COVID-19 Crisis Mitigation Legal Packages – Find Out More

Blog

What’s NEXT?
Legal and business news for startups and entrepreneurs.

What is a Down Round?

Augie Rakow

Better Series A

You switched to remote-only operations and your team is executing amazingly.  Customers are still buying and your company just might thrive in the post-corona era.  Investors in your network took notice and want to allocate more funds to your company.  But their valuations are roughly flat with your last financing. How do you negotiate a better deal for your company and drive existing investors to contribute to the new round? 

In this article we explain what is a down round and the numbers that define a “down-round” vs. “up-round” financing.  Then we introduce 6 lesser-known deal structures to incentivize your existing investors to contribute their share toward the new round. 

What is a “down round”? A “down round” is a financing round in which shares purchased in the financing are less expensive per share than those bought in the last financing round.  This happens when the new round’s pre-money valuation is lower than the post-money valuation of the prior round — after adding a buffer in the cap table to refresh the option pool, and maybe an additional buffer to convert any new safes, notes or warrants. 

These buffers significantly lower the share price math and are often overlooked when planning a new financing. As a result, you will likely need a significantly higher valuation than the last round just to avoid issuing shares at a lower price.  

Let’s illustrate with numbers. 

Say you closed a Series A financing last year. In that Series A financing you sold 20% of your company for $4M. These terms already imply a $16M pre-money valuation and a $20M post-money valuation.  (Remember: pre-money plus new cash equals post-money.) 

Your sales keep growing despite corona, and an investor now wants to invest another $4M in a new Series B round. The investor is requesting a 20% available pool. 

How much valuation growth do you need to stay above your Series A price?

If you already used up your Series A option pool, then your new pre-money valuation for the Series B will need to be at least $26M just to squeeze the new pool into the cap table. Anything lower than that will bring the new Series B price below the Series A price.  

How do we know that?  

We already noted that the Series A post-money valuation was $20M. And we noted that the Series B pool size needs to equal 20% of the Series B post-closing cap. With these two values we can infer values for the following variables A-E:

Variable

Definition

Value

A

Series A Post-$. 

The Series A post-money valuation.

A = $20M

A = E – D – B

B

Series B Pool. 

The available pool in the new Series B round.

B = 0.2 * E

C

Series B Pre-$. 

The Series B pre-money valuation.

C = A + B

D

Series B New Cash. 

The Series B investment funds.

D = $4M

E

Series B Post-$. 

The Series B post-money valuation.

E = C + D

E = A + B + D, 

These inferences tell us that to maintain or increase the share price in the new Series B round, the new valuation needs to satisfy the equation A + B = E – D.  

Sticking with our example of a $20M pre-money valuation A, if we look at Series B pool sizes B listed below, we see that $6M is the pool size that satisfies A + B = E – D:

A

B

C

D

E

Old Post

 ($20M)

New pool

20%

 ($M)

Implied pre-$ value 

($M)

New Cash

($4M)

Implied post-$ value 

($M)

   Analysis

20

0

-4

4

0

A + B > E – D

20

1

1

4

5

A + B > E – D

20

2

6

4

10

A + B > E – D

20

3

11

4

15

A + B > E – D

20

4

16

4

20

A + B > E – D

20

5

21

4

25

A + B > E – D

20

6

26

4

30

A + B = E – D

20

7

31

4

35

A + B < E – D

So the pre-money valuation needed to price this new Series B round at least at the Series A price, is the sum of the Series A post-money valuation A ($20M) plus the new pool B ($6M), or $26M.  

(Keep in mind this is a simplified example.)

While VCs need far more than a 30% growth for their investment to work, even the world’s strongest companies are challenged to show 30% growth during great market crashes. Investors are understandably cautious and looking for discounts.  Even Facebook had a down round during the Great Financial Crisis. 

Let’s look at 6 financing deal structures to improve your financing transaction.  These may be unfamiliar to newer companies. 

No deal structure replaces having a strong business and competing investor interest.  Those are table stakes.  The deal structures discussed here don’t replace fundamentals.  We’re assuming you have a good business and are running a good fundraising process. But you can use these techniques to improve an offer by 10-15% or to drive more of your existing investors to contribute to your new round.

  1. Leave headroom.  We already discussed setting the valuation floor to avoid a down-round. There’s a natural valuation ceiling, too.  You need to leave room for the new investor’s investment to grow before the next To do this, calculate the pre-money valuation of the current round by looking at what the implied post-money of the round would be (again: pre-money plus new cash going in).  Then imagine your team successfully executes its plan for the next 18 months, and use that projection as a baseline to estimate the likely pre-money value of the next financing round 18-24 months from now. Remember, you don’t want to set investors up for a down-round in the next round either.  A strong business with headroom for growth is the most effective ‘carrot’. 
  1. ‘Pull-through’ to reward participating insiders. Existing investors are often the most reliable financing source in tough times. But why should one investor carry the company for all investors?  How can you reward the insiders who step up?  Consider a ‘pull-through’ financing.  A pull-through is where an investor who contributes significantly to the new financing round gets the option to trade in some of their older preferred shares for more of the more valuable shares being issued in the new financing round.  This method is used most frequently in connection with a pay-to-play or other mechanisms to encourage participation in the financing round.
  1. ‘Pay-to-play’ and ‘Pay-to-play lite’. One of the more aggressive ‘sticks’ to incentivize existing investors to contribute to a new financing round is called a ‘pay-to-play’.  A pay-to-play provision says that investors who don’t contribute their pro-rata share to financing rounds lose their preferred stock. In the ‘lite’ version they only lose their pro-rata right, or maybe a board seat. Pay-to-plays are ‘sticks’ to investors who don’t contribute, but they are ‘carrots’ to those who do. Participating investors will see their share of the preferred stock and related rights expand as non-participating investors lose their preferred rights. 

Pay-to-plays aren’t typically included in Series A documents, so you’ll probably need your Series A lead investor’s approval to add a pay-to-play right before the Series B financing.  This option works best if your Series A lead will invest in the new round. 

  1. Reverse-split & top-up. Sometimes a large portion of a company’s cap table is held by people who no longer contribute to the company. There may be founders who vested large equity chunks and left the company years ago. Or investors with value-add in areas that are no longer relevant to the company.  With the right controlling votes, you can ‘reverse split’ or merge current outstanding shares of stock so that stockholders who had 100k shares will now have 10k or 1k shares. The new investors can then invest on a post-merge basis and acquire correspondingly larger ownership for their investment.  

Keep in mind the CEO and key employees will also lose their shares in the reverse-split, so be sure to budget equity top-ups into your transaction model. This technique works best with a lateral CEO and when current management’s equity position is less than say 10-20%. 

  1. Anti-dilution protection. Series A investors typically receive anti-dilution protection against future down-round financings. Typical anti-dilution is called ‘broad-based weighted average’. Perhaps try a ‘narrow-based weighted average’ or a ‘limited full ratchet’ — two versions that give investors stronger protection — but make them apply for only the next 18 months to deal with expected macroeconomic headwinds.
  1. Upside protection. If the investor doesn’t already have a pro-rata right to participate in future financings, you can give them the right to maintain their pro-rata share. Or try a ‘super pro-rata’ entitling the investor to double their position in the next round. 

How do I decide the right deal structure for my company?

Each of these strategies has a cost to the company and its cap table.  Your existing investor or experienced startup lawyer can help model possible deal structures for you and your investors. 

As part of a good action plan, you will:

  1. Build a model to make sure you understand the dilutive impact of each option described above. 
  2. Confirm whose approvals you need to execute the plan.
  3. Plan communications to employees and investors.
  4. Ensure you have appropriate D&O insurance.
  5. Obtain legal advice on opportunities and risks.
  6. Work with a trusted investor or legal counsel to review investment offers. 
  7. Prepare a company term sheet that you can propose to investors.

Can NEXT help?
YES!  NEXT is currently offering a flxed-fee arrangement to assess your legal records and build a financing model that lets you compare the potential benefit of the measures discussed above.  We also offer fixed-fee packages for the financing transaction itself.  For additional information or to schedule a consultation, please contact NEXT at info@next.law.