INSIGHT: Minimizing Risks in Down-Round Financing During Covid-19

No one can predict the long-term economic impact of Covid-19, but early indications show similarities to the 2008 economic downturn, when venture capital investment decreased significantly both domestically and abroad and the decrease in available capital led to a significant uptick in financing rounds at lower valuations than in previous rounds, or so-called “down-round financings.”

Companies should be prepared for a similar occurrence and be ready to take precautionary steps to minimize risks relating to a down-round financing.

A Down Round

If a company will need capital in the near future, it should be continuously searching for capital sources long before that need becomes dire.

If, after careful consideration, a company believes that a down-round financing is the best (or only) available option to obtain necessary funding, it should be aware that the lower valuation and frequently onerous terms of a down-round financing—which can include tranched payments based on company milestones, pay-to-play provisions, forced conversion of non-participating current investors from preferred stock to common stock and loss of important rights by non-participating investors—could cause existing stockholders to engage in litigation.

Generally, such claims will center on a breach of a fiduciary duty by the company’s directors, particularly when the down-round financing is led by existing stockholders of the company.

Fiduciary Duties

The vast majority of venture-backed companies are Delaware corporations, and under Delaware law, each director owes fiduciary duties of good faith, care and loyalty to the corporation and its stockholders. The Delaware courts made it clear in the Trados case that the fiduciary duties are owed to common stockholders, not preferred stockholders.

Because a down-round financing usually results in significant dilution to common stockholders, it is important that the board of directors carefully exercise its fiduciary duties in order to minimize potential liability.

In particular, in a down-round financing led by existing stockholders, a transaction approved by the majority of the disinterested directors or, where there is no controlling stockholder, a majority of the disinterested and informed stockholders, will receive the benefit of the business judgment rule, which directs a court to show deference to the decisions of the company and assume that the directors acted in accordance with their fiduciary duties. Where the business judgment rule applies, the burden to prove a breach of fiduciary duties is on the plaintiff.

In contrast, where the business judgment rule does not apply, the Delaware courts will apply the entire fairness standard of review, which places the burden on the defendant company to prove that the price and course of dealing between the parties were fair, a much more burdensome and expensive proposition for a company.

Further Precautionary Steps

Obtaining the approval of disinterested directors or disinterested and informed stockholders is highly desirable, but Delaware courts have complicated the process by broadly construing the concept of a conflict of interest and have found a conflict of interest even when a director or stockholder is not affiliated with an investor.

As such, it is wise to take further steps to minimize litigation risk. One such step is for a company to appoint a special committee of the board comprised entirely of disinterested directors to make an independent determination with respect to the financing. A special committee is especially prudent in a case where existing investors, particularly those participating in the financing, hold a majority of the board seats or otherwise have the ability to block or influence a board decision.

Another way to limit the risk of litigation is by conducting a rights offering, whereby all current investors in a company are allowed to participate on a pro rata basis at the same price and on the same terms as the investors proposing the down-round financing. This mitigates the argument that the existing stockholders were unfairly diluted by an incorrectly priced financing because they have the opportunity to benefit from the depressed valuation.

However, rights offerings are imperfect solutions because not all existing investors will have the liquidity to be able to participate, and most rights offerings are limited to accredited investors to avoid securities law complications. Moreover, in a recent unpublished bench ruling, the Delaware Chancery Court found that a rights offering does not necessarily preclude all claims for breach of fiduciary duty.

Closing the Deal

For a company looking to obtain funding through a down-round financing, we recommend the following steps be taken to minimize any potential liability to the company and its directors:

• Appoint a special committee of disinterested board members to review, negotiate and approve the transaction;
• Start looking for alternative funding sources early and carefully document those efforts;
• Find an outside third-party investor to lead the round, but be mindful of the broad interpretation of conflicts of interest when determining if such outside third party is truly independent;
• Engage in a rights offering whereby current investors are afforded the opportunity to participate in the current financing;
• When feasible, obtain a third-party valuation or fairness opinion immediately prior the financing to show that the valuation utilized for the financing is reasonable and fair;
• Disclose the terms of the financing to the stockholders as well as any potential conflicts of interest and obtain the approval of a majority of the disinterested stockholders;
• Carefully document the deliberations of the special committee and the board with respect to valuation of the proposed transaction; and
• Require or strongly encourage participating investors to seek their own counsel with respect to likelihood and scope of potential liability.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Jeremy D. Glaser is co-chair of Mintz’s Venture Capital & Emerging Companies Practice. He has over three decades of experience guiding life sciences and technology companies in growth and financing strategies, including public offerings, financings, mergers and acquisitions, and SEC compliance.

Sebastian E. Lucier is a highly technical attorney at Mintz. He has deep ties to the start-up community and significant experience related to financing, corporate formation and governance, and mergers and acquisitions.

Sebastian A. Bacon is a corporate attorney who focuses his practice on venture capital and emerging companies, mergers and acquisitions, public company representation, capital markets, and additional corporate matters.