“Down rounds” and why they are contentious

Early-stage companies often raise capital in multiple rounds.  While founders and investors hope that a company’s valuation is on a one-way trip upwards, the next round could be at a lower valuation.  The general economy or a company’s industry may be in decline, or the company may have underperformed.  Whatever the cause, a new financing at a lower valuation is a “down round.”

Down rounds are high-stake transactions often negotiated on a compressed timeline.  They may involve rewriting economic and governance fundamentals (see examples below) while the company faces looming payroll or other deadlines.  They frequently involve new investments by conflicted insiders and can result in “winners” and “losers” (e.g., participating investors that increase ownership on favorable terms, versus non-participants that are diluted), and the latter may sue.  With a high risk of post-closing litigation, the “winners” need to be careful to preserve the agreed economic outcome. 

How post-closing claims arise and the standards on which they are judged

Like most equity financings, down rounds require board and stockholder approval.  Directors face the daunting task of justifying decisions consistent with fiduciary duties, and a controlling stockholder (or group of stockholders, in some cases) can be held to the same standards.  They must exercise due care in the decision-making process and in setting the ultimate terms (including valuation) and must act in good faith and in the best interests of the company and all stockholders (not just stockholders that designate directors to the board).  They also must disclose material facts, including any conflicts of interest, to stockholders when soliciting their approval.

The directors’ (or controlling stockholder’s) task becomes more difficult if the terms include penalties or harsh consequences, such as a pay-to-play (i.e., a provision forcibly converting non-participant preferred stock into common stock, sometimes at unfavorable ratios), a “pull-through” (i.e., granting more favorable rights and economics for preexisting equity to participating investors), elimination of stockholder rights (such as anti-dilution, preemptive or information rights), liquidation multiples (i.e., preferred stock that receives 2X or more return of capital before other stockholders in an exit), or warrant coverage.  They may face the decision of either approving a deal that advantages some stockholders over others, or letting the company go out of business.

Down rounds also may involve renegotiating employee equity or other rights.  Key employees may no longer own meaningful equity stakes in the company due to dilution, or their existing option grants may be significantly underwater (such that the exercise prices are well above the common stock fair market value).  In these situations, the directors may consider equity top-ups (i.e., new equity grants), management carve-out plans (e.g., granting key employees the right to receive exit proceeds senior to or pari passu with preferred stockholders), or option repricings (i.e., resetting option exercise prices to the new common stock fair market value).  Among other things, such concessions may result in additional conflicts of interest for directors that also are employees. 

After the deal closes (sometimes long after, at exit), non-participating stockholders may sue for breach of duty to capture gains through settlements or judgments.  Depending on the protective measures taken, either (1) the plaintiff has to overcome the “business judgment rule” (i.e., the presumption that the directors and stockholders complied with their fiduciary duties) by showing, for instance, that the decision lacked a rational basis, was not in good faith, or involved a conflict of interest or failure to disclose, or (2) the defendant director(s) or stockholder(s) have to prove that the transaction satisfied “entire fairness” (i.e., it was fair from both a process and terms perspective (pricing in particular)).  Clearly, the business judgment rule is more favorable than the entire fairness standard for the decisionmakers.

Pebbles on the scales of justice

So, how do directors and controlling stockholders fend off litigation or at least mitigate the risk of becoming liable for monetary damages?  By adding as many pebbles to the scales of justice as possible to tip the outcome in their favor, and perhaps make the outcome a foregone conclusion in order to discourage potential plaintiffs.  There are many such pebbles, and the ones chosen depend on, among other things, the pool of potential litigants, timing, expense, and risk tolerances.

At a minimum, the company’s board should take typical compliance steps, such as: 

• Search for alternatives (the earlier the better) and document efforts to receive other offers;
• Negotiate offer terms on an arms-length basis in consultation with outside advisors;
• Meet frequently as a board to discuss the situation, alternatives and offers;
• Have good meeting hygiene – share information in advance of meetings, encourage attendance by all directors, ask questions, allow time to deliberate, invite company counsel to attend, document consideration of relevant factors in written minutes, and follow up on open questions;
• Make good decisions – be informed about the company’s status, financing alternatives and other material facts, disclose conflicts of interest and receive disinterested director approval, and make decisions in the best interests of the company and all stockholders;
• Disclose material facts to stockholders when seeking their approval;
• Review the certificate of incorporation, bylaws and indemnification agreements to ensure maximum indemnification and limitation of personal liability;
• Review the director and officer insurance policy to ensure appropriate coverage; and
• Obtain a post-closing 409A valuation for equity top-ups or option repricing.

For inside-lead, down rounds or other scenarios with harsh terms, the board should strongly consider additional steps: 

• Conduct a “rights offering” to all stockholders allowing them to purchase their pro rata share of the new financing round, whether or not they have such rights by contract.  There are lots of nuances to such offerings, such as when to make them, purchaser qualifications, how many shares to set aside for the offering, and the form and content of the offering notice;
• Obtain majority consent from the disinterested stockholders; and
• If implementing a pay-to-play, rely on an existing special mandatory conversion provision, or conduct a pull-through pay-to-play using existing mandatory conversion features, rather than a newly authorized special mandatory conversion provision.

In the most troublesome scenarios, consider adding other layers of protection:

• Appoint a special committee of the Board consisting of disinterested directors.  The committee should be empowered to fully negotiate the deal, including potentially rejecting it, and to hire outside counsel separate from company counsel or to retain a financial advisor; and
• Obtain supermajority consent of the disinterested stockholders.  Stockholders that consent to the transaction will have a hard time challenging it later.

Successfully navigating a down round is difficult, but litigation risk can be mitigated and potentially avoided with the right preparation.