Legal Risks Of Down-Round Financing

John B. Quinn is the founder of Quinn Emanuel Urquhart & Sullivan LLP, the world’s largest law firm devoted solely to business litigation.

With venture capitalists tightening their investment protocols and company valuations beginning to fall, the market is likely to see an increase in down-round financings. A down-round occurs when a company raises additional funds at a valuation lower than in previous rounds. Down-rounds typically carry adverse consequences for earlier investors, founders and employees, such as dilution and reduced value of their holdings. But when companies need equity capital to continue to operate in the face of economic downturns, subpar performance or increased competition, down-round financings may be their only chance of survival. Although the punitive financial effects of down-rounds are widely known, the legal landmines and litigation risk are often overlooked.

Anti-Dilution Provisions

One concern for directors of companies contemplating down-rounds should be the effect of anti-dilution provisions in agreements between the company and certain classes of investors. Assessing the effect of dilution on shareholders, and whether anti-dilution provisions exist and should be maintained, is complicated by the fact that the interests of the company may conflict with the interests of its individual directors or their nominating entities. Venture capital funds typically obtain anti-dilution rights when investing in a startup. Such rights protect their investment value against the dilution that would otherwise occur in a down-round by permitting them to convert their preferred shares into a sufficient number of increased shares in the next round to maintain their ownership percentage of the company’s total equity.

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Companies have taken different approaches to address anti-dilution provisions in the context of down-rounds. The simplest is to honor and implement them, but that is rarely acceptable to new investors or practically feasible. Alternately, some companies have sought to amend their charters to avoid anti-dilution provisions.

To avoid the stigma of a down-round, companies sometimes get new investors to agree to a flat or slightly increased valuation, but typically must offer onerous terms that structure future economic returns so the new investors disproportionately benefit over earlier investors by many multiples.

Though not technically a down-round, this leads to the same litigation risk. Directors owe fiduciary duties of care, loyalty and candor to stockholders, and in some jurisdictions may owe fiduciary duties to creditors when companies are experiencing financial distress. Similar duties exist for senior management. In some cases those duties may extend to controlling shareholders.

Avoiding Litigation

Although most down-round financing does not result in litigation, it is important to review these situations with an eye toward litigation risk.

The majority of states provide at least some procedural mechanisms—in effect, safe harbors—to protect companies and their directors who have conflicts of interest arising from down-round transactions. In Delaware, three safe harbors can be used to address a conflict and return the transaction to the business judgment rule presumption: (1) majority disinterested director approval, (2) approval by an independent special committee, and (3) stockholder approval. These safe harbors are found in both Delaware common law and in Section 144 of Delaware’s General Corporation Law. Section 144(a)(3) also contemplates that the “entire fairness” standard may be met in other ways even when a transaction does not meet any of the safe harbor requirements.

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In down-round financings, there are two areas where directors frequently encounter conflicts of interest. The first is when a majority of the directors are deemed “interested” in the transaction. Such scenarios commonly arise when the director plans to invest in the down-round financing, the director will derive a personal benefit from the financing that other stockholders will not receive, or the director is designated by a stockholder who has an interest in the financing. The second common source of conflicts of interest is when the transaction was engineered by a controlling or dominating shareholder.

Companies can take multiple approaches to avoid or overcome such shareholder claims:

1. Pay-To-Play Provisions

Pay-to-play provisions incentivize existing investors to participate in future down-round financings. These provisions require preferred stockholders to continue to invest in further financing rounds or face conversion of their preferred stock to common stock or a more junior security. This may even be done at a punitive ratio. Companies without existing pay-to-play provisions may consider a charter amendment or other means of implementing such provisions for a down-round, assuming they comply with the applicable Delaware or other state statutes governing charter amendments.

2. Rights Offerings

A rights offering provides all stockholders with equal opportunity to participate in the down-round. There are some indications this may cleanse any conflicting interests. But some Delaware courts have expressed skepticism, questioning whether stockholders actually have a fair opportunity to participate, whether they have financial ability to participate and whether they have been given adequate time and information. Rights offerings have also been scrutinized as imperfect solutions, given that they are often limited to accredited investors to avoid securities law complications.

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3. Building A Supportive Record

When considering down-round financing, companies and their directors can take multiple steps to avoid, or prevail in the face of, an “entire fairness review. One key step is to create a supportive record. A company should maintain a record of all deliberations of its board and any special committees that concern a down-round financing. The record should be detailed enough to memorialize key events and provide context explaining why the financing was necessary, including (as is often the case) the need to ensure the company’s survival.

Final Thoughts

Down-round financing presents litigation risks that are often overlooked but can be avoided. Companies contemplating down-rounds should create a supportive record that documents steps taken to ensure a deliberate and even-handed process. With courts willing to criticize boards that fail to show an understanding of their fiduciary duties or potential conflicts of interest, applying a litigator’s eye in advance can help minimize litigation risk and create the strongest record possible.

The information provided here is not legal advice and does not purport to be a substitute for advice of counsel on any specific matter. For legal advice, you should consult with an attorney concerning your specific situation.

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