Despite some recent upwards trends and a more optimistic outlook from some parts of the market, the announcement that the UK economy slipped into a recession at the tail end of 2023 marked formal confirmation of the economic difficulties that many business have been enduring for the last year or so. For a closer look at the investment market in 2024 please take a look at our separate article on the key trends for the year, available here.
Many businesses benefitted from the investment ‘boom’ period of 2020 and 2021, when raising funds through venture capital or angel investment felt more accessible, and those investors were more willing to agree to what, with hindsight, could perhaps be considered as generous valuations. Though as the economy starts to creak, more and more companies often start to hear the phrase ‘down round’ when considering their investment opportunities.
This article covers the definition of a down round, what businesses need to consider from a legal and drafting perspective and how anti-dilution provisions operate. We also look into how businesses can achieve balanced outcome, their pre-emption rights and highlight why investor consent is important.
As runway from the early 2020s, funding boom starts to dwindle and businesses look to the next tranche of investment. Some businesses may be coming to the realisation, whether themselves or through conversations with investors, that their next valuation is in fact lower than the valuation of their prior investment round. These circumstances, where the price per share offered to potential incoming investors is less than the price offered on a previous investment round, are referred to as ‘down rounds’.
If you are facing a down round, you may be wondering what the implications are for you as a business, and how your lower valuation, and position with your existing investor or shareholder base, might affect the terms of your new investment.
Whilst the legal and commercial implications of a down round can be broad, there are three key matters for businesses to consider from a legal and/or drafting perspective when this often-dreaded term comes up:
Each of these issues will be dependent on your existing investment documents, typically a shareholders agreement, subscription or investment agreement, and articles of association. To help you to assess your options, we have set out our view of some of the most common issues arising on these matters in the event of a down round below.
Anti-dilution, in practice, can be complicated. These rights may have been granted in your existing articles of association to help protect your investors from the potential of a down round in the future.
Anti-dilution provisions are only triggered on a down round, and so when they were first put in place on a prior investment round, sometimes a company’s optimism for the future may have meant that they didn’t pay these provisions much attention.
These provisions can come in various forms and we don’t intend to go into detail here on the various specific types of anti-dilution rights which you may find in your existing articles of association, but more information on those specifics can be found in our separate articles:
Broadly speaking, anti-dilution provisions operate to compensate your existing investors from the dilution that they will suffer as the result of a down round. Typically, on the new round additional shares will be issued to those investors on the basis of calculations contained in your articles of association. Existing investors would pay nothing, or only a nominal sum, in return for those additional shares.
You should understand the nature of the anti-dilution rights in your existing articles of association, and on what terms new anti-dilution shares may be granted to existing investors. Evidently, if you do not have any anti-dilution provisions in your articles, then you need not worry about their potential implications.
If the provisions are investor friendly, then the existing investors may benefit from a re-basing of their prior rounds at the price of the proposed new round, which may in turn influence how the terms of your new round are negotiated. If these investor friendly provisions mean that a new round is no longer appealing to new investors, you may need to have frank discussions with your existing investor base about whether those provisions need to be amended or waived, so that the business can secure the new funds and its future.
Where you have anti-dilution provisions, your understanding of potential new rounds will be best shown by a share capitalisation table which models the implications of various proposed valuations on your share capital. This can help to visualise how the anti-dilution provisions will impact your incoming investor and your existing shareholder base.
Where a down round occurs, the shares issued to the new investor plus any anti-dilution shares to be issued to the existing investors can mean that founders and other shareholders suffer significant dilution, which may feel unjust.
In the case of founders, becoming overly diluted may be seen as a disincentive for their continued support, and a low shareholding position for founders can actually be unattractive to future investors for this reason. If anti-dilution results in these scenarios, businesses should look to discuss their concerns with both existing and incoming investors, and collectively consider whether the relevant individuals could have their equity stakes topped up or rebalanced by way of share options or some other means. This may, again, require formal consents and approval from existing or incoming investors.
Although anti-dilution provisions can seem unfair, they can also be an important protection for investors who took a risk to back the company in its earlier stages. Although down rounds tend to be reflective of the national economy as a whole, they are often underpinned by weaker than expected financial performance of the business in question, failure to achieve targets and/or a general lack of resilience. For these reasons, investors can be reluctant to entirely waive the anti-dilution provisions granted to them in your articles.
It is important to understand the precise rights granted to investors in your articles of association, consider the commercial proposals for a new round, and have thought out an approach on how to navigate those competing interests in your negotiations.
It is always worth taking legal advice when negotiating the articles of association for a new round, or for any round where anti-dilution provisions are proposed.
Ideally, following a down round, the price at which anti-dilution rights may apply in future for all relevant investors should be re-based to the price of the down round itself. Or alternatively, anti-dilution rights could only be re-offered to those investors who participate on the down round, therefore falling away for those who have already benefitted, but not provided new money. These are commercial points which should be carefully negotiated with all investors during the course of the round.
Occasionally anti-dilution rights are accompanied by a ‘pay to play’ concept. In essence this provides that any investor who does not take up their pre-emption rights, see comments below on pre-emption, as part of the down round will not be entitled to benefit from their anti-dilution rights. This can help to ensure that investors looking to benefit from anti-dilution are still actively backing the company and providing new funding. However, not all investors will accept this position.
Pre-emption rights allow existing investors, on an issue of new shares, to acquire such number of shares as would allow them to maintain their current percentage ownership in the company. These rights are triggered regardless of whether the new issue is a down-round or at a higher price. Unlike anti-dilution provisions, in order to exercise their pre-emption rights and protect their ownership percentage, an existing investor would need to invest new funds at the price of the new round.
Whilst such rights can be disapplied by or set out in more detail in your articles of association, pre-emption rights on an issue of shares is granted automatically by law. So without an express exemption in your articles of association it is likely that such rights will apply on any future issue of shares.
In practice, when an investment round is proposed, the pre-emption provisions, which require that equal investment terms are first offered to all existing shareholders, can be clunky. Before fully considering pre-emption, businesses have typically already reached out to existing, and potentially new, shareholders about the proposed investment to see if they would be interested in participating.
Having to run through a more formal pre-emption process with all the applicable notice period can often delay a new round more than is desired. To address this, often companies seeking further funding will informally agree participation, or non-participation, in the new round with existing investors early on. Companies will do this before asking those investors to formally waive these rights as part of the new investment documentation, pursuant to the waiver terms set out in the existing articles of association.
However, specifically in relation to a down round, when new investors are given the opportunity to invest on a low valuation, existing investors may be less willing to waive their pre-emption rights and may be more inclined to require that the formal pre-emption procedure is followed. Inevitably, if investors are to enforce these terms then this will impact the proposals for the new round.
In any event, but particularly in a down round, companies should ask for as early as possible an indication from existing shareholders as to whether they intend to exercise their pre-emption rights or otherwise be involved in the round, or if they would be willing to waive such pre-emption rights.
Depending on the terms of your prior investment round, it is often the case that certain things the company may want to action in future would be subject to shareholder or investor consent.
These usually include matters that are necessary on a new financing, such as issuing new shares, or adopting new articles of association. Very often, for a higher-priced round, investors are happy to consent to the new financing, subject to understanding their potential involvement and pre-emption rights as noted above. This is because the new funds allow the business to grow and hopefully increase their chance of a healthy return on their investment. There can also occasionally be opportunities for early investors to exit on a higher priced round by means of ‘secondary investment’, i.e. sales of shares to incoming investors.
However in a down round, existing investors may be less willing to consent to the terms of a low valuation and the implications this may have on their shareholding, or on how they would like the business to be operated.
Unlike pre-emption rights, depending on your existing investment terms, these consent rights can sometimes operate as an essential veto. This means that you may be contractually required to turn down investment offers if your existing investor base is unwilling to accept the terms of a new round.
If this scenario is affecting you, then you will need to work and negotiate with your existing investor base to establish a solution that enables the business to action the fundraise that it needs, whilst maintaining the existing investors’ position at an acceptable level. You could consider amending the terms of your articles of association to include anti-dilution provisions, if not already available, or you could do the following to help to sweeten their deal and secure their approval for the new round:
Unfortunately there is no easy answer to this scenario. However, in our experience investors are aware that down rounds can occur, particularly in economic environments like the one seen recently, and rarely use their consent requirements to block bona fide investment opportunities.
Either way, seeking guidance from appropriate expert advisors is essential to ensuring that investment rounds, particularly down rounds, run smoothly and that rights and interests, including consent rights which may block future rounds, are appropriately balanced.
For many businesses, down rounds can simply be an inevitability of fundraising. Ideally valuations would continue to increase as the business grows. But thinking pragmatically, there can often be periods of stagnation or potential decline in growth as day-to-day business and complicated investment scenarios are navigated.
When you are looking to raise in those conditions, being aware of the detail in your existing documentation and the likely position of your existing investors is extremely important so that you can safely secure the new financing. It can be very frustrating to secure commitments for an exciting new fundraise only to find that your existing shareholders can create conditions that make those terms unobtainable.
Ultimately, having open and honest discussions with your existing investors about the terms of any incoming fundraise, and how that can work for both the company and your investors, is going to be a necessary part of dealing with any proposed down rounds. Balancing out all interests is key.
If you have any further questions on a down round you are facing, please contact a member of our corporate team.
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