The Perils of a 'Down Round' Financing

When entrepreneurs work with equity investors to structure an angel or venture capital round of financing, most have to agree to an anti-dilution provision in the term sheet. This provision is meant to protect investors if the company's valuation is reduced in the next round of financing. (Such a round is known as a "down round.") Unfortunately, because of the recession and plunging markets, management at many companies will have to decide whether or not to pursue a down round to raise additional capital at some point in the near future.

How do down rounds work? Consider this example: The founders of ABC Corp. raised $1 million two years ago in a Series A round with venture capitalists at a $5 million valuation, giving up 20% of the company's equity. The investors received 1 million shares, resulting in a price of $1 per share. Since then, ABC has encountered various problems, and its valuation has fallen to about $3 million. To keep things moving ahead, the company needs to raise another $3 million. Assuming there is no anti-dilution provision, the founders will suffer a reduction in their equity stake from 80% to 45.7%.

Of course, things get much worse if there is an anti-dilution provision in the agreement. The impact depends on the type involved. There are two common types of anti-dilution provisions:

1. Weighted Average: This includes two flavors, the "narrow weighted average calculation" and "broad-based weighted average adjustment." They will reduce the founder's ownership by 40% to 37%, respectively (the calculations require a sophisticated spreadsheet). More detail on the differences between the two is available in my previous column.

2. Full-Ratchet: Here, the Series A investor will get the same price as the Series B investor, which has a more punitive impact on the founders. The ownership stake will fall to 33.3%.

Something else to consider: The Series B round of financing is likely to have an assortment of harsh provisions in the term sheet. Pay attention to the following four:

1. Liquidation Preference: This means that the investor will receive the initial investment back before any other shareholders get anything. But in the case of a down round, an investor may want to get a liquidation that protects the investment at a 2X, 3X, or even 4X multiple. Consequently, in the case of ABC, the founders will need to sell the company for at least $18 million to get any proceeds (this is at a 3X multiple). Interestingly enough, the Series A investor may also have its own liquidation preference. In light of this, it's imperative that the founders negotiate hard to keep the multiple at 1X.

2. Anti-Dilution: The Series B investor will try to get a full-ratchet provision. However, it's worth pushing for a weighted average anti-dilution variety. Or, if the investors are insistent on a full-ratchet, see if you can get a time limit, say one year or so.

3. Drag-Along Rights: With this, the Series B investors will have the right to sell the company and essentially force the rest of the shareholders to go along. It's certainly a powerful tool, especially when there are large liquidation preferences. That is, the Series B investors may sell the company for an amount under the liquidation preference and still make a bundle. Of course, the remaining shareholders will be left with nothing. While it would be good to negotiate away the drag-along rights, it could prove difficult. This is why the founders need to focus on the liquidation preference.

4. Tranche Investing: This means that the investor will release portions of the capital to the company based on milestones. But defining the milestones can be difficult and, as a result, the investor may have an out on further commitments. No doubt, this can put a company in a vulnerable position. So it's advisable to negotiate for a full-funded round of financing instead.

Given the foregoing, it's clear there is little advantage to a down round. Simply put, there will be blood. That's why a company's management needs to consider all its options. For instance, it might make sense to sell the company, even if the gain is minimal or nonexistent. Another approach is to put the company into hibernation mode. This means radically reducing expenses, leaving just a minimum to keep the lights on. In the meantime, the company can continue to slowly build a customer base and a brand.

However, if these options don't make sense, the company needs to tread carefully if it takes a down round. Needless to say, the Series A investors will be angry because they will have suffered major losses on their investments. In some cases, there may even be a shareholder suit, which can be expensive and even scare off the Series B investor.

With this in mind, entrepreneurs considering a down round need to retain experienced counsel and even a third-party valuation firm. (Disclosure: I'm the founder of, which is a valuation Web site focused on small businesses.) It's critical they be forthcoming and transparent. They should also work hard on updating their business plan. The key question to answer: Will the down round really provide enough money to get the company back on track?

All in all, the decision to accept a down round is complicated and distressing. Based on realistic projections, if it's not possible to get more value than the liquidation preference, then it's probably best to try to sell the business, go into hibernation, or even wind down operations. Yes, it's a tough decision to make. But given the harsh economic environment, it's something many companies that depend on equity funding must deal with—probably sooner than later.

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