When faced with an unavoidable down round, a climate tech startup needs to tread carefully. This article – the third in a series – discusses some important things to keep in mind in managing a down round venture financing. See Part 1 of our series to learn about alternatives for averting a down round, and see Part 2 of our series to learn about common investor-favorable deal terms in a tough financing environment.
What if, despite your best efforts, your business needs a cash infusion and you’ve run out of costs to cut to extend your runway? You may have no choice but to accept a suboptimal financing offer at a lowball valuation to keep the lights on. Here are some key considerations in that unfortunate scenario:
Deal with dilution. Selling shares at a lower price than prior issuances can cause significant dilution to existing equity holders (including both holders of preferred stock and, quite possibly, holders of common stock or options). To avoid this result, virtually all venture investors will negotiate for broad-based anti-dilution protections, and these provisions are likely to be triggered for existing preferred stockholders in the event of a down round. Anti-dilution provisions generally operate by changing the ratio at which existing preferred stock would convert into common stock, so that existing investors’ shares convert at a greater than 1:1 ratio following the anti-dilution adjustment. Anti-dilution adjustments typically benefit existing investors at the expense of the common stockholders, who may face massive dilution as a result, or find that their existing stock options are underwater and essentially worthless.
The good news is that, since most common stock and option holders are employees of the company, investors may be open to solutions to this dilemma. After all, it’s ultimately in their interests to make sure employees and executives remain motivated to stick with the company and help the business succeed. Some possible fixes might include issuing new, catch-up option grants to employees following the preferred stock financing, or exchanging or repricing existing underwater stock options (which requires close coordination with tax counsel to ensure compliance with Section 409A of the U.S. tax code). Another option, of course, would be for existing investors to simply waive their anti-dilution rights or agree to a less punishing conversion ratio than they may have the right to get, but convincing investors to agree to that may be difficult, depending on how dilutive the financing would be.
Double down on fiduciary duties. Down rounds can result in disgruntled stockholders, a scenario that may increase a company’s litigation risk. Corporate boards should be mindful that their decision-making may be subject to heightened scrutiny and take care (as they should in any deal) to rigorously vet the company's financing alternatives, document their discussions and decision-making processes, and focus on producing an optimal and fair outcome for the company and its stockholders. Of course, this is especially important when existing investors are represented on the board, due to the potential for a conflict of interest or the appearance of a conflict between an investor director’s fiduciary duties to act in the best interests of all shareholders and the more narrow interests of the investor that employs that director. Independent directors should take a lead role in the process to the extent possible.
Don’t delay. Deals may take longer to come together in a challenging fundraising environment, even taking into account the additional time companies may need to spend finding suitable investors and terms they can live with. Investors may need additional time to line up capital, and there may be more sticking points in the negotiation of terms and transaction documents. Companies should be mindful of their cash needs and burn rate, and realistic about deal timelines. No one wants to be forced to accept even tougher terms because the company is a week away from missing payroll.
FURTHER INFORMATION
For further information about these matters, please contact Samantha Rothberg at srothberg@klavenslawgroup.com or 617-502-6286, Frans Wethly at fwethly@klavenslawgroup.com or 617-502-6285, or Jonathan Klavens at jklavens@klavenslawgroup.com or 617-502-6281.
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