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Down Round refers to an equity financing that raises money at share prices lower than the previous equity funding. For example, a sale of one million shares of Series B Convertible Preferred Stock at $2.50 per share after an earlier sale of Series A Convertible Preferred Stock at $3.00 per share would be a down round. While any sale of voting securities reduces the percentage ownership and relative voting power of existing shares, down rounds do so more dramatically than rounds at higher prices. They can also depress ownership and voting power of management shareholders more than earlier venture investors. This is because antidilution protections contained in the terms of most convertible preferred stock entitle their venture investors to receive extra shares of common stock when they later convert their shares of convertible preferred stock into common stock. These rights are not typically provided to management or other holders of common stock. The result is that holders of common stock, like management, are usually disproportionately diluted in a down round. In difficult fundraising environments, such as the period after the bust of the dot-com bubble, and in situations where fundraising has been particularly difficult, creative down round investors have employed other mechanisms to enhance their ownership rights and reduce the value of the shareholdings of existing investors even more. The combined use of some or all of these mechanisms can reduce the ownership and voting power of existing shareholders, including earlier venture investors, to next to nothing. These mechanisms include: · Pay-to-play provisions · Liquidation preferences · Participating preferred stock · Adjustments to existing shareholder rights Pay-to-play provisions. These are requirements imposed by the investors of new money on prior investors, as a condition to making the new investment, that require the prior investors to invest with the new investor to avoid being penalized. One example of a pay-to-play provision is an amendment to the company’s charter that enables existing shareholders who invest in the down round to convert their existing convertible preferred stock into a more valuable amended series of convertible preferred stock that allows conversion into a greater number of shares of common stock. Existing venture investors who do not reinvest are left with their original, now devalued, convertible preferred stock. For example, participating investors might be allowed as a part of their investment of new Series B stock to convert their Series A into a preferential Series A-1 stock. The preference might be a revised conversion formula that increases the number of shares of common stock they are entitled to receive on conversion by a factor of five to make the new conversion more closely resemble the value afforded in the subsequent Series B down round. Nonparticipating investors are left with the original Series A stock. Another pay-to-play strategy might issue a highly dilutive new Series B stock, say at one-tenth the price of the Series A stock, and provide existing shareholders who invest their pro rata portion in the Series B stock to also receive additional shares of another class of stock that enables them to retain some of the value diluted out of the Series A stock. A third approach is to build the pay-to-play requirement into the original Series A stock when it is first issued. Then the stock terms themselves can provide for different treatment of Series A shareholders who invest in the later round and those who do not. Liquidation preferences. Many venture capital investment vehicles, such as convertible preferred stock, contain provisions that give the investor the right to receive back its investment amount before other shareholders receive proceeds from a liquidation. These preferences can be used to reserve first value to new investors and decrease the value of other shareholdings when a later liquidation event occurs, such as a sale of the business. In down rounds the value of this liquidation preference is often increased to exaggerate this reduction in value to existing shareholders. For example, a down round liquidation provision might provide the Series B shareholders with three dollars for every dollar they invested out of the first funds distributed from a liquidation event and before any funds are made available to other shareholders. By defining liquidation to include a sale or merger of the business, the Series B investor of $5 million assures himself of receiving the first $15 million dollars generated by a qualifying liquidation event and reduces the value of the company to other shareholders. Participating preferred stock. Down round investors sometimes couple participation features with their liquidation preferences to enhance the prospective value of their securities even further. The participation feature entitles them to receive a liquidation preference before distribution of proceeds to other shareholders and then to participate with the other shareholders in the proceeds remaining after payment of the preference. Adjustments to existing shareholder rights. Antidilution protections afforded to existing shareholders, either as incorporated into the description of their stock or by separate contractual negotiation, may increase the shareholdings of existing shareholders after a down round. Liquidation preferences or participating preferred rights might also exist in earlier series of convertible preferred stock. Because of this, another condition sometimes imposed in a down round is that existing holders of preferential rights agree to terminate or reduce those rights. This could take the form of cancellation of antidilution rights, reduction of a liquidation preference or amendment to remove a participating right. It could also take the form of a forced conversion from a preferred security into common stock or a new form of convertible preferred stock with reduced rights. See: Antidilution Provisions, Dilution (Percentage), Dilution (Value), Equity Penalties, Follow-on Fundings, Liquidation Preferences, Liquidity Event, Participating Preferred Stock, Pay-to-Play Provisions, Ratchets, Weighted Average Antidilution. |