Down, but not out! Survive your down round and come back swinging

During the tech boom of 2020-2021, many startups will have raised money at a valuation that may prove a tough act to follow.  If a company has also failed to meet certain ambitious commercial milestones, then finding investment at a higher valuation to follow the previous round could be a challenge.

If you’re raising money in today’s cooling market, you may need to consider a down round – i.e. where shares are issued at a price lower than the price of the previous round.

Successfully navigating a down round is no walk in the park, resulting in greater dilution than founders or existing investors probably planned for and potentially shaking the confidence of the company’s shareholders and employees. However, a carefully managed down round can provide the company with a critical lifeline at a time it is needed.

If you’re a founder, director or shareholder of a company contemplating a down round here are some questions you should ask yourself before you even look at a term sheet.  

What is your end game?

If you only take away one thing from this post, it should be this – a down round should be a tool for the company to get back on track.  You need a realistic business plan that will result in an up round next time, or a successful exit.  Now is the time for the board to take a hard look at the company’s prospects and consider whether the business plan is still sound.

No one wins if your down round allows you to hang on for another year but you don’t have a realistic plan to steer the company through the valley of death.  

How much time do you have?

Solvency (and director liability associated with reckless trading) is a real concern for any company considering a down round.  You should meet with your board as soon as possible with an honest appraisal of your runway.  If you think you have 9 months, you might actually only have 6 – it can be expensive and take time to negotiate any fundraising round, but especially one which might ruffle the feathers of your existing shareholders.  You don’t want to be running out of cash when you are in the midst of negotiating the terms of your round – the company will be on the back foot and more likely to concede points on which it could have held firm.

Do you have any other options?

You’ve probably already been thinking about this, but it’s worth mentioning that you should thoroughly examine other options. For example, can you take on debt to avoid dilution?  Even better, do you have a friendly, well-financed existing investor who might be able to provide a bridging loan on terms that don’t cripple the company?  Debt might be a good option to consider if you have confidence in your company’s ability to increase in value or increase its revenue in the short term, to see you through to the next priced round.  

If you think you just need to buy some time before the company can attract a higher valuation, it may also be worth considering a convertible note round to kick the can on valuation, but of course, attempting to time the market could also come back to bite.  Consider also whether there is any non-dilutive grant funding available in your vertical that might tide you over until you can attract further investment.

As above, it’s important to know when to quit.  Consider your reasons for raising at a down round valuation and really look at where you are going.  

How much should you raise?

This is a difficult balance to strike, but ideally you should buy yourself enough time so you don’t have to contemplate another down round.  On the other hand, money that you raise today is likely to be more costly to your existing shareholders in terms of dilution than in the future, when (everything going to plan) your company may have increased in value.  

How will this impact your team?

A down round can be a bit of a downer for your team’s morale.  Consider what incentives you have in place, and what you can do to retain key people.  For example, you could consider amending the exercise price of share options issued in the previous round to reflect the price of the current round.  

What are your obligations to existing shareholders?  

You likely have an anti-dilution clause lurking in your shareholders’ agreement which means you might be obliged to issue top-up shares to preferred shareholders who paid a higher price for their shares.  While we could fill another post with this topic, make sure you model the down round scenario yourself.  You need to understand the dilutionary effect of the round, and whether it has any significant impact on key governance items like veto or board appointment rights.  

However, don’t go into the conversation assuming that existing shareholders will insist on being issued top-up shares in the round.  Are there any other incentives or rights you can offer for them to waive these rights?  

What are the risks to the company’s directors?

Carefully consider director liability as part of your down round.  Any time the company does something that is likely to cause friction with shareholders is a risky time for directors.

To minimise the risk of shareholder claims:

• Seek unanimous approval:  Ideally, get all of your shareholders and directors to approve the round (including a waiver of their pre-emptive rights, if any). If you don’t think you can get everyone onboard, be aware of the minimum approvals you will need, and the risks associated with having dissenting shareholders and/or directors.  
• Document the evidence for your valuation:  In a down round more than ever, if the board is approving the issue of the shares, directors need to be able to articulate and document why the price for the new shares is fair and reasonable to the company and all existing shareholders.  
• Consider insurance and indemnities:  Due to the elevated risk of shareholder claims, consider putting D&O indemnities/insurance in place if you haven’t already.  Under NZ law, specific approvals and certifications are required before the company indemnifies/insures its directors.
• Get legal advice early:  Have your lawyer review your term sheet before you agree to it.  Once a term sheet is agreed, even if it is non-binding, you’re in a weak negotiating position if you then want to change a term of the round.  If your cash is running low, it’s even more critical to do the heavy lifting on negotiations early when you have a better walk away position.

Contemplating a down round shouldn’t fill you with dread, but you need a solid game plan.  If you’d like to have a chat about your next fundraising round with a capital raising expert, please get in touch.