COVID-19 has put pressure on startups that might not have the cash reserves to make it through lockdown unscathed. To stay afloat, many startups may turn to venture capital-type financings to get access to much-needed funds. As during the previous recession, many startup founders and their companies’ boards may need to resort to down-rounds to keep their companies alive in the wake of COVID-19.
What Is a Down Round?
When all goes well for a startup, it will have a higher valuation in each subsequent round of financing. For example, a company could be valued at $5 million for its Series A, $8 million for its Series B, and $15 million for its Series C. A down round is when the company accepts a lower post-money valuation than at its previous financing. For example, valuing the same company at $13 million for its Series D would be a down round.
While down rounds aren’t ideal, raising money at a lower valuation is often necessary to keep startups running — especially in a recession. The goal would be to use the funds, though expensive, to weather the storm and live to fight another day.
Additional Down Round Terms
A down round may be more likely to have unfavorable terms for the company seeking financing and its existing stockholders. For example, down rounds might come with the following protections for new investors and penalties for existing investors:
Milestone payments. Instead of the startup getting access to 100% of the invested funds immediately after closing, investors may release funds when the business hits certain milestones. For example, the company might get only 25% of the cash after closing. Investors may distribute the other 75% after the business hits targets for revenue, customer acquisition, or product development. We see this most often in life sciences venture rounds, but are now seeing this in tech company financings. This is great for the investors (they have the valuation locked in, but are able to reduce their risk), but not so great for the company and its existing equity holders.
Pay-to-play. Pay-to-play provisions require current investors to participate in future financings or lose some (or all) of their preferential rights.
Forced conversion. Investors may compel existing holders of convertible securities to convert to common stock. Sometimes existing stockholders can be forced to convert into common stock or other equity securities on a less than 1 for 1 basis, resulting in potentially catastrophic dilution.
Existing investors who purchase their full pro rata portion of the round will usually avoid any forced conversion and other penalties. Lower valuations and other provisions unfavorable to previous stockholders may result in lawsuits based on breach of fiduciary duties. So board members need to be careful not to violate their fiduciary duties in approving such transactions.
Down Rounds and Fiduciary Duties
Corporate board members owe fiduciary duties of care and loyalty to the corporation and its stockholders. If a financing round has more investor-favorable terms and a lower price than a previous round of financing, earlier investors may claim that directors are breaching their fiduciary duties by approving the transaction, especially if existing investors are significantly penalized for not participating. Essentially, these investors claim that it’s not fair that they bought at a high price, only for the company to subsequently sell shares at lower prices and further penalize the existing investors.
The Business Judgment Rule
If a down round is approved by a fully-informed majority of disinterested directors exercising due care — or disinterested and informed stockholders — courts typically defer to the board and won’t interfere with the decision to accept financing, even if on awful terms. This deference is called the “business judgment rule.” That rule is a presumption that, in making a business decision the directors of a corporation acted on an informed basis, in good faith, and in the honest belief that the action was in the best interest of the company. The business-judgment rule insulates directors from liability if the directors acted in good faith, without conflicts of interest, and they did what they believed to be in the best interest of the corporation. If a plaintiff can show a conflict of interest or a breach of the duty of care, the burden shifts to the directors to show the entire fairness of the transaction (fair price and fair dealing).
How Startup Boards Can Protect Themselves During Down Rounds
While the business judgment rule helps protect companies when a fully-informed majority of disinterested directors or stockholders approve the transaction, courts often find that parties have a conflict of interest even if they’re not directly affiliated with an investor in the down round. With fewer disinterested directors, getting majority approval becomes more difficult.
To help get the benefit of the business judgment rule and prevent successful shareholder litigation, businesses agreeing to down rounds (especially pay-to-play rounds) should take the following precautions:
Appoint a special committee of disinterested directors to approve the down round.
Get the approval of as many directors and stockholders as possible (providing detailed information).
Offer existing investors the right to participate pro-rata in the down round.
While these measures won’t always preclude stockholder lawsuits, they increase a startup board’s chance of closing a down round with success and reduce the risk of a successful stockholder suit.