Search

The 'Down Round' Caution : Things You Need to Know! (Silicon Valley × LexStart)



Silicon Valley: S02E01 (Part 2) - The episode shows investors in a startup being spooked by a possible “down round”. What is a down round and what are its implications?

A funding round is a stage where scaling 10x or 100x of business becomes possible where the proof of concept, the addressable market and the business model of revenue generation is validated by investors of choice. For understanding of funding rounds, refer to our previous blog in this series at:

https://www.lexstart.com/post/seed-series-series-a-series-b-which-series-are-you-silicon-valley-lexstart

When a startup grows and functions as per the entrepreneur’s plan and vision, it can choose two ways of growth in funding-

  1. Either there aren’t a whole lot of fundraising rounds and the company grows by employing the revenue it generates, or

  2. Each subsequent funding round is executed at a price higher than the previous round to reflect an increase in the valuation of the startup.

Reality of valuation is subject to a variety of factors and may or may not increase with each subsequent fund round, despite the entrepreneur’s best efforts. A decrease in valuation of the startup as compared to the valuation in the last round of funding is what results in a down round.[1] [2]

A funding round is termed as a ‘down round’ if the pre-money valuation of the startup in the current round is lower than its valuation in the last round. In a down round, securities are offered to the participating investors at a lower price than the preceding round.

What happens when you go through a down round?

Well, apart from the fact that the valuation of the company takes a hit, most important is the consequential dilution of every shareholder on the cap table prior to such round, which is significantly higher.

Typically, investors invest in a company through CCPS (Compulsorily Convertible Preference Shares) instead of equity shares. If the investor has invested in the startup through CCPS, then such investor would have anti-dilution rights granted to him/her in the Investment Agreement / the Shareholders’ Agreement. If the investor has anti-dilution rights, then such investor’s shareholding will be adjusted using the anti-dilution mechanism spelt out in the Investment Agreement / Shareholders’ Agreement.

The adjustment, in case of CCPS, is done by changing the conversion ratio of the CCPS. What happens if an investor holds equity shares and not CCPS? Are they not granted anti-dilution protection? Well, they can. Just remember this, anti-dilution protection is a contractual right, so any investor, irrespective of the instrument they hold, can be granted this protection as long as the same has been incorporated in the Investment Agreement / Shareholders’ Agreement.

The critical distinction between the anti-dilution mechanisms in case of CCPS and equity shares is that while in case of the former, the holder can adjust their shareholding ratio by simply adjusting the conversion ratio of the CCPS, in case of the latter, equity shares not being convertible instruments, the holder will have to infuse more capital in the startup to adjust their shareholding in order to reduce the quantum of dilution.

This investment can be made at the minimum price permissible under law, which is effectively the face value of the shares. One will of course have to evaluate the ensuing tax consequences.

To summarize, in case of CCPS, the anti-dilution adjustment will protect the holder’s shareholding without the need for any additional investment. In case of equity shares, the anti-dilution adjustment will require the holder to infuse additional capital, albeit nominal.

Recent Posts

See All

About us

Career

Contact us

Terms & Conditions

Privacy Policy

Contact Number

Email Address

  • Facebook
  • LinkedIn
  • Instagram
  • Twitter

© LexStart Consultancy Private Limited | CIN: U74999MH2015PTC265981

REGISTERED OFFICE - 7916, Tulsiani Chambers, Nariman Point, Mumbai - 400021