The Low Down on Down Rounds

Tom Gump: Thanks Mike. In doing down rounds we see a number of characteristics which come up from time to time and are present in a greater or lesser extent in nearly every deal. These are characteristics which investors rely upon to minimize their risk in investing in what is seen as an increasingly risky transaction and to improve their returns. The first characteristic of course is lowered valuation and a small raise. In an up financing, existing investors are diluted of course. But in that up financing, the existing investors are not always troubled by that dilution because the value of their stake increases. The down financing is a sort of double whammy so to speak. The existing investors in the company, including the employees, have to bear the dilution of the financing and the value of their stake is worth less, often much less, than what they originally ' than the original value of their investment or what they paid for that investment. With respect to employees, this, of course, has the potential to create significant dissatisfaction among the existing employees and also among the existing shareholder base. The second common characteristic is the use of staggered financing. In a staggered financing, the investors in the down round will only disperse the proceeds of the offering upon the attainment of financial or operational milestones by the company. This creates uncertainty, of course, for the issuer because they never know if they're going to get the next drip of the financing. And it's an additional source of employee dissatisfaction and discontent. The third characteristic is use of increased liquidation preferences. In an up financing, you'll commonly see a one X liquidation preference and a stock which is not a participating stock. As we've seen more down rounds in the last couple of years, liquidation preferences have risen to between two and five times the original purchase price of the stock. In fact, we're seeing some deals where if the company that issued the stock in the down round were to be sold, the increased liquidation preference of the down round stock would consume nearly the entire, or the entire, proceeds of that liquidity event. We touched a little bit upon the issue of participating preferred stock. I can't remember the last down round I did that didn't have a fully participating preferred stock although in a healthier environment, the preferred stock issued is usually not participating or participates only with caps.

Mike Halloran: I mean what it results in Tom is very often a fairly vigorous negotiation with the existing employees and management and perhaps the initial rounds. So whether there ought to be a cap on the participation preference of a certain dollar amount and then the common or the other preferred gets to come in, and then after they're satisfied then the cap is released and the new preferred gets [in]. [S]o that you will see the participations negotiated, but at the end of the day if the company's in trouble the down round financier wins.

Tom Gump: Anti-dilution provisions are also an important subject [of] negotiation in down rounds. In an up financing, you'll usually see a broad based or narrow based weighted average anti-dilution formula for the preferred stock. That weighted average formula means that the effects of the dilution are spread among the entire shareholder base after the financing is consummated. In down rounds, you see a lot of ratchets, whole ratchets, where the burden of the diluted financing is born exclusively by the existing shareholders of the company. The ratchet in effect has the effect of reducing the effective valuation of the securities issued in the down financing to the lower valuation in a subsequent down round. We're seeing a lot more redemption rights. Redemption rights are being used. One as a path to liquidity; but two also is a means to exert control over the company if the company's progress has not gone as the investors had foreseen. Down rounds are often characterized by cumulative dividends which are a firm dividend entitlement. This is in contrast to the non-cumulative dividend you usually see in an up financing which is payable only when, and if, declared by the board. The cumulative dividend, of course, is a firm commitment by the company to pay dividends and has the effect of draining cash from the company often at times when that cash is desperately needed.

Mike Halloran: Of course what happens is very often the company just can't pay the dividend legally under Delaware law and so what happens is the thing cumulates anyway even though it's mandatory, which has the effect of that preferred achieving, if you will, a higher and higher interest in the company. And sometimes these dividends are fixed which means that in effect when that happens, when they convert, they convert the accrual of the dividend as well which gives them a higher interest in the company anyway.

Tom Gump: Down rounds are resulting in an increased number of protective provisions being requested by venture capital investors. The VCs are staying very involved in the operations of the companies in which they invest and negotiate contractual right to a broader number of items than before. Whereas in an up financing you might get a consent right with a charter amendment that changes your rights, down rounds consent rights are broader. You might get a charter ' a consent on a charter ' on any charter amendment. You might negotiate consent rights as a VC with respect to limits on expenditures by the company, limits on the hiring and firing of employees, limits on incurring new debt, granting liens in your assets, just with a broader range of business activities of the company. I think this is a good time to mention the benchmark case from last year. This was a case where the Delaware court looked at the scope of consent rights which were negotiated by a venture capitalist that was on the losing end of a down financing arranged by other investors. That in benchmark- the venture capitalist had negotiated a consent right with respect to corporate actions that would change their right. This venture capitalist, however, didn't negotiate a consent right with respect to mergers and the issuer's counsel on this down round saw that gap in the consent right effected a merger, and used that merger in order to change the consent right of the prior round VC. The prior round VC asked the court to enjoin this action, saying I have a consent right on changes to corporate actions. And the Delaware court disagreed, saying that a change to your consent right effected by a merger would not be enjoined on the basis of the consent right which had been negotiated. So I think the message of the Benchmark case is to pay particular attention to the drafting of protective provisions to make sure that then you negotiate with protective provisions that you're actually getting in fact what you think you're getting in theory.

Mike Halloran: The Benchmark case, which by the way is called Benchmark Capital Partners v. Vague, [CA. No. 19719-NC, Court of Chancery, July 9, 2002]. But this is typical of the Delaware courts. They read these charter provisions very literally and so if you stick into your protective provision something that says, you know, we have a vote on any material adverse change in the rights, preferences and privileges, okay, and don't put in, you know, comma whether through merger, by operation of law or otherwise, if you don't put those magic words in, then a merger, as was done in this Benchmark Capital deal, can be used to end run the protective provision. And the Delaware courts upheld that again and again in a very literal reading. Now it's interesting that the California Corporations Code would not allow that, I mean the merger, because the California Corporations Code has a provision in 1201c of the Code that says that if the merger effects an amendment of the articles that would require a vote if it were amended, then you got to get the vote. So it's a completely different result in California.

The following is an excerpt from a conference call hosted by VCExperts.com, of which Advising Start-Up & Emerging Companies Editor-in-Chief Joe Bartlett is Chairman. Participants included Joe Bartlett, Mike Halloran, senior partner in Pillsbury Winthrop LLP's 341-lawyer corporate and securities practice group, and Tom Gump, Senior Associate in the corporate and securities group in the San Francisco office of Pillsbury Winthrop.

To purchase the full transcript of the conference call at a 20% discount go to http://invitation.vcexperts.com/ and use the access code “buzz”. Offer expires July 15th.

Mike Halloran: We're talking about down round financings, which seems to be the order of the day and has been the order of the day perhaps for the last year and a half in venture capital finance, at least where you have a company with existing rounds. And we – Tom and I wrote a chapter which appears in this venture capital book that we edit, and I would encourage anybody to perhaps get a copy of the chapter which I think is basically on [the VCExpert.com] Web site. Why don't we have Tom go ahead and talk about the legal structures for implementing down rounds and sort of the terms and terminology that we use in this down round era.

Tom Gump: Thanks Mike. In doing down rounds we see a number of characteristics which come up from time to time and are present in a greater or lesser extent in nearly every deal. These are characteristics which investors rely upon to minimize their risk in investing in what is seen as an increasingly risky transaction and to improve their returns. The first characteristic of course is lowered valuation and a small raise. In an up financing, existing investors are diluted of course. But in that up financing, the existing investors are not always troubled by that dilution because the value of their stake increases. The down financing is a sort of double whammy so to speak. The existing investors in the company, including the employees, have to bear the dilution of the financing and the value of their stake is worth less, often much less, than what they originally ' than the original value of their investment or what they paid for that investment. With respect to employees, this, of course, has the potential to create significant dissatisfaction among the existing employees and also among the existing shareholder base. The second common characteristic is the use of staggered financing. In a staggered financing, the investors in the down round will only disperse the proceeds of the offering upon the attainment of financial or operational milestones by the company. This creates uncertainty, of course, for the issuer because they never know if they're going to get the next drip of the financing. And it's an additional source of employee dissatisfaction and discontent. The third characteristic is use of increased liquidation preferences. In an up financing, you'll commonly see a one X liquidation preference and a stock which is not a participating stock. As we've seen more down rounds in the last couple of years, liquidation preferences have risen to between two and five times the original purchase price of the stock. In fact, we're seeing some deals where if the company that issued the stock in the down round were to be sold, the increased liquidation preference of the down round stock would consume nearly the entire, or the entire, proceeds of that liquidity event. We touched a little bit upon the issue of participating preferred stock. I can't remember the last down round I did that didn't have a fully participating preferred stock although in a healthier environment, the preferred stock issued is usually not participating or participates only with caps.

Mike Halloran: I mean what it results in Tom is very often a fairly vigorous negotiation with the existing employees and management and perhaps the initial rounds. So whether there ought to be a cap on the participation preference of a certain dollar amount and then the common or the other preferred gets to come in, and then after they're satisfied then the cap is released and the new preferred gets [in]. [S]o that you will see the participations negotiated, but at the end of the day if the company's in trouble the down round financier wins.

Tom Gump: Anti-dilution provisions are also an important subject [of] negotiation in down rounds. In an up financing, you'll usually see a broad based or narrow based weighted average anti-dilution formula for the preferred stock. That weighted average formula means that the effects of the dilution are spread among the entire shareholder base after the financing is consummated. In down rounds, you see a lot of ratchets, whole ratchets, where the burden of the diluted financing is born exclusively by the existing shareholders of the company. The ratchet in effect has the effect of reducing the effective valuation of the securities issued in the down financing to the lower valuation in a subsequent down round. We're seeing a lot more redemption rights. Redemption rights are being used. One as a path to liquidity; but two also is a means to exert control over the company if the company's progress has not gone as the investors had foreseen. Down rounds are often characterized by cumulative dividends which are a firm dividend entitlement. This is in contrast to the non-cumulative dividend you usually see in an up financing which is payable only when, and if, declared by the board. The cumulative dividend, of course, is a firm commitment by the company to pay dividends and has the effect of draining cash from the company often at times when that cash is desperately needed.

Mike Halloran: Of course what happens is very often the company just can't pay the dividend legally under Delaware law and so what happens is the thing cumulates anyway even though it's mandatory, which has the effect of that preferred achieving, if you will, a higher and higher interest in the company. And sometimes these dividends are fixed which means that in effect when that happens, when they convert, they convert the accrual of the dividend as well which gives them a higher interest in the company anyway.

Tom Gump: Down rounds are resulting in an increased number of protective provisions being requested by venture capital investors. The VCs are staying very involved in the operations of the companies in which they invest and negotiate contractual right to a broader number of items than before. Whereas in an up financing you might get a consent right with a charter amendment that changes your rights, down rounds consent rights are broader. You might get a charter ' a consent on a charter ' on any charter amendment. You might negotiate consent rights as a VC with respect to limits on expenditures by the company, limits on the hiring and firing of employees, limits on incurring new debt, granting liens in your assets, just with a broader range of business activities of the company. I think this is a good time to mention the benchmark case from last year. This was a case where the Delaware court looked at the scope of consent rights which were negotiated by a venture capitalist that was on the losing end of a down financing arranged by other investors. That in benchmark- the venture capitalist had negotiated a consent right with respect to corporate actions that would change their right. This venture capitalist, however, didn't negotiate a consent right with respect to mergers and the issuer's counsel on this down round saw that gap in the consent right effected a merger, and used that merger in order to change the consent right of the prior round VC. The prior round VC asked the court to enjoin this action, saying I have a consent right on changes to corporate actions. And the Delaware court disagreed, saying that a change to your consent right effected by a merger would not be enjoined on the basis of the consent right which had been negotiated. So I think the message of the Benchmark case is to pay particular attention to the drafting of protective provisions to make sure that then you negotiate with protective provisions that you're actually getting in fact what you think you're getting in theory.

Mike Halloran: The Benchmark case, which by the way is called Benchmark Capital Partners v. Vague, [CA. No. 19719-NC, Court of Chancery, July 9, 2002]. But this is typical of the Delaware courts. They read these charter provisions very literally and so if you stick into your protective provision something that says, you know, we have a vote on any material adverse change in the rights, preferences and privileges, okay, and don't put in, you know, comma whether through merger, by operation of law or otherwise, if you don't put those magic words in, then a merger, as was done in this Benchmark Capital deal, can be used to end run the protective provision. And the Delaware courts upheld that again and again in a very literal reading. Now it's interesting that the California Corporations Code would not allow that, I mean the merger, because the California Corporations Code has a provision in 1201c of the Code that says that if the merger effects an amendment of the articles that would require a vote if it were amended, then you got to get the vote. So it's a completely different result in California.