Venture capital financing plays a crucial role in funding the growth and expansion of startups. However, the path to success is not always smooth, and companies may, at certain points in their lifecycle, need to raise capital on less-than-ideal terms.
In today’s challenging economic climate, this is becoming even more common, as venture capital firms are holding onto their capital to support their existing portfolio companies, and generally are requiring new prospective portfolio companies to demonstrate ever more traction (usually in the form of revenue), as a means to de-risk investments. Companies that do not have waiting capital from existing investors to draw from or who are at a stage of development where they cannot demonstrate the necessary traction to attract new investors are increasingly encountering challenges in fundraising. This often leads to discussions about raising a down round.
In this article, we will explore what a down round is, how broad-based weighted average antidilution mechanisms function, and the implications of down rounds on preferred stock conversion prices.
What is a Down Round?
A down round refers to a financing round in which a company secures investment at a lower valuation compared to the post-money valuation of its previous funding round. Typically, this occurs when a company experiences difficulties, such as missed milestones, slower-than-expected growth, or changes in market conditions. In a down round, existing stockholders face dilution of their ownership stakes as new investors acquire a larger percentage of the company for a smaller investment.
Understanding Broad-Based Weighted Average Antidilution Mechanisms
To mitigate the impact of a down round on existing investors, many venture capital investment agreements (including the widely used open-source forms published by the National Venture Capital Association (NVCA)) include antidilution provisions, with the most common being the broad-based weighted average (BBWA) antidilution mechanism.
The way antidilution mechanisms function is commonly misunderstood. Their purpose is to decrease the effect of the dilution from the down round to existing preferred stockholders at the expense of the common stockholders, resulting in even greater dilution to the common stockholders (the class of stock generally held by the founders and employees). However, they do so by adjusting the price at which the existing preferred stock can convert to common stock; they do not result in the immediate issuance of additional shares to the existing preferred stockholders, which is a common misconception.
The BBWA antidilution mechanism is calculated using a formula that takes into account the price per share of the new financing round (down round price), the original price per share paid by the existing investors (old price), and the number of shares then outstanding. By using a weighted average formula, the mechanism accounts for both the size and price of the down round relative to the size of the company’s outstanding capitalization and price of prior investment rounds, such that a smaller down round will result in less of an antidilution adjustment than a larger down round.
The formula for the BBWA antidilution mechanism can be represented as follows:
New Conversion Price = (Old Conversion Price) * (A / B)
In this formula, A represents the sum of (i) the number of shares outstanding before the down round multiplied by the old price, and (ii) the number of shares issued in the down round multiplied by the down round price. B represents the sum of (i) the number of shares outstanding before the down round, and (ii) the number of shares issued in the down round.
Implications for Preferred Stock Conversion Price
Preferred stockholders in a venture-backed company typically have the option to convert their preferred stock into common stock under specific circumstances and on predetermined terms. The conversion rights of preferred stockholders are typically outlined in the company’s governing documents, such as the Certificate of Incorporation. The terms vary depending on the specific agreements in place, but preferred stockholders commonly have the right to convert their preferred stock to common stock in connection with an acquisition or other liquidity event. Investors would choose to exercise this conversion right if they stand to receive a greater share of the proceeds of such an event as common stockholders than they would as preferred stockholders.
The conversion price of preferred stock determines the ratio at which preferred stock can be converted into common stock. Typically, the initial conversion price is a 1:1 ratio, such that one share of preferred stock has the right to convert into one share of common stock. In a down round, the conversion price is adjusted downward (usually using the BBWA formula described above) to reflect the reduced valuation of the company, resulting in more common shares being issued to the investor at a conversion event. This adjustment protects the preferred stockholders from excessive dilution in a down round and preserves their economic interests.
It is worth noting that while antidilution mechanisms protect existing preferred stockholders from significant dilution in a down round, down rounds can still have negative implications for a company. A lower valuation may lead to a reduced ability to attract investors and cause challenges in future financing rounds and can also reduce founder and employee morale. For these reasons, companies may opt to look at other alternatives to a down round, such as a raising a convertible note bridge round as a means to delay the valuation discussion to a time when the company is on stronger footing.
Conclusion
Down rounds in venture capital financing are challenging situations for companies, but they can be navigated with the help of antidilution mechanisms like the broad-based weighted average mechanism. By adjusting the conversion price of preferred stock, these mechanisms ensure that existing preferred stockholders are protection from excessive dilution in a down round.
While down rounds help protect ownership stakes, they may have broader implications for a company’s valuation and subsequent funding opportunities. Understanding the intricacies of down rounds and their impact on preferred stock conversion prices is crucial for both entrepreneurs and investors in the dynamic world of venture capital financing.
Emily Strack is a shareholder in the Memphis office of Baker Donelson and vice chair of the Emerging Companies Team. She concentrates her practice in the areas of corporate law, mergers and acquisitions, and venture capital fundraising and fund formation, with a particular focus on clients in the healthcare and life science industries. estrack@bakerdonelson.com