Navigating Down Rounds in the UK Venture Capital Landscape

Posted Monday 4th September 2023

Not so long ago, record valuations were the norm. Now, due to current market sentiment, down rounds have become more common than the fundraising community has seen in nearly half a decade. According to research from Carta, 20% of venture investments in the first quarter were down rounds, the highest proportion since at least 2018. With current market conditions making down rounds more of a necessity for many start-ups, we take a closer look here at down rounds, their implications and some of the alternatives a company may wish to consider.

What is a down round?

Private companies raise money through a series of investment rounds. In a perfect world, each investment round is expected to have a higher price as the valuation of the company increases. However, things do not always go as planned. A down round occurs when a company raises a financing round of investment and the pre-money valuation of the company is lower than the post-money valuation of the previous round. Down rounds are typically viewed in a negative light. In the context of equity fundraising transactions, the occurrence of a down round can significantly impact both investors, founders and employees.

A down round occurs for various reasons, and they often reflect a complex interplay of factors within the company and broader economic environment. Here are some of the reasons why down rounds happen:

Failure to meet investors earnings target: If a company fails to reach the necessary milestones, investors’ growth forecasts will have to be revised downwards as well as the company’s valuation.
Deteriorated competitive environment: If new competitors have emerged for a company, the expectations of its ability to obtain market share will also weigh on valuation.
Tightening of general funding conditions: Lower investor appetite for private company equity will decrease valuations across the board.

What are the legal implications of a down round?

The main implication of a down round is the triggering of anti-dilution protection in the company’s articles of association. Typically, existing investors will hold a different class of shares from founders and employees. Amongst other different characteristics, the main difference between ordinary shares is anti-dilution protection. The way that the anti-dilution provision works is that if the Company issues new shares at a lower price per share than the investor had originally paid for them (provided the investor does not waive its right), the company is obliged to issue additional new shares to the investor. This is known as the anti-dilution ratchet and the investor will be diluted less than the other parties on a down round. This is usually done at the expense of the founders’ shareholding.

The three main types of dilution are:

Full ratchet. This mechanism effectively rebases the subscription price originally paid by an investor to the new down round price. It works by establishing the number of shares an investor would have received for its investment amount if it had paid the down round price per share.
Narrow-based weighted average ratchet: This mechanism reduced the subscription price originally paid by an investor to an average share price across the subscription rounds. It takes into account the relative number of shares issued at the down round price compared to the number of shares in issue before the down round issue.
Broad-based weighted average ratchet. This mechanism reduced the subscription price originally paid by an investor to an average price based on the fully diluted share capital of the company following the down round issue. The term “fully diluted” includes all shares in issue together with all outstanding options, warrants and other rights to subscribe for shares in the company, plus the down round shares.

It is useful to consider worked examples of how each ratchet would operate in practice. In short, the full-ratchet is considered to be investor friendly, the narrow-based weighted average is considered to be the middle ground, whereas the broad-based weighted average ratchet is seen as founder-friendly.

There are other considerations to note such as how investor rights and preferences might change going forward as a result of the down round. Here are some of the rights and preferences that the investors might ask to include:

Higher liquidation preferences: This is the multiple of the investment that an investor would be paid back in the event of a sale.
Pay-to-play provisions: This is an important economic term that is relevant in a down round financing and ensures that investors must keep participating pro-ratably in future financings in order to not have their preferred shares converted to ordinary shares in the company. It causes the investors to agree to support the company during its lifecycle. If they do not, the shares they have will be converted from preferred to ordinary shares and they stand to lose the rights associated with the preferred shares. Another way to think about pay-to-play is that it reshuffles the future preferred shareholder base by ensuring that only the committed investors continue to have preferred shares and the corresponding rights that go along with preferred shares.
Most favoured nation clauses: This allows the investors to take the benefit of preferential terms negotiated by other investors. It is a controversial provision and will be less appealing to new investors and for this reason is often resisted by the company but in the context of a down round the bargaining strength is in favour of the investor.

Other considerations to note include:

Trust and confidence

Down rounds can strain the trust and confidence that investors and the board have in a company. Investors who participated in earlier rounds at higher valuations may feel disappointed and may question the management team’s ability to execute the business plan effectively. In some cases, investors may become more involved in the company’s operations, seeking to exert greater control to protect their investments. This increased scrutiny and interference can be distracting and cumbersome for the founders and management team, making it challenging to execute their strategic vision without constant oversight.

Motivation and Control

As discussed above, one of the most significant consequences of a down round is the potential dilution of the founders’ ownership stake. As additional shares are issued at a lower valuation, founders may find themselves owning a smaller percentage of the company. This loss of ownership can be demotivating for the founders, as they may feel less personally invested in the company’s success. Furthermore, a significant dilution of founder ownership can result in a loss of control over critical decisions and strategic direction. In early-stage companies, the founding team and key employees are often the driving force behind the company’s vision and execution. Losing control over these crucial aspects of the business can be disruptive and hinder the startup’s ability to navigate its challenges effectively.

Employee Morale

Down rounds can have a cascading effect on employee morale, which is pivotal to a company’s success. Employees often hold options on common stock, and a down round can substantially devalue these options. As a result, employees may face the prospect of their equity holdings being worth significantly less or even underwater. This not only affects their potential financial gains but also dampens their motivation and commitment to the company. The combination of reduced financial incentives and uncertainty about the company’s future can lead to decreased morale, increased staff turnover, and a challenging work environment, all of which can hamper the company’s ability to retain and motivate the talent pool.

What are the alternatives to a down round?

There are alternatives to a down round, but it is important to consider whether the options are appropriate in the circumstances. Companies can also look to bring in money through different avenues such as short-term, bridge financing, venture debt, accelerated multi-year revenue deals with upfront cash payments, government incentives or shared revenue agreements. There is also the option to renegotiate with their original investors. The terms of the down round can be renegotiated, for instance by mitigating the anti-dilution protection, or by exchanging these rights for other investor perks, such as upside protection. Investors that are close to the founders and believe in the company are likely to be more supportive, so from a company perspective, it is very important to communicate with the investor at all times.

Conclusion

Down rounds, though challenging, are not uncommon. Navigating the legal intricacies of down rounds requires a comprehensive understanding of existing agreements, regulatory obligations, and investor, founder and employee dynamics. Be sure to engage legal counsel at an early stage to help safeguard stakeholder interests while maintaining the health and growth potential of the company.

This article is for reference purposes only. It does not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking or deciding not to take any action.