How distressed venture-backed start-ups can navigate a down round
During difficult economic times where funding is uncertain and capital deployment slows down, start-ups have to adopt hyper-cautious cash preservation strategies (like reducing salaries and cutting back on product development or further bootstrapping their products) to keep their heads above water.
But these cost-cutting strategies can only be sustained for a short period of time, and companies will eventually have to raise capital at short notice in a less friendly environment leading to the possibility of a down round.
The expectation of founders and investors alike is that in each subsequent funding round, the price per share paid by new investors will increase as the company’s valuation soars, consequently reducing the dilutive impact of that subsequent financing on the existing shareholders. A down round is a priced-equity financing round where the price per share paid by the investors in the new financing round is lower than the price per share paid by the investors in the previous financing round.
If the investors agree that a down round is the only viable option after eliminating other alternative strategies, there will typically be a race against time to get a deal done, with emotions and tensions running high. Going into a down round with an awareness of the potential issues that can arise can help significantly reduce the risks that come with the territory.
Having had extensive experience in working on distress mandates with our clients, in this article we offer some high-level guidance to companies and investors on how to manage a down round in a distress scenario, focusing on delicate and important considerations deal sponsors need to keep in mind.
The most important thing to remember is that a distress scenario requires delicate handling and agile and decisive decision-making and consensus building. All parties involved need to move fast and collaborate on structuring a deal to save the company.”
Rights under the governing documents
The deal sponsors should ensure that their legal counsels have carefully reviewed the applicable governing documents to assess all the rights accruing to the shareholders and what consents are required to approve a new equity financing. This can be quite complex and layered as many share classes might be involved and other restrictions may exist that could block a new equity financing.
In addition, a down round will probably entail the triggering of anti-dilution mechanics allowing the relevant preferred shareholders to receive a more favourable conversion rate and resulting in more dilution to the existing shareholders, as well as the management team.
Impact on the management team - do you want to retain the old team?
A fundamental principle of running a start-up is that companies aren't expected to pay generous salaries to their employees but instead offer equity incentives to retain talent.
Although a down round is usually perceived as a sign of poor management, there are many cases where the investors will still believe in the management team despite the company running out of cash. In such situations the sponsors of a down round must be conscious of the round’s impact on the management team, and in particular the impact on the value of the employees’ shares.
If the financing has the effect of materially reducing the retention value of outstanding awards, this is going to demotivate the team. A declining share price can be a signal to employees that the company is a sinking ship, and it won't achieve a favourable exit, pushing them to leave as soon as they can.
Retaining the team in such cases might involve cash payments, equity incentives or a combination of both. In many down rounds, the sponsors agree to an adjustment of the existing share option plan to offset the effect of the down round. They may also agree to attach the vesting of share options with the completion of turnaround milestones in order to offer a layer of protection to the investors if the team is unable to execute a turnaround.
In some cases, however, the sponsors may believe that it's inevitable that they'll need to replace the existing management team with an external team who have the expertise needed to steer the business in the right direction. In this case, the company will most likely need to adopt a new employee share option plan or offer a lucrative cash payment (or both) to the rescue team.
Dynamics between the new investors and the existing shareholders
Depending on how the down round is structured, it could potentially also be dilutive to the current shareholders. New investors participating in a down round may require a waiver by the existing shareholders of their anti-dilution rights, and this will certainly be heavily negotiated. In addition, new investors may insist on a preferential anti-dilution formula (such as a full-rachet formula rather than the more common broad-based weighted average formula) or demand higher liquidation preference multiples to offset any potential dip in the valuation in the future.
Fiduciary duty considerations
Navigating a down round involves significant fiduciary duty considerations for the board and the management team. The board is obligated to act in the best interest of the company and the benefit of its shareholders by considering all available options to save the company, be appropriately engaged in the discussions regarding viable turnaround plans and carefully evaluate available alternatives to a down round.
When considering a down round, sponsors and their counsels will need to consider the law at the holdco level applicable to the proposed down round, as well as the relevant laws where the directors reside and work.
The sponsors of a down round and their counsel will need to be very clear on what duties are owed by the directors (and in some cases shareholders with management control) of a company and to whom those duties are owed. The applicability of local laws will also need to be considered and tested.
Conclusion
The most important thing to remember is that a distress scenario requires delicate handling and agile and decisive decision-making and consensus building. All parties involved need to move fast and collaborate on structuring a deal to save the company.
On most occasions, and in spite of what’s at stake, most distress scenarios aren't insurmountable, but they require the involvement of the right legal counsel to get the deal done. They must be prepared to handle multiple discussions simultaneously (for example, the sponsors, non-participating shareholders and the team) and have a robust and watertight negotiation strategy to avoid being dragged into lengthy negotiations that risk the continued existence of the company.
Knowledge and assuredness at the holdco level isn't sufficient; local laws need to be heeded and boards need to ensure that there's no insolvent trading at the opco level or failure to adhere to local laws even where the financings and the down round itself are taking place in a different jurisdiction. Refer to our article on directors’ duties and distress situations involving venture-backed companies across MENA for more information on director duties.
