What happens when your Company has a down round


With the market for venture capital tightening up over the last few months, an increasing number of companies can expect to have to raise on a down round.

A down round, broadly speaking, is where the valuation of the company, or the price per share, is lower than the previous fundraising round. For example if your price per share in your Seed round was $5 per share, and then during your Seed Extension you raise at a price per share of $4, that’s a down round.

This can get quite complex when you have existing preference shareholders with anti-dilution protections in play.

What are anti-dilution protections and how do they work?

Generally speaking, sophisticated investors in Australia will expect to receive Preference Shares, which can be converted to Ordinary Shares (usually in the event of an exit; for more information about preference shares, see our post here). Those Preference Share rights will usually be paired with anti-dilution protections for the investor.

This means that when the company fundraises for a lower price per share than their original investment, their shareholding is protected, whilst founders and any other shareholders have their shareholding evenly reduced. There are two primary types of anti-dilution protections:

  1. Full-ratchet
  2. Weighted average

Worked Examples

Gumtree Capital invests $1 million into Froogl during its Seed Round at a price per share of $10. It receives 100,000 shares, which represents 10% of the total issued share capital, giving Froogl a post-money valuation of $10 million.

Froogl subsequently raises a Seed Extension round of $800,000, and issues another 100,000 shares at a price per share of $8. The post-money valuation of Froogl is now $8.8 million.

Let’s have a look at how this scenario might play out in each case.

FULL-RATCHET ANTI-DILUTION

A full-ratchet anti-dilution clause provides the most comprehensive protection to the shareholder, but can be restrictive in future fundraises down the track. Full-ratchet anti-dilution allows a VC fund to convert their preference shares to ordinary shares at the reduced price whenever they like - usually on exit from the company.

Let’s look at the Froogl example again:

If Gumtree Capital invested $1 million in Froogl’s Seed round for 100,000 shares at $10 per share, and then Froogl runs a down round at $8 per share, their preference shares become convertible to ordinary shares in a 5:4 ratio, which in this instance would be 100,000 x 5/4. Gumtree Capital now owns 125,000 shares - an increase from their initial 100,000 shares for no extra cost. Now not only do they avoid dilution when new shareholders come on board in the down round, but they have more shares to sell at a later point.

BROAD-BASED WEIGHTED AVERAGE ANTI-DILUTION

Weighted average anti-dilution clauses are typically the default and provide a more standard approach to protecting preference shareholders from dilution. Here, shareholders increase their shareholding by a weighted average amount of the new price per share. Different shareholders deeds will contain varying formulas for how this weighted average is calculated, but it typically takes into account the amount of money raised prior to the down round and the average price per share across all fundraising rounds. Importantly, weighted average anti-dilution may not fully protect shareholders from dilution, its main purpose is just to minimise its effect.

Taking the same example from above:

Gumtree Capital with $1 million in the Company for 100,000 shares at $10 per share is now at risk of dilution by the $8 per share down round. The shareholders deed states that the anti-dilution formula is:

NP = IP x (Outstanding Shares + X) ÷ (Outstanding Shares + Y)

where:

NP is the new price per share;

IP is the investment price per share;

X is the number of shares that would have been issued at the old price; and

Y is the number of total shares actually issued at the new price.

If there are currently 1,000,000 shares in the company and 100,000 new shares being issued in the down round, the VC fund is affected as follows:

NP = 10 x (1,000,000 + 80,000) / (1,000,000 + 100,000)

The result is that the conversion price into ordinary shares is now $9.82, where it was previously $10, advantaging the preference shareholder and allowing them to increase their shareholding to mostly avoid dilution.

EFFECT ON FOUNDERS AND OTHER SHAREHOLDERS

Because it is unlikely that founders, employee shareholders and other early stakeholders will have anti-protection clauses working in their favour, they are likely to be disproportionately diluted relative to the number of shareholders when a company runs a down round. Further, when a company runs multiple down-rounds in succession, anti-dilution provisions give preference shareholders far greater protection than other shareholders and some anti-dilution provisions stack together so that convertible preference shareholders get an even better deal before they exit.  
A way for companies to avoid this, is including a Pay-to-Play clause in the shareholders deed, meaning that if a VC fund wants to be protected from dilution, they have to participate in future financings. Though they can have negative impacts on ordinary shareholders, with the right settings a down round can entice new shareholders to invest into the company and can lay the foundations for a successful up round later on.

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Jamie Larson
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