Structuring a down round: key aspects to consider
By Abdullah Mutawi, Partner and Daniel Sterling, Associate
Venture capital financing peaked in the MENA region between 2020 and early 2022 following a sustained bull run across global tech markets fuelled by years of quantitative easing, low interest/low inflation economies and a gung-ho attitude among some of the biggest global venture investors.
Mirroring trends in more mature venture markets, MENA had become no stranger to early and growth-stage tech companies looking to disrupt traditional industries achieving inflated valuations. But in contrast to venture investors in more mature markets, the closest most investors in the MENA region had come to experiencing a down round was a theoretical understanding of the implications of anti-dilution rights and the various permutations of just how aggressive and pro-investor these can be.
Now, due to economic headwinds that emerged late last year, many more investors face the prospect of experiencing (or may have already experienced) a down round first hand. A torch has been shone on fragile business models and valuations, and MENA markets are now awash with companies coming to the end of their runway with scant hope of being able to raise further capital at a higher valuation than they raised at the last round.
This type of ‘soft distress’ raises the spectre of company failures because, unlike in markets that have seen down-cycles come and go before, our venture ecosystem is going through a down-cycle for the first time. Unless stakeholders work proactively, collaboratively, and promptly to find satisfactory outcomes, the alternative is inertia, paralysis and an inevitable death spiral.
At Taylor Wessing, we're proud to have worked on some of the most challenging distress mandates in the MENA region. We have a strong track record of structuring win-win deals that preserve some value for everyone and provide a fighting chance that companies can rebound and, ultimately, deliver exits to venture investors.
While no two down rounds are the same, to help those who might be encountering one for the first time we've laid out some of the key technical aspects of a down round and how it might be structured below.
Setting the scene
To help apply some of the concepts we'll discuss below in practice, we have assumed that a company (the company) is raising its Series B financing at a down round valuation, having previously raised funds in Series A and Series Seed priced equity rounds.
Overview of key drivers
A down round involves the issue of shares at a valuation lower than the valuation of a previous funding round. During a down round financing, the lead (or group of) investors investing new money in the Series B financing (the new investors) will likely seek to restructure the company’s cap table.
This is done in an effort to simplify the share capital to reflect a quasi-restart of the company’s fundraising journey. Another way of looking at it is to imagine that the Series B financing round is actually 'Series Seed' round. If the Series B round valuation is slightly lower than the Series A round valuation however, it may be that no cap table restructuring will be required.
With a lower valuation, new money Series B investors will likely request that liquidation preferences are recalibrated to align with the existing (lower) valuation of the company. This ensures that liquidation preferences in the future are not distorted, where earlier round investors (existing investors) receive higher payouts on a multiples basis than later-stage Series B investors.
Finally, existing investors who are already on the cap table will likely have concerns with committing additional capital, as they may have lost faith in the underlying business or the market conditions may have adversely affected their investment strategy. In order to incentivise existing investors to co-invest in the round, it's common for the new funding round to be structured in such a way that offers certain advantages to existing investors if they invest in the down round.
What follows is a set of terms that are often negotiated by the new investors and the company to achieve the key objectives highlighted above.
Pay-to-play
A pay-to-play structure is one that requires an existing investor to invest in the upcoming round (typically on a pro rata basis) to maintain its current rights. Not all down rounds will include a pay-to-play structure, and not all pay-to-play structures are offered on a pro rata basis, although these are quite common when the down round valuation is so low that the transaction warrants a total reset of the company’s share capital.
This is done to simplify and reset the existing share structure by collapsing the various outstanding classes of preferred shares (in our case, the Series Seed preferred shares and Series A preferred shares) into ordinary shares or a lower ranking class of preferred shares (for example, Series Pre-Seed preferred shares).
For example, the company may have raised its Series Seed financing at a valuation of US$30 million and its Series A financing at a valuation of US$80 million, while its upcoming Series B financing is expected to close at a valuation of US$20 million.
In this case, a total reset may well be necessary, and putting in place a pay-to-play structure requires existing investors to invest in the new round or accept a total or partial loss of their rights as preferred shareholders (ie loss of their liquidation preference, anti-dilution protection, conversion rights and reserved matters) by being forced to convert their preferred shares into ordinary shares (or a lower ranking class of preferred shares).
Mandatory conversion
A total reset of the share capital and all preferred rights can be accomplished by a mandatory conversion of all outstanding preferred shares to ordinary shares, which results in all existing investors sitting pari passu with founders and other holders of ordinary shares.
Mandatory conversion of preferred shares (in most standard conversion clauses contained in shareholders’ agreements) is triggered by the vote of majority of the preferred shares, although thresholds may be higher based on the outcome of negotiations from previous rounds.
Building the consensus necessary for a majority to vote in favour of the mandatory conversion is a rather contentious process. Emotions and tensions tend to run high as the decision will invariably result in a misalignment of interest between existing investors that have decided to invest in the down round, and others who may believe the down round represents a false dichotomy and there may be better offers available to fund the company.
We have seen this divide on almost all down round transactions we have advised on, and unfortunately in a few cases a deal was not struck before the final dollar of the company’s cash was spent. This resulted in a total breakdown in decision-making, a cash-starved business, and ultimately the forced dissolution of the company.
It is therefore imperative that existing investors and the company’s board of directors appreciate the potentially nuclear outcomes if they vote ‘no’ on a down round financing, bearing in mind the board’s duty to have searched for better terms if it was able to do so in the circumstances.
This type of [distress] raises the spectre of company failures because, unlike in markets that have seen down-cycles come and go before, our venture ecosystem is going through a down-cycle for the first time. Unless stakeholders work proactively, collaboratively, and promptly to find satisfactory outcomes, the alternative is inertia, paralysis and an inevitable death spiral.
Recalibrating liquidation preferences
The liquidation preference right is a 1x non-participating preference, which typically means a payment to the investor equal to the higher of the amount invested, or the amount that would be distributed on a pro rata basis. An investor’s liquidation preference amount is calculated by multiplying the number of shares held by the investor by the price per share at which that investor invested (the 'original subscription price per share'), which, unless an investor has disposed of some of their shares, would equal the total amount they originally invested.
In order to achieve a more appropriate balance on liquidation preference payouts between existing investors and new investors in the down round, it is common to reduce the liquidation preference payout to an amount that more closely aligns with the company’s valuation at the closing of the down round. This is typically done by synthetically reducing the original subscription price per share to either match or better align with the current price per share in the Series B down round.
Reducing liquidation preference amounts for previous investors help avoid unbalanced payouts on a liquidation (or deemed liquidation) event, for example by having Series A investors receive 4x the amount Series B investors would receive. They also help keep the management team and employees, all of whom hold ordinary shares, incentivised by giving them a real opportunity to realise returns notwithstanding the liquidation preference payouts that rank ahead of them.
Adjusting anti-dilution rights
Anti-dilution provisions in shareholders’ agreements are included to protect existing investors from a reduction in the value of their shares. As an example, at the closing of its Series B financing, the company will issue shares at a price per share that is lower than the original subscription price per share paid by the Series A investors (and potentially at a price lower than the Series Seed subscription price per share), which implies that the valuation of the Series B financing is lower than the valuation from previous rounds.
This would then trigger the anti-dilution provisions (also known as an adjustment to the ‘conversion price’ or a bonus issue of shares), which would require the company to either:
- allot bonus shares to the earlier round investors, or
- adjust the conversion ratio from preferred shares to ordinary shares.
Both cases result in the existing investor receiving additional shares to compensate for its economic loss.
It is almost certainly a condition to the new investor’s investment that the existing shareholders waive their anti-dilution rights. This is required as anti-dilution rights will likely distort the cap table and the post-money ownership thresholds contemplated by the new investors.
Furthermore, the new investor will require that the original subscription price per share for the Series A and Series Seed preferred shares be reduced such that a future 'up' round at a valuation higher than the Series B valuation does not trigger the anti-dilution protection provisions (for example a Series C at a valuation that is higher than the Series B, but lower than the original Series A valuation).
Pull up/Pull through structures
In order to incentivise existing investors to invest, it is common to offer them what is commonly referred to as a ‘pull up’ or a ‘pull through’. A pull up incentivises existing investors by allowing them to convert their shares (which at that time would convert into ordinary shares or a lower ranking series of preferred shares pursuant to a mandatory conversion) into a more senior class of preferred shares.
At the risk of having their preferred shares mandatorily converted into ordinary shares (or a lower ranking preferred share), an existing investor is given the opportunity to invest its pro rata portion in the new Series B round. In return, they would then have their shares redesignated into a new (more senior) class of preferred shares with rights superior to those of the ordinary shareholders.
The pull up may also offer existing investors enhanced liquidation preferences, for example, senior preference that may be participating, a multiple higher than 1x, or a synthetically original subscription price per share for liquidation preference purposes. It may also offer them better protection with respect to anti-dilution rights, for example a narrow-based weighted average anti-dilution adjustment or a full-ratchet adjustment.
Fiduciary duty considerations
Navigating a down round involves significant fiduciary duty considerations for the board of the company. The board is obligated to act in the best interest of the company and the benefit of its shareholders by considering all available options to save the company. The directors will need to be appropriately engaged in discussions regarding viable turnaround plans and must carefully evaluate available alternatives to a down round.
The sponsors of a down round and their counsel will need to be very clear on what duties are owed by the directors of the company (and in some cases shareholders with management control). The applicability of local laws will also need to be considered and tested if any of the company’s directors are also directors of any of the company’s subsidiaries.
