Traps Management Should Avoid in a Down-Round Financing

Traps Management Should Avoid in a Down-Round Financing

The recent economic downturn is forcing smaller emerging companies in need of capital to make some difficult decisions. For companies having trouble finding new backers or convincing existing investors to inject additional capital, down-round financings can be the best available strategic solution. However, given the myriad of legal issues that can arise, management must take steps to minimize their liability risks.

Understanding Down Round Financing

The term “down-round financing” refers to financing at valuations of a company below the valuations it received in prior rounds of financings. In the new capital raise, the company issues securities at a lower price per share, for example, at $8 when the shares of the prior round were issued at $10 per share.

Because of the lower valuation, the equity outstanding immediately before the down round may experience significant dilution. While down rounds can create issues that concern employees and existing investors, they also create structuring issues for the issuing entity, its directors, and controlling shareholders, including issues of conflicts of interest and risks of shareholder claims.

Key Board Considerations

There are a number of implications for a board of directors to consider when contemplating a down-round financing, including how the transaction will impact the issuer, its employees, consultants, shareholders, creditors, and new investors. The board’s fiduciary responsibilities and the issuer’s need for new monies also give rise to a number of additional considerations, such as technical and adoptive process issues and structuring considerations. These include: 

• How does a down-round financing affect employees and consultants who hold company stock, options, or stock appreciation rights (SARs)?
• What are the potential board conflicts that arise in down-round financing, and what steps can management take in mitigating against the risks of shareholder, option holder, or creditor actions?
• How do various anti-dilution provisions affect financing structures?

Employees and consultants often have a financial interest in the company via stock options or other equity awards.  These are often-used, important tools for hiring and retaining key personnel and consultants. A down-round financing reduces the value of employee stock awards and lessens the likelihood of the type of  profitable cash out that they envisioned when they joined the company. To compensate for a down-round reduction, the company would likely need to offer additional equity awards or a management carve-out plan to prevent key employees or important consultants from looking for greener pastures.

While directors have fiduciary duties to their shareholders, they may also have conflicts of interest in how they deal with a down round.  This can result in litigation brought on behalf of earlier investors, creditors, or shareholders aggrieved by the down round. Companies can seek to mitigate the risks of litigation and to insulate themselves from certain claims by the appointment of an independent committee and having an independent appraisal evaluating the proposed transaction, followed by a disinterested stockholder vote, or a structured rights offering for existing shareholders to accommodate the perceived loss of value in a down round.

While the down-round financing may be unavoidable, it can be further complicated by anti-dilution provisions in agreements that favor creditors and preferred shareholders.  These complicated formulaic anti-dilution provisions may allow the creditors and shareholders who have such provisions in their agreements to receive a more favorable conversion rate and enhanced voting rights as a result of the proposed down-round financing. Management should maintain open lines of communications with the leading shareholders and creditors, in order to lessen the need for negotiations down the line and to avoid litigating later.

Considering Alternatives

While time is of the essence when securing funding, it is imperative to explore all of your options. In some cases, financing may be available under more structured terms or from outside investors. Additional funding alternatives include convertible debt financing,  mergers, asset sales, and liquidation.

Boards should carefully document the decision-making process. The written record should reflect the analysis conducted and conclusions reached at each step of the process, including guidance provided by legal and financial advisors. This not only helps ensure that the board is making the best decision for the company, but can also help insulate it from liability.

Key Takeaway for Companies Considering Down-Round Financing

In difficult economic circumstances, down-round financing can be essential to a company’s survival. In the months to come, the stigma around such funding is likely to decrease as more and more companies are faced with fundraising challenges. Nonetheless, the legal issues implicated by down-round financing will remain, making it essential to consult with experienced corporate counsel. The attorneys of Scarinci Hollenbeck’s Corporate Transactions & Business Group understand how best to navigate the issues involved in down-round financing. With decades of combined experience advising startups and emerging private and publicly traded companies, we can also help businesses explore other alternatives to determine the best strategy for your unique circumstances.

If you have questions, please contact us

If you have questions or if you would like to discuss the matter further, please contact me, Dan Brecher, or the Scarinci Hollenbeck attorney with whom you work, at 201-896-4100.