Bloomberg Law
Nov. 14, 2022, 2:00 AM

ANALYSIS: As Down Rounds Loom, VC-Backed Companies Have Options

Andrew Miller
Andrew Miller
Legal Analyst

Venture-backed companies are feeling the negative knock-on effects of the uncertainty plaguing equity markets—which is expected to last well into 2023—on their own valuations. This impacts late-stage companies nearing initial public offerings, as well as their early- and mid-stage counterparts.

If a venture capital-backed company plans to raise capital in 2023, its managers are already likely considering alternatives to, and consequences of, issuing stock at a lower valuation than before, an act commonly known as a “down round.” To avoid the consequences of a down round, companies can offer enhanced rights to investors to justify propped-up share prices or extend an ongoing funding round. Alternatively, venture debt may be an ideal financing option that preserves shareholder equity.

Each of these options presents unique benefits and disadvantages that attorneys are well-suited to address.

Opportunities to Raise Capital Diminish

In light of a looming recession and geopolitical volatility, companies in 2023 should prepare for fewer opportunities to raise capital at propped-up valuations. The aggressive pace of venture capital deal activity in 2021 makes 2022 seem like a drought in comparison. But VC fundraising in the first three quarters of 2022 still produced 6.4% more deals—and 23.7% higher total deal volume—than in all of 2020, and has surpassed 2019, 2018, and 2017.

With 2022 poised to be the first year that VC fundraising volume doesn’t increase year-over-year, there’s uncertainty as to whether the overall historical upward trend will continue into 2023.

Identifying Contractual Risks

Attorneys advising VC-backed companies should keep an eye on the unique risks that arise when the value of client-companies decreases between financing rounds. Analysts informed by trends seen following the dot-com and financial crises of 2000 and 2008 anticipate that a record number of private companies will be forced to consider down rounds in 2023.

Down rounds are generally disfavored and regarded by some as “horribly embarrassing” and likely to harm a company’s reputation, ability to raise future capital, and appeal to top talent. Considering that the value of VC-backed businesses can be heavily weighted down by negative trends in the public market, the truth is that a down round isn’t necessarily indicative of a company’s pending failure. Reputational concerns aside, down rounds may trigger price-based anti-dilution provisions designed to protect preferred shareholders by increasing the number of common shares each preferred share is convertible into, without requiring new consideration from both parties.

Price-based anti-dilution provisions typically fall into one of two categories, “full ratchet,” or “weighted average.” The effect of full ratchet clauses is relatively straightforward—they grant shareholders the right to convert preferred shares into a number of common shares based on the lower share price in the new round rather than the original investment price. Alternatively, the effect of weighted-average anti-dilution provisions depends on the magnitude of the aggregate amount raised and the share price in the new round compared to the outstanding shares of common stock.

Regardless of the precise mechanics, anti-dilution provisions inherently magnify the dilutive effect of subsequent funding rounds on existing shareholder equity, so it’s important to know whether investors would consider waiving them.

Earning Buy-in With Enhanced Contractual Rights

Anti-dilution provisions and related shareholder rights can be negotiated if a company wishes to enter a new round of fundraising with a lower, flat, or increased valuation, or for the extension of an ongoing round. By enhancing certain contractual rights, companies can convince investors to waive anti-dilution rights, extend ongoing rounds, or even pay a higher share price despite adverse economic trends.

Recently, companies have successfully negotiated favorable terms by enhancing preferred shareholders’ rights to include warrant coverage, liquidation preferences of 2x to 3x compared to typical rates of one to one, or accruing dividends participating preferences.

Alternatively, rather than initiate a new fundraising round, which may warrant a revised valuation, a company may simply continue an ongoing round. Investors commonly allow for the extension of a round when a company has yet to achieve performance benchmarks already set. Extensions keep valuation and contractual terms static.

Though disfavored, a down round may be the right move for a company that needs the capital and has yet to grow into a previously established valuation. Provided a down round is in a company’s best interest, investors are regularly willing to engage with counsel to reduce or waive anti-dilution rights.

Obtaining Venture Debt

The use of debt is a primary alternative to the sale of equity that allows current owners to avoid dilution of their equity and ownership rights, and we’ve already seen an increase in venture debt this year. Venture debt is typically issued within several months of a prior round to companies that have already raised more than $5 million in a single round.

Some analysts expect the use of venture debt to continue to increase in 2023, but rising interest rates may keep usage low. Like down rounds, the use of debt can frustrate some investors who view the use of debt as an undisciplined means to postpone inevitable collapse. (Note that venture debt has unique attributes that distinguish it from typical loans. It’s advisable to pay close attention to the events of default set out in loan documents and the lender’s history working with distressed debtors.)

In 2023, companies should be prepared to make swift decisions regarding the best source of funds. Some companies may sidestep the need for a revised valuation by extending an ongoing round, while others may obtain loans to forgo fundraising rounds altogether. Counsel will provide vital support for their client-companies by explaining contractual obligations and finding solutions that satisfy investors.

Access additional analyses from our Bloomberg Law 2023 series here, covering trends in Litigation, Transactional, ESG & Employment, Technology, and the Future of the Legal Industry.

Bloomberg Law subscribers can find related content on our M&A Deal Analytics resource.

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