority over common shares upon
the liquidation, dissolution or winding up of a company (a
Liquidation“). 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 Liquidation, 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 where 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 Liquidation, the parties may also consider including
a cap on the total amount the investor can receive in the event of
a Liquidation. This may be a compromise that meets both
parties’ interests.

Anti-dilution protection

Investors in venture capital financings are typically issued
preferred shares that are, at the option of the investor,
convertible into common shares based on a predetermined formula. If
certain events occur, such as a down round or a dilutive share
issuance, the conversion ratio or price may be adjusted so that the
number of common shares the investor will receive on the conversion
of preferred shares would increase. There are two main types of
calculation for this down-round protection: full-ratchet adjustment
and weighted-average adjustment.

  • Full-ratchet A full-ratchet
    anti-dilution provision leads to the greatest amount of adjustment
    and is not typically seen in venture capital financings. For a full
    ratchet, the conversion price of the preferred shares will be set
    at the lowest price for the company issued common shares (or shares
    convertible into common shares) following the investment no matter
    how many shares are sold at the lower price. For example, if the
    price per share in a future round goes down by 50%, then the
    conversion price at which the investor could convert all their
    preferred shares into common shares would be reduced by 50%. Full
    ratchet anti-dilution provisions are seen as punitive as they can
    be triggered by an insignificant issuance of shares.

  • Weighted-average
    Weight-average adjustments may be calculated on a broad or narrow
    basis: Weighted-average anti-dilution provisions take into
    consideration the number of common shares (or shares convertible to
    common shares) that are subsequently issued at a lower price.
    Weight average adjustments lead to significantly smaller
    adjustments as they take into account the size and price of the
    down round in relation to the capitalization of the company
    immediately before the down round. Broad-based weighted-average
    adjustments are more commonly seen in venture capital
    financings.

Anti-dilution provisions can lead to unintended consequences and
can be triggered by certain issuances that are unrelated to the
economic condition of the company. Fortunately, certain types of
issuances, such as shares issued upon the conversion of options
issued under a stock option plan, are typically excluded from
anti-dilution protections. However, emerging companies should
carefully review what types of issuances are excluded to ensure
that there are no unexpected consequences.

When considering conducting a financing at a lower valuation,
emerging companies must consider the anti-dilution protection of
existing investors to understand how these will impact the
company’s capitalization table. Companies can look to
renegotiate anti-dilution provisions and other key terms with
investors before conducting the financing so as to limit this
dilution.

Cumulative dividends

Investors may also have a right to a distribution of the
company’s earnings by way of a dividend. Dividends may be
either cumulative or non-cumulative. In most instances, dividends
will be non-cumulative, i.e. paid only as declared by the
company’s board of directors. That said, in instances where the
investor may deem the investment to be risky, the investor may
insist on cumulative dividends. In contrast to non-cumulative
dividends, cumulative dividends will accrue at a specified rate,
regardless of whether or not the company actually declares
dividends on those shares and generally carry a right to receive
those accrued dividends in priority over any other shares ranked
junior to such preferred shares. Emerging companies must carefully
consider the impact of any cumulative dividends on future cash
flows of the company along with their impact on distributions in
the event of a Liquidation of the company.

Tranche financing

Where there are concerns about the company’s performance,
investors may agree to advance funds only when certain milestones
are met. For example, investors may agree to advance a certain
portion of their investment only after the successful
accomplishment of a milestone, such as securing a key client. Where
there are concerns about the future success of the emerging
company, an investor may look to tranche financing to limit their
exposure. Although this may seem like a balanced option, emerging
companies must carefully consider the attainability of any
milestones they set. Milestones should be specific and attainable.
If the company fails to meet a milestone, then it will be in a weak
bargaining position with the investor should it require any
additional investment before meeting any specific milestone.

Conclusion

With rising interest rates and the possibility of a looming
recession, emerging companies may need to make tough decisions when
raising capital. Emerging companies must take steps to limit their
cash burn to what is necessary to maximize their runway. Ensuring
that emerging companies also understand the terms of any financing
documents they agree to will help protect the interests of all
stakeholders going forward. Before conducting a down round
financing, companies should consider if there are any alternatives
available, such as convertible debt or bridge financing. Venture
debt may also be an option that could provide a much-needed
injection of cash that could allow the company to meet its
short-term objectives.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.



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