Coping with Down Rounds
Times for VC fundraising are tough. Led by a decline in listed stocks, the private markets have equally been caught by bearish investor sentiment and lower valuations. Later stages, where public valuations are a more important benchmark, are particularly affected, but investors in seed and series A rounds have become a lot more selective too. What used to be a virtue (high growth, high burn) has become a vice, and what used to be boring and uninspiring (profitability and time to break-even) has become all the rage.
Lucky those with long runways and/or “AI allure” (or solid and steadfast investors like Point Nine!). Absent any rapid turnaround in market sentiment, everybody else will eventually have to deal with the new reality. From a process perspective, this may well mean the encounter with “bad practices” like reopening signed term sheets, drawn-out due diligence periods and the sudden trimming of funding commitments, which were an anathema not long ago but have become much more frequent since early 2022[1].
In this post, we want to focus on what ultimately defines a distressed funding round: poor commercial terms. In today’s market, down-rounds have gotten a lot more common and have (more or less) lost their “stigma of failure”. Yet not just (really) low valuations but also certain notorious contractual terms have become a lot more common. Based on our experience, especially the following “special instruments”, which were mostly outlawed before 2022, are increasingly thrown into the ring to give extra value and/or protection to investors:
- Liquidation preferences beyond the standard 1x non-participating
- Upgrading of lower-ranking shares held by participating investors
- Earn-out-like structures based on performance
- Exit-driven price adjustments
Founder beware!
Before talking about these instruments in more detail we want to provide some context. At Point Nine we are NOT a fan of this kind of “contractual engineering”. Special investor protections can easily
- generate legacy risks that complicate further funding rounds and, in a worst case, deter future investors;
- misalign incentives and divert attention from maximising value for all stakeholders;
- lead to convoluted contracts, higher costs and substantial delays.
Still, as a founder you may be confronted by demands for such terms and may have to take them more seriously than in the good old days. Sometimes, there may be no other way, but we want to make sure you are aware of the dangers of these “investor specials” and how to push back. First and foremost, it may be possible to rejig your planned funding in favor of
- a scaled-down round excluding the aggressive investor; this will mean a shorter runway, but may be sufficient to strengthen your company’s operational and financial position and allow for a bigger raise at better terms later; or
- a convertible instead of a fully-fledged funding round — which we’ll talk about in more detail below.
If neither a smaller (but straightforward) equity round nor a convertible is a possible way out, you should carefully weigh the (huge!) costs of most contractual engineering against a somewhat lower valuation. Based on our experience, in almost all cases coming clean in a straightforward down-round will in the long run be better for all shareholders, even if this means greater dilution and more far-reaching changes to the ESOP.
Funding tool
In many cases, especially for internal rounds, the best and easiest way to avoid or at least mitigate a distressed round is a convertible (or SAFE). Besides its well-known advantages in terms of timing and costs, a convertible can help bridge the gap between the valuation expectations of existing holders and what the investor is willing to pay (without special rights).
This is because the (implied) valuation of a convertible is not just determined by the so-called “cap”, i.e. the maximum valuation at which a convertible converts even if the valuation of the relevant funding is much higher. In addition to the cap, the convertible investor retains the option to convert below the cap if the conversion round is priced at a lower value (with or without discount). In contrast to a straight equity round the convertible provides more downside protection.
This means investors may be willing to set the cap somewhat higher than the valuation of the company in an alternative equity funding. If things go according to plan and the convertible is converted in a higher-priced round, the negative consequences of a down round (first and foremost the issuance of anti-dilution shares and adjustment of employee incentives) have not just been avoided, but the overall dilutive impact of the conversion shares will generally be lower than if the shares had already been issued in an earlier down round (because of the somewhat higher cap).
Of course, this comes at the “cost” of greater dilution in a scenario where the conversion valuation falls below the cap, but given the realistic possibility of avoiding a down round altogether, this risk seems worth taking.
Deal terms
Yet a straight convertible (or SAFE) may not always be possible. A new investor may want to get on the cap table right away for governance and other reasons. He may also want to lock-in certain terms in his favour rather than relying on a side agreement to a convertible providing such rights at the time of conversion, making a (more cumbersome and dilutive) equity round unavoidable.
This is hardly a catastrophe per se but becomes tricky if combined with the aforementioned special investor demands — which are more likely to be tabled if there is a full negotiation of funding terms, but of course can also be appended to a convertible/SAFE. Either way, here is an overview of the most notorious terms and how to push back:
1. “Privileged” liquidation preference
A liquidation preference with more beneficial terms than the standard 1x non-participating preference[2] is probably the most common instrument to provide extra value to the holders of the privileged shares. It comes in two varieties:
The more dangerous one is a participating preference, which means the investors always get their investment (or even a multiple thereof) in addition to what they get in a pari passu distribution (i.e. there is no catch-up). You should try to avoid such a participating preference like the devil avoids holy water, as it will inevitably lead to a 1:1 valuation discount in subsequent funding rounds. It also brings the significant risk that later investors will ask for the same, adding complexity to the cap table and hurting all existing holders — something that investors often don’t fully appreciate.
The alternative is bumping up a non-participating preference from the standard one times to, say, twice the investment. This may seem less problematic than a participating preference because such a preference becomes irrelevant if things go well as other shareholders will eventually catch up in terms of proceeds per share.
Still, a non-participating preference, just like the participating variety, is treacherous because it misaligns incentives, tends to attract copycats in later rounds and signals distrust of existing investors. Exorbitant liquidation preferences might have a purpose in large private equity-style deals to avoid a wash-out, but should be kept away from growth-oriented venture investing if at all possible.
2. Upgrade existing investor shares
Another conceivable “use” of the liquidation preference to reward an existing investor willing to support a company in a difficult situation is upgrading her existing shares. This only plays a role where there is a waterfall amongst preference shares (or where such a waterfall is to be introduced as part of the funding round), i.e. one or several later-stage class(es) of preference shares (e.g. series C and higher) rank senior to earlier series (esp. seed shares). For founders such a measure would be neutral as the ranking in the waterfall is a matter of allocation amongst preference holders and does not affect the proceeds allocated to holders of common shares.
Upgrading the investor’s earlier shares means additional proceeds for the investor in case of a distressed exit at the expense of the non-upgraded shares. It’s a bad idea not just because of the accompanying whiff of distress, but also because it punishes the early investors (especially angels and seed investors), for whom investing in late-stage rounds generally is not a realistic possibility.
3. Financial milestones
An investor may argue that she cannot pay a full price because of the increased uncertainty over the company’s ability to meet its financial targets. The obvious way to address this is the introduction of a threshold or milestone which, if missed by the company, leads to a (downward) adjustment of the round’s valuation.[3]
While the idea may sound conceptually sound, it rarely works in practice. To make the exercise halfway manageable, you’d have to keep the number of milestones small, preferably limited to one (e.g. ARR). But this will inevitably lead to misincentivisation in favour of the metric, e.g. towards generating revenues regardless of the cost. Introducing additional parameters, such as EBITDA, will turn the exercise into a complex case of financial engineering looking outright strange in a venture round.
You should therefore rather accept a (moderate) valuation discount and keep your funding docs clean than start negotiating and defining financial benchmarks. Keep in mind: A good investor should be able to assess the quality of the founding team, the existing operations and the prospects of the business as a package. There will inevitably be uncertainty, not just around the business plan. It’s the art of venture investing to deal with this by finding a valuation that adequately reflects the opportunities and risks of the investment (or not investing at all). Introducing an element of financial engineering simply with the argument of elevated uncertainty does not chime well with this basic premise.
4. Exit-driven price adjustment
If your company is already reasonably close to an exit you may face a request for an adjustment mechanism that links a potential price adjustment to the valuation of the business in an ultimate sale or IPO. If, say, the selling price is less than twice the price paid by the investor in the funding round, that price is adjusted by, say, 10%.
The investor(s) might argue that an exit-driven adjustment is straightforward to implement and pushes out the “time of reckoning” to when it really matters. You may also find comfort in the fact that an exit without support by the (managing) founders is hardly conceivable, giving you full control over whether and when such an adjustment mechanism becomes relevant.
Still the whole thing is dangerous: There will generally be no certainty that the next big move will indeed be an exit because in most cases, if you’re indeed close to an exit, you’ll hardly need an amount of additional funding that might merit this type of financial engineering. If you end up having to do more funding rounds the exit-driven adjustment clause quickly becomes a burden with the potential to confuse or, in a worst case, deter new investors.
Of course there will likely be plenty of similar clauses already (e.g. anti-dilution protections and liquidation preferences), but these are better known in the market and future investors can easily protect themselves by requesting customary equal treatment. In contrast, you would definitely not want an exit-driven price adjustment to turn into a precedent in later funding rounds.
A few concluding thoughts
As an early-stage investor we (Point Nine) are clearly not unconflicted when it comes to assessing the structuring tools discussed in this post. We still believe that our thinking largely aligns with how founders should approach the topic (one of the reasons why we like early-stage investing so much). We also think that many of the arguments against the various instruments should also resonate with the investors requesting them. Ultimately, all stakeholders have an interest in keeping the funding documentation clean and avoiding bad signaling. Conveying a sense of doubt, which most structuring inevitably does, hurts the investors benefiting from the relevant clause just as much as everybody else.
We do recognize that investors who are willing to invest in a difficult situation do not want to look foolish and may feel entitled to additional protections. This argument is not invalid, but the right way to deal with it is an adequate — small — adjustment of the valuation (cap in case of a convertible or SAFE), not elaborate contractual engineering in favor of certain stakeholders.
As a note of caution: Every situation is different and there are no rules without exception, so what we convey here should not be understood as a “Point Nine axiom”. If you have an investor at hand who is — hypothetically and unrealistically — focused entirely on downside protection and willing to pay 100% more than any other investor in return for a 2x non-participating liquidation preference, this may of course be worth considering. Generally though, things do not work out this way.
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[1] There’s little founders can do to avoid this unless they’re able to create competition amongst several investors or fall back on a reliable shareholder base, but at least there is a simple way to alleviate the associated risks: Leave ample time for the funding process so you don’t risk an immediate cash crunch if the investor(s) start playing games, and make sure the financial plan you present is rock-solid.
[2] At Point Nine we’re generally skeptical of liquidation preferences even in the most benign form and hence rank them towards the bottom relative to other terms typically agreed in VC funding rounds.
[3] Really just a footnote which will hopefully never become relevant: If a milestone mechanism was to be introduced the typical technique to do this is the issuance of additional shares to the investor(s), thereby lowering the overall purchase price to the desired level. Alternatively, adjusting the conversion ratio used to convert preference to common shares can achieve the same result, but without the need to implement another capital increase, although this only makes sense where a conversion mechanism is customary and provides the same legal certainty as the issuance of real shares (i.e. primarily in the US where the conversion mechanism is a common part of the articles).
