JONES DAY TALKS®: A Trip to the Dark Side – Venture Capital Down Rounds and Recaps
Down round financings recently reached their highest levels in 15 years, leaving investors, growth-stage companies, and other venture capital market participants searching for guidance and clarity. Jones Day partners Tim Curry, Taylor Stevens, and Alexandre Wibaux explain how down rounds work, and talk about what affected parties need to know as we look toward 2025.
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Dave Dalton:
When a company raises venture capital at a share price lower than what investors paid in the previous offering, that's called a down round. Now, of course, there are a number of reasons why a company might consider a down round option. In fact, we're seeing down round activity at a rate not observed in 15 years. Jones Day's Tim Curry, Taylor Stevens, and Alex Wibaux are here to explain down rounds, what they are, what they mean for a company, how they work, and what effective parties need to know in the current environment. I'm Dave Dalton. You're listening to JONES DAY TALKS®.
Based in Silicon Valley, Tim Curry leads Jones Day's emerging growth and venture capital efforts. He represents startup and public technology companies and public offerings and growth equity financings and mergers and acquisitions. Taylor Stevens, based in San Diego and Silicon Valley, advises clients on venture capital, M&A, and capital markets transactions. His practice is focused on representation of emerging growth and established technology, as well as life sciences companies. And Alex Wibaux, based in New York, represents clients in private equity, growth equity, buyouts, M&A, and capital markets activities. Taylor, Tim, Alex, thank you so much for being with us today.
Taylor Stevens:
Hey, terrific, Dave, thanks to be back and certainly fun to be back here with Tim and we're happy to have Alex with us today, he brings a great lens not only as a colleague, but as a seasoned venture lawyer from the East Coast.
Dave Dalton:
Oh, for sure. In fact, Tim, tell us a little bit about what we're talking about today and why it's important for people in the market to know about.
Tim Curry:
Thanks very much, Dave, and great to be back together with you, Taylor. And Alex, welcome to the team. Really glad to have your perspective. You're going to be a great participant. Thanks a lot for joining us. So today we're going to go a little bit to the dark side of the venture capital world, down round financings. As you all know, down rounds are rounds that are priced at a lower valuation than a company's previous financing round. Down rounds can occur due to specific company challenges, downturns in specific industries, or overall declines in the venture industry.
We've noticed that down rounds have been on the rise with near record levels in both Q1 and Q2 2024. The good news is that the early data suggests that down rounds are plateauing, but there's still a significant part of the current ecosystem. Today we will discuss the significant legal and financial considerations in down rounds that differ from typical up round financings. But before we begin, I want to leave it on a little bit of a positive note here, and that's that many, many companies recover from down rounds to become very successful businesses with highly accretive liquidity events. Down rounds are a challenging and sometimes stressful step in the journey, but if they're managed properly, they're just one event and certainly not the end of the story.
Dave Dalton:
Tim, thanks. Great introduction to where we're going with this conversation. Let's flip to Taylor for a second. Taylor, Tim said down rounds are at levels we've not seen in nearly 15 years, but give us some context. I mean, how far down is down? Where are we?
Taylor Stevens:
Yeah, you bet. Thanks for the intro, Tim, and good question, Dave. I think it's a great starting point for our discussion today. Look, historically, we see down rounds hovering around 10% of all venture deals, at least here in the US market. And as Tim mentioned, look, down rounds can come into play for a number of different reasons. Some are particular to the company and others are just attributable to overall market conditions. But it's fair to say that at any point in time you're going to see down rounds hanging in that 10% range. So what have we been seeing out there? About 20% of VC deals in each quarter last year were down rounds, and that jumped up to 25%, 30%, even 35%, depending on some data, in Q1 of this year.
Now, let me pause for a minute. To put things in context, it's not the worst that we've seen. We're still well below the rate that we saw in the dot com bust, which was over 60%. And the down round rate that we saw in the '08, '09 financial crisis was hovering around 40%. But this is the highest rate we've seen in a long time and if you compare that against the 20-year record low that we saw in 2022. It's not that great, so it is an issue. And in addition to the rise that we're seeing in down rounds, we're seeing a big increase in convertible bridge rounds. Now, that shouldn't be a huge surprise for folks, right? One of the attractive features of the bridge financing is the ability to punt on valuation. So when you're in a down market, you're going to expect to see more bridge rounds. But interestingly, convertible bridge rounds through the first part of 2024 saw more than 25% with valuation caps that were below the valuation of the company's last priced round.
So what we're seeing here are three things. Number one, an increase in down rounds. Number two, an increase in bridge rounds. And number three, essentially what we're seeing is an increase in down round bridge rounds. So it's really an interesting combination. And I'll say that recent data for Q2 is coming in. It's showing some plateauing, maybe even a little bit of a decline in the rate of down round. So we'll see where the market settles out here. But down rounds are a reality and it's important to address some of the unique issues and complexities around these types of financings, which is why we're here chatting with you today.
Dave Dalton:
Taylor, to pick up on a point you made, okay, so we're plateauing. Historically, what happens after you see this substantial increase in down rounds? I mean, at some point, there's light at the end of the tunnel, right? What might you expect coming next 12, 18 months?
Taylor Stevens:
It's a great question and it doesn't fluctuate moving up at a certain cadence and moving down at a certain cadence. What tends to happen is when you're in a down round market and you're looking at these down rounds, what happens is a lot of the companies who needed to do a down round may have done that. They take their medicine, so to speak. So they bite the bullet and it positions them for a different type of growth. So I wouldn't say you'll see a huge drop-off, but you can see a bigger adjustment in the overall percentage because you have a bunch of companies out there that are just taking the medicine, so to speak, and then moving forward from there. If that's helpful from that lens.
And then Dave, if I can add something on that, the other thing is that the valuations in new first-time financings for companies tend to come down during these same environments. And so they're more rational valuations from the very beginning so that those companies when they do their second round or their third round are starting at a more rational base and probably less likely to have to do a down round themselves.
Dave Dalton:
Sure that's a realistic, understandable reaction. That's for certain. Let's go to Alex for a second. And Alex, thanks again for joining us today.
Alex Wibaux:
Thanks for having me.
Dave Dalton:
Yeah, first excursion with JONES DAY TALKS®, and thanks for being here. Alex, let's talk logistics, how these things actually work. When you bring out a down round financing, what is actually happening? How does this work and what do the parties focus on or what should they be thinking about?
Alex Wibaux:
So like Tim mentioned, a down round happens when a company raises funds by selling shares at a price that is lower than what was paid in previous financing rounds. It's essentially a signal that the company's valuation has dropped, which can be a red flag for investors and employees alike. Now, that sounds like an illegal corporate drama. So why should we really care about down rounds? Well, first things first, this is not illegal, but it has a clear impact on morale.
For venture-backed startups, which all thrive on rapid growth and high expectations, a down round can be a morale killer. It may suggest trouble ahead, and it can lower enthusiasm among employees who are often motivated by positive growth signals. It's not only a problem for the VC-backed startup, but it's also a problem for the existing investors, because existing investors need to adjust the value of their holdings on their financial statements.
This can affect their fund’s valuation and make their own future fundraising more challenging. In terms of fund performance, a down run can also negatively impact the perceived performance of a fund. It will influence its ability to attract new investors, and it will most certainly affect the compensation of the fund's managers. And with that being said, and going back to the VC-backed company side, it's more dilutive to the common than an up round since you're issuing more shares of preferred to raise the same amount of money.
So it has this natural dilution to founders. For existing investors, since they often hold preferred stock with anti-dilution clauses, all of these protections will kick in to shield them from the impacts of dilution. To put it differently, a down round will indeed trigger anti-dilution adjustments for the current preferred stockholders. This will increase the dilution for the common holders. But due to the anti-dilution adjustment I mentioned, the dilution for the preferred holders is mitigated.
Tim Curry:
Hey, Alex, I find that this is one of the concepts that gets confused by founders and venture investors alike. Can you clarify how that anti-dilution works?
Alex Wibaux:
So Tim, let's debunk a common misconception here. Instead of issuing more shares of preferred stock, the protections I mentioned will adjust how many common shares each preferred share can be converted into. The adjustments are increased based on three items. The first one is the relative difference of issuance price between the rounds. The second one is the size of the down round itself. And the third one is the type of protection existing investors have.
There are two types of anti-dilution protection. The first one is full ratchet, and this protection adjusts the conversion price of preferred shares to entirely match the new lower price from the down round. For example, if an investor bought shares at $10 each and the new round prices them at five, the investor's shares will convert into double the number of common shares.
The second protection, which is a lot more common, is broad-based weighted average. And this method adjusts the conversion ratio based on a formula that considers the size and the price of the new round relative to the company's total stock. So it's less dramatic than full ratchet, and it still helps mitigate the impact of dilution.
Tim Curry:
Hey, Alex, let me just chime in really quickly on that just to further a point that you made. But in terms of founders who may be listening to this or other common holders, the bad news from a down round is twofold. One is you're issuing shares at a valuation that you don't like, so you're issuing more shares.
But then on top of that, the preferred holders get this anti-dilution adjustment, which further dilutes the common holders and the founders. So it's really kind of a double whammy here, which is what makes it a tough deal for founders and common holders.
Dave Dalton:
Let's swing back to Taylor for a second. Let's pick up on some of the points that Alex and then Tim made. Talk about how these recapitalizations are actually structured in a down round, and how do you incentivize participation so companies can realize the ultimate financing goals?
Taylor Stevens:
Yeah, you bet. As you can gather, all of this stuff gets kind of technical. It's going to get a little more technical here, but we're going to keep it at a high level. Look, as Alex explained, the anti-dilution mechanics, they adjust the cap table. It moves things around, but it doesn't do anything to incentivize investor participation in a down round. In fact, an investor who is subject to anti-dilution adjustment, they're going to get the benefit of that adjustment regardless of their participation in the round.
So when you have a lead investor coming in, an inside investor that's going to lead a down round, they don't want to be the only one putting capital in at a difficult time. They're going to want to encourage participation from the other investors. They don’t want to permit a free ride on their coattails, so to speak. So how do they do that? So this is where we get into the pay to play. So what is a pay to play? In its most simple form, it's an incentive for other investors to invest in a subsequent round.
So how does that work? Well, it's based on pro rata participation in a future round. In other words, if you don't invest your pro rata in the new round, something happens to you. You're going to be impacted. So what is that impact if you fail to meet your pro rata? Well, the typical construct is two things. Number one, you're going to get converted into common stock or maybe a shadow series of preferred stocks, some junior series.
And number two, you're going to get reverse split basically into nothing. So it could be a one for 100 reverse split or maybe something even more aggressive than that. But what's happening here is it's removing the rights, privileges, and preferences of the preferred stock that you hold, and it's essentially taking you off the cap table, or at least it's drastically reducing your ownership on a fully diluted basis.
So it's taking nonparticipants out, and this is a Draconian method. It's what I refer to as using the stick. In other words, pony up or you're essentially going to disappear.
Now, there's another pay to play variation, which is the contractual pull up. And this can get you to the same economic place essentially, but it looks and feels a lot different. And this is what I refer to as using the carrot, not the stick. And I think generally, it's a less common form of pay to play, but it's a really important part of pay to play deals.
So how does the contractual pull up work? Suppose you have a company that has Series A, Series B, Series C out there, and they're going to do a Series D round. If you're a participating investor in the D round, meaning you're going to buy your pro rata or maybe there's some other predetermined threshold, which could be a multiple of your pro rata or a fraction of your pro rata, but in any case, you are a participating investor doing your pro rata amount. When you buy one share of Series D in that round, you get to reach back and pull up a certain number of your shares of Series C, your Series B, and your Series A, and you magically turn those shares into shares of the newly issued Series D.
So there's going to be a pull-up ratio here, and that ratio is typically designed by the lead investor so that their investment amount allows them to pull up all of their prior preferred into the new Series D shares. So the contractual pull-up, what it's really doing here is it's reallocating the liquidation preference stack and it buries non-participants.
So there’s a lot of similarities economically to the traditional Draconian pay to play, what I call the stick, but it differs in two important ways.
Number one, the traditional pay to play, it's mechanized through the charter and it converts and splits the stock of non-participating investors through the charter that gets filed in Delaware. The contractual pull-up is different. It's merely a contractual exchange, and it happens through the preferred stock purchase agreement, not the charter that gets filed in Delaware. So it's kind of stealth-like, right? It can be undetectable because it's not filed in Delaware. It's also a little sneaky, and it can circumvent certain protective provisions that the investors may have.
So it can really be a trap for the unwary. And I'd say anyone listening to this that's doing a down round or structuring a down round, really be careful about this and look at your protective provisions because there's a lot of ways to circumvent this. And I've done quite a few of these deals and seen a lot of different variations.
Okay, now, the second main difference with the contractual pull-up is that it can look more favorable than this traditional pay to play. It's not changing or taking away anything that you have. I'm not touching anything you've got, Dave. I'm just layering on top and I’m burying non-participants.
So the optics here are pretty important for a lead investor that's structuring a down round with a pay to play. So when you use a contractual pull-up, it can look a lot more attractive, which can be important from an investor to investor relations standpoint. But it's also really important for fiduciary considerations, which as we're going to discuss next, is a really important part of down rounds and pay to play structuring.
Dave Dalton:
In fact, that's a great segue. Thank you, Taylor. Let's take it right to Tim because this sounds complicated and they are complex transactions, I'm sure. But beyond the structuring, Tim, what are the considerations for the parties involved here? What else should they be thinking about?
Tim Curry:
Thanks, Dave, and thanks, Taylor. As Taylor has outlined, these transactions are not only complicated, but they have a lot of negative ramifications for junior preferred non-participating investors and then, of course, the common and the founders. And so there's a lot to take a look at and a lot to consider in these deals. The first is the economics. When you start down this road of a pay to play or even just a straight down round, the first thing you got to do is create a really good spreadsheet that reflects how the cap table is going to be reallocated, what the changes are going to be, what the economics will be in a future sale of the company or an IPO where this preferred that you're issuing probably converts. It's going to be different in a sale versus an IPO. And so we need to look at both of those scenarios.
The other thing that can change dramatically is after you've done these pay to plays is who now controls the preferred? And by virtue of controlling the preferred, who controls the protective provisions and the other governance provisions that you have in your documents? Things can shift around pretty dramatically.
And as a founder, you might think about, well, one of my favorite investors, who tends to support management in various initiatives, maybe converting out to common and therefore isn't going to have any control and may even lose their board seats. So how does that feel? What does that do to the company? What does that do to the board? And what does that do to getting things done later? So all that needs to be looked at really carefully.
The other thing you need to look at is what's the impact to the common, and are the employees still going to be incentivized to grow the business and push for a sale of the company? Do they have anything left at the end of the day? Do you need to do refresh option grants after the recap or after the down round, or put in place a management incentive program to make sure that management still has some skin in the game and is interested and incentivized to grow the company?
So those are some of the economic and spreadsheet cap table things that I think companies, investors need to look at. The second are the governance protections and the governance steps that need to be followed. As we described, remember, these financings are not good news for the preferred stock, especially those that don't participate, or to the common stock.
And where there's bad news, there's the potential for litigation and claims that can really get in the way of a sale of the company later or an IPO. So it's really important to try to de-risk these transactions as much as you can, and there's only so much you can do. But there's four or five steps that I'll run through here in a second that I think can really help to de-risk these transactions for companies and boards. The first is to run a really good process.
And what I mean by process is at the time that you're looking to do a new financing, turn over every rock, turn over every stone, go out to the market, try to figure out if there's equity alternatives. Are there instead, debt alternatives? Is there a piece of an asset that you could sell to raise money? What are the options? What are the company's options? And by doing that, you're showing that you've taken every step possible to get the best deal possible.
And if you minute that correctly, meaning put that discussion in multiple sets of board minutes, as the company's board is looking to do some sort of financing, you can show that the board has complied with its fiduciary duties by taking every step possible to get the best deal that it can for the company and its stockholders before it turns to maybe the inside down round or the recapitalization transaction.
The second is to set up a disinterested board committee to run this process. And disinterested means non-employees, because employees' livelihood depends on getting this financing done, and then also non-investor representatives who are likely to be either leading the financing or even participating in the financing. So what this typically means is your outside independent directors would form a committee.
And the critical piece of these committees is that in order to get the protections that you're looking for by setting up a committee, you've got to set up the committee very early in the process. So at the beginning when you're starting to turn over these rocks and stones trying to figure out what your best financing alternative is, set up the committee at that point, because this committee needs to be involved every step of the way, not just there at the very end to bless the transaction before it goes forward.
Thirdly, and this is a tough one to get, but it's something to keep in your arsenal in case you're able to, but if you can get approval for the transaction from a majority of your disinterested stockholders, so again, those stockholders who are not participating in the financing, those stockholders whose livelihood isn't dependent on getting the financing done, if you can get those stockholders to vote for the transaction, that is a big cleanser of the overall process and can de-risk the transaction itself.
And then finally, and this is really important, the other three sometimes can be difficult to pull off depending on your facts and circumstances, but one thing you should always consider doing is a rights offering. And what a rights offering is at a high level, it's an offer to your accredited common shareholders and all of your preferred holders to participate in the new financing.
And why is this important? Well, it really can mitigate claims that preferred and common holders can make against the company because they've had the chance to participate in it, and it undercuts their ability to say that this was an evil, overly aggressive, damaging financing that was too generous to its participants when they had the chance to actually participate themselves.
And so putting this offer out to shareholders, many of whom will not accept it, and it's okay if they don't accept it, it's the fact of the rights offering that's the important piece, can be a really important insurance policy for the overall transaction and protect you against the risk of future claims. And then finally, I just want to say that maybe somewhat counter-intuitively, the risk of these kinds of claims is actually at its highest if the company pulls out of this down round and becomes a really successful company.
So if it sells in a big bang sale or if it does a really well publicized IPO, that's when these types of claims may come out of the bushes. They don't tend to come out while the company's struggling a little bit. But the minute the company does something great, where the stockholders feel like they should have benefited from that is when they're going to come out and take a look at the stock they think they have and wonder why they didn't have the opportunity to participate.
Alex Wibaux:
So to go to your point, Tim, I believe that in order to really see this as an insurance policy, we should always encourage funders to keep three items in mind. You should really, as a funder, open this fundraising to common and preferred holders, even include option holders as well.
And by sending out robust disclosure, including financials, risk factors, and description of the round, together with the impact on the cap table, if there is something like a sale process occurring, you should provide accurate disclosure on status as of the date of the rights offering document. And you should open this offering for 20 business days, which is really the gold standard here.
Dave Dalton:
We've covered a lot in a little more than 20 minutes, and I thank you all for your time. Why don't we close with this? Raising funds in this market, it's never easy, but it's a trying time right now. But let's go to each of you, starting with Alex. What advice would you have right now for corporates trying to raise funds in this particular market? What would you tell people right now, Alex?
Alex Wibaux:
To keep their heads high. Just because a previous financing round included anti-dilution protection tools doesn't really mean that they're set in stone. So I tend to recommend to funders to often renegotiate them. A major factor in these negotiations is whether the management team, who's really usually the significant common stockholders, whether they will still be motivated to run the business effectively with their post-financing equity stake. So keep your options open, I would say.
Dave Dalton:
Thanks, Alex. Taylor, what say you?
Taylor Stevens:
I would say, look, these deals, as you can tell from our discussion here, they're tough, they're tricky, they're complex. We've seen a big uptick here in down rounds, but we're seeing these numbers start to plateau, if not taper off. And as I mentioned at the beginning of our discussion here, many companies that needed to do a down round, they may have already done them, and they may have already taken their medicine, so to speak.
Now they're moving forward. So here's my takeaway. I would say appreciate that we may be at a turning point in the market here with down rounds and with general deal terms. So go into your deal knowing your market, know your industry, know the data points within your industry and your relative leverage here, because we may be at a peak with some change on the horizon.
Dave Dalton:
Tim, what would you add?
Tim Curry:
I'd reiterate what Taylor said. They're tough, they are tricky, and they are complicated. And what that means is it's really important to not cut corners and take any shortcuts. So follow the four or five things that I mentioned a little earlier in terms of governance and process. And by all means, use experienced counsel and listen to them and follow their advice, as it's very probable to come out the other side on these financings, but you don't want to come out the other side with litigation risk and potential claims.
Dave Dalton:
Sure, sure. And there's great information here at Jones Day about all these topics. We'll have contact information for Alex, Tim, and Taylor at the conclusion of this podcast, and always feel free to reach out. People, I think we did a pretty good job today. This was a deeper dive than I expected. We covered a lot. But Tim, Taylor, Alex, we're going to do this again in the fall, right? We've already planned our next JONES DAY TALKS® Podcast where it comes to venture capital. What can people look forward to?
Tim Curry:
Yeah, we're looking forward to this one, and we're going to turn a little more to the optimistic, sunny side of the venture capital market, which is where we all like to play, which is how do you protect later stage investors' economic rights when they're coming in and doing a much bigger fundraise than the prior investors have, but oftentimes will own fewer shares because of the increased valuation of the company, and how do you protect those investors in those kinds of deals?
Dave Dalton:
Sounds great. That'll be a nice addition to the library of content y'all are building, so that's terrific. Tim, Taylor, especially Alex, Alex, thanks for being here today. We enjoyed having you.
Tim Curry:
Welcome to the team, Alex.
Taylor Stevens:
Yeah, thank you, Alex.
Alex Wibaux:
Looking forward to the next one.
Dave Dalton:
Terrific. Taylor, Tim, Alex, thanks so much for being here today, and we'll talk to you next time.
Taylor Stevens:
Sounds great. Thanks, everyone.
Dave Dalton:
Take care. For complete bios and contact information for Tim, Taylor, and Alex, visit JonesDay.com. Be sure to check out our Jones Day Insights page for more content relating to trends and venture capital. Subscribe to JONES DAY TALKS® at Apple Podcasts or wherever you find your podcast content. JONES DAY TALKS®, produced by Tom Kondilas. As always, we thank you for listening. I'm Dave Dalton. We'll talk to you next time.
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Thank you for listening to JONES DAY TALKS®. Comments heard on JONES DAY TALKS® should not be construed as legal advice regarding any specific facts or circumstances. The opinions expressed on JONES DAY TALKS® are those of lawyers appearing on the program and do not necessarily reflect those of the firm. For more information, please visit JonesDay.com.
