Chief Legal Officer at OpenView; previously the inaugural Director for the Center for Law and Entrepreneurship at Villanova Law School.
Recent data indicates that the venture financing market may have hit a peak in 2015. While valuations are up for the year, the fourth quarter numbers were down in terms of capital invested. And more alarmingly, venture liquidity events slid in Q4 to the lowest number since 2011. The paucity of exits, as well as pullback in the public markets, cannot help but drive down private company valuations in 2016.
These trends may not affect every company. But in general, companies will now have a more difficult time raising money at the valuations and on the terms they would like. Any company that is not profitable and in need of raising capital in 2016 will face the real possibility of a down round (a financing at a valuation lower than the previous round) and must be prepared.
Know Your Current Preferred Stock Documents
Venture capital preferred stock documents typically include a number of protective provisions for investors that a down round could trigger. If a company sells stock at a price lower than the last round, there will be anti-dilution adjustments to the preferred stock’s conversion price. There are two general types of anti-dilution:
- Weighted-average anti-dilution, in which the conversion price is adjusted using a formula that weighs both the price and number of new shares issued; and
- Ratchet anti-dilution, in which the conversion price is reduced in one step to the price of the new round (regardless of how much or how little new stock is sold).
Weighted-average anti-dilution is by far the more common in venture capital financings. Even so, a well-prepared entrepreneur will know exactly how the anti-dilution formula in his preferred stock works, and will be able to calculate quickly the effect of any proposed dilutive financing.
In addition, preferred stock has other protective voting provisions, which may require approvals on a series-by-series basis of any down round. It is important to know whose votes you might need to approve a new round at a lower price. In extreme cases, where investors contemplate a recapitalization, a vote of the common stock as a separate class may be required. Obviously, the more people needed to approve a new financing, the more time and energy will be needed to get those approvals.
Price Is Not the Only Concern
Besides the price of the new round, you should not assume that the preferred stock issued in a down round will have terms similar to those of the previous round. For example, although your current preferred stock may have weighted-average anti-dilution, the new investors may ask for a ratchet. Similarly, if your current preferred stock has a liquidation preference equal to the purchase price plus accrued dividends, the new stock might have a liquidation preference equal to a multiple of two or three times the purchase price, plus a much higher dividend rate. Voting and approval rights may also be heavily weighted in favor of the new investors in the down round. In other words, you can expect much more onerous terms to be offered along with the reduced price, so be prepared to focus on the terms that matter to you most.
Existing Investors Will Feel Exposed
