down round financings: tough terms or tough love?
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Down Round Down Round Financings: Tough Financings: Tough
Terms or Tough Love?Terms or Tough Love?John Hession
Testa, Hurwitz & Thibeault, LLP
Mass Software & Internet Council
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1999, 2000 = 1999, 2000 = AberrationsAberrationsOver the last 21 years since 1980:
70% of Technology Venture Capital financing occurred in 1999 & 2000
56% of Technology IPO financings occurred in 1999 & 2000
62% of Technology M&A transactions ($$ volume) occurred in 1999 & 2000
69% of Venture Capital funding of last 25 years occurred in 1999 & 2000 ($165 Billion raised in ’99 & 2000
Source: Morgan Stanley Report, April 2001
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More Aberrations of ’99, More Aberrations of ’99, ‘00‘00 54% of Technology Follow-On
Financing occurred in 1999 & 2000 62% of U.S IPO Equity Issuances in
2000 were Technology 45% of U.S. IPO Equity Issuances in
1999 were Technology 23% of Vintage 2000 IPOs were trading
above IPO price (@12/31/00) 25% of Vintage IPOs were trading
above IPO price (@12/31/00)
Source: Morgan Stanley, April 2001
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Technology IPO VolumeTechnology IPO Volume 2000 Tech IPOs = record 55% of all IPO
proceeds versus average contribution of 28% over last 20 years
32% of the Technology IPOs in past 21 years occurred in 1999 & 2000
1982, the “PC Boom” Vintage Year, contribution was also 55%
Severe technology correction occurred in 1983-1984
Recovery from 1983/1984 drought occurred in 1985-1986
Source: Morgan Stanley
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The Death SpiralThe Death Spiral NASDAQ overinflated by March 2000
NASDAQ doubled from 1983-91 (8 years); doubled again 1991-95 (4 years); doubled again 1995-97 (2 years); doubled again 1998-2000
Explosion in Technology IPOs followed by Poor Performance in After Market
Big-Cap, High-Growth Technology Leaders missed earnings in 2000 & 2001
Weak Macroeconomic Environment Hyper-Aggressive Growth Expectations
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The Current The Current EnvironmentEnvironment
VC Industry is flush with Cash! … but Capital scarce for new companies
Investors more discriminating -- tougher due diligence on business models
Longer lead times to raise capital Down Rounds prevailing on second-third
rounds Mezzanine rounds at lower valuations Pendulum Shift: Investors control Terms &
Valuation B2C, B2B, e-Commerce comatose
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Current EnvironmentCurrent Environment Deal Terms are Tough: participating
preferred, ratchet anti-dilution, “multiple of capital” preferences, redemption with penalty clauses
Investor Memory is long on rich valuations paid in 1999 & 2000
Solid Business Models: pathways to profitability, cash flow, scaleable & predictable revenue, customers
Mezzanine financiers missing
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Current EnvironmentCurrent Environment Capital Expenditures comatose: IT
spending re enterprise software, semi & telecom equipment still down
Large Cap bellweather stocks trading at low valuations
No appetite among mutual fund managers for technology IPOs (despite PayPal)
M&A marketplace moribund: buyers conserving cash, not using undervalued equity in stock-swap mergers
So … No visible Liquidity Horizons
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What’s Driving Tough What’s Driving Tough Terms???Terms???
Desire to:Minimize riskGuarantee rates of returnPolice investors, punish non-
participantsRevisit prior valuation historyPrepare company for sale
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Minimizing Risk = DebtMinimizing Risk = Debt Bridge loans, not permanent equity
investment: bridge to nowhere Staggered disbursements of cash Senior, secured (IP) instruments “Super Premium” guaranteed principal:
2X-5X (usury issue) Staircase discounts based on time to next
equity financing event Heavy warrant coverage
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Guaranteed ReturnsGuaranteed Returns Multiple liquidation preferences upon
sale of company: 2X-5X Multiple liquidation preferences
coupled with participating preferred “Ratchet” with guaranteed rate of
return or guaranteed pricing (or conversion rate) on sale of company
Redemption premiums, increase in conversion ratio re blown redemption
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Police Police Investors/Punish Investors/Punish Non-ParticipantsNon-Participants
Pay to Play provisions (prospective and retroactive) ; forfeit anti-dilution protection for non-participants
Re-capitalizations, ”wash outs” Careful selection of co-investors Cram down of preferred stock into
common stock for non-participants “Drag Along” rights on sale
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Revisit HistoryRevisit History Repricing of prior rounds; resetting
valuation as part of new financing New consideration received by
Company for repricing event? Rights Offering to all stockholders? Breach of fiduciary duty risk to
directors re non-participating stockholders
Difficult without broad-based support among stockholders
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What’s The Result?What’s The Result? More complicated, costly deals More constituencies affected Employee Issues:
–Impact of prior purchases
–Value of options (past & new)
–Reload or reprice options?
–Techniques to retain & motivate employees
–Sale/retention bonuses
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Minimize Contractual/Minimize Contractual/Statutory ObstaclesStatutory Obstacles
Modified preemptive rights Reincorporation in Delaware,
Massachusetts close corporation rules, stockholder fiduciary issues
Avoid inadvertent blocking rights (e.g. Del §242(b)(2) consent of each class of stock to increase stock)
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Other Protective Other Protective ActionsActions
Exculpatory Charter Provisions Indemnification Agreements D&O Insurance Adding Independent Directors
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Fiduciary Duty IssuesFiduciary Duty Issues Focus:
–“Duty of Loyalty” and ”Interested Director” Transactions
Relevant Definition:
–A transaction between a corporation & an organization in which a director has a financial interest
Example:
–VC fund with board representative invests in portfolio company
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Why This Focus?Why This Focus? Interested director transactions are
most attractive basis for fiduciary duty claims–Highest level of judicial scrutiny, higher
than M&A scrutiny
–Courts see higher inherent risk of abuse in “insider” deals; more receptive to claims, more reluctant to dismiss them early in the case -- fact-based claims
–Potential rescission & damages remedies available
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Standard director liability shields may be of limited application/value–Exculpatory charter provisions,
indemnification, insurance
VCs = Deep Pocket Defendants Result:
–Plaintiff’s lawyers see attractive basis for claims, enhanced nuisance value, deep-pocket defendants
Why This Focus?Why This Focus?
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So Why Isn’t Suit Filed So Why Isn’t Suit Filed On Every Deal?On Every Deal?
The company, and the claim, typically not of significant value at time of down round financing
–Low enterprise value, modest actual damages, or both
–High cost of litigation, absent contingent fees Private company shareholders may be difficult for
plaintiff’s bar to identify, sign up as clients
–Sharp contrast to publicly-held companies
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SolutionsSolutions Focus on the corporate decision- making
structure/process:
–Put the corporate decision in hands of disinterested directors or shareholders:• Add independent directors to board?
• Assess the disclosure obligations/risks attendant to seeking broad shareholder approval
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Suggested Solutions:Suggested Solutions: Share the Wealth and the Risk
–Offer participation to other shareholders
–Rights Offering to shareholders Assess the risks realistically
–Would the deal pass a “fairness” test? (price & process analogue to M&A)
–Overdoing the solution can be nearly as harmful as ignoring the issue
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The Tough TermsThe Tough Terms
Super Liquidation Preferences Participating Preferred Stock Heavy Cumulative Dividends (10% ++) Ratchet Anti-Dilution Mandatory Redemption -- Forced Sale Board Takeover provisions Drag-Along Rights on Sale of Company Pay or Play, Play or Lose Provisions
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Super Liquidation Super Liquidation PremiumsPremiums
Investor receives a Multiple of Capital return on investment [2x-4x return]
Super Preference is quid pro quo for healthy valuation
Multiple is paid on Acquisition, forfeited on conversion (IPO)
Vanishing Preferences: Super Premium implodes on Acquisition with Stated Return on Investment
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Cumulative DividendsCumulative Dividends Built-In Return; Rates Vary from 8% - 20% Dividend Accumulates Until Paid on an
Acquisition, Public Offering, Redemption, Liquidation or Cash-Out Election Event
Issue: Dividend Should be Forfeited on Voluntary Conversion or Public Offering Event - Investor Loses the Built-In Return if Company Achieves IRR better than the Dividend Return
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Cash-Out Election Cash-Out Election RightsRights
Investor to Demand Payment of the Liquidation Amount in Event of a Sale, Merger, Recapitalization
Cash-Out Election Rights Can Potentially Frustrate a Stock Merger, Pooling Deal or Tax-Free Reorganization
Issue: Try to Get an “IRR Hurdle” or Threshold if the Deal Yields a Defined Internal Rate of Return (>25%)
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Participating PreferredParticipating Preferred
Investor Gets $$$ Back & Then Participates in All Residual Amounts on an “As-Converted” Basis
Potentially Disastrous Impact on Founders’ Stock if Acquisition Does Not Yield a Decent IRR
Investor Recovers the Investment & Then Plays Again in Upside Gain
Issue: Resist It! Get an “IRR Hurdle”/ Multiple of Capital Threshold Such that Investor Forfeits This Right
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Anti-Dilution ProtectionAnti-Dilution Protection If Subsequent Rounds of Financing are
Dilutive as to Price, Investor Reprices Old Money at Today’s Dilutive Valuation
Ratchet Formula: If Company Issues 1 Share at Lower Price, Conversion Rate of Preferred is Reduced to Lower Price
Weighted-Average Formula: Factors in Overall Impact of Total Shares Issued in New Dilutive Round and Adjusts Old Conversion Rate Based on Impact on Total Capitalization
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Special Anti-Dilution Special Anti-Dilution FormulaFormula
Anti-Dilution = Risk & Valuation Adjustment Mechanism, Post-Finance
Special Anti-Dilution Adjustments Failure to achieve Revenue Targets Failure to complete Product
Prototype on time Failure to Complete Management
Team Failure to hit stated Milestones
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Mandatory/Optional Mandatory/Optional RedemptionRedemption
Investor Wants Money Back After Some Period of Time
Depends on Stage of Company and Venture Fund Investing, Business Plan and Profitability Model, Expectations of Liquidity Events
Redemption for Dollars Invested, Dollars Plus Cumulative Dividends, Stated Return, or Fair Market or Appraised Value
Delinquent Redemption: Increase in Conversion Rate for Missed Redemption
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Blown Redemptions?Blown Redemptions? What happens on a failed redemption? Conversion of Equity to Debt Board Takeover provisions Increase in Conversion Rate for every
six months of missed redemption Investor gains control of foundering
company, makes changes
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Drag Along RightsDrag Along Rights Investor control group compels other
stockholders to sell along in acquisition
Stockholders forfeit ability to vote against merger, surrender appraisal rights
What level must control group own to trigger Drag Along right? Less than Majority?
“Drag Along” right implodes on acquisition above a stated IRR
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““Play or Lose” Play or Lose” ProvisionsProvisions
Investor Does NOT Receive Benefit of Price Anti-Dilution Protection if Investor Does Not Play for Full Pro-Rata Share in any New Dilutive Financing
Incentive for Investors to Play in Dilutive Financings and Support the Company
Ensures that Investment Syndicates will Remain United in Support