Like much of the rest of the economy, though even more so, the high risk/reward entrepreneurship and investing sector has been on a roll these past few years. The venture industry has been raising and investing record amounts of capital; valuations have skyrocketed; and deal-terms have been ever-more founder-friendly.
Well, those days are over, at least for now. Look for 2020 to see declines in venture capital raised and invested; valuations to fall; and deal terms to pivot back towards investors. The future is here, and its looking more like 2001, or 2009, than 2019.
For entrepreneurs, the outlook is grim, at least by comparison to recent years. Ditto for venture investors, although they at least have the silver linings of declining valuations and better deal terms. Those in both camps who have lived through a down-cycle can probably dust off and update old playbooks for the new realities. For less experienced folks, and particularly entrepreneurs, now would be a good time to start thinking about successfully navigating through a venture cycle trough. Which is to say, start thinking about … down rounds.
First, a clarification. By “down round” I mean a round at a meaningfully lower price than the preceding round. So, for example, a round of $0.75/share when the last round was at, say, $1.00/share. For my purposes, the term down round does not encompass “washout” or “cram down” rounds, where the price falls much more dramatically, say from $1.00 to $0.05. While both kinds of deals can and do happen in good markets and bad, down rounds are more of a cyclical phenomenon, and in all events much more common than washouts. The two animals share some features, but down rounds are to cramdowns what, say, Bobcats are to Tigers.
The Lay of the Land. The starting point for thinking about down rounds is the same as thinking about up rounds: get out your prior round documents and figure out what rights your prior investors, you, and your team have on paper. Still more important, start asking yourself what the realities on the ground – of your progress, the market, and the perceived performance of you and your team are - and how those factors will impact the legal positions of the various players.
This bears emphasis. In a down round, as in any round, the legal posture of the various parties is a starting point, not an end point, for figuring out who has what leverage across the moving parts of a financing round. It is like the proverbial plan for battle: it warrants serious study, but once the contest is joined it becomes a, not the, factor in how the battle plays out.
Ordinary Course Down Rounds. Once you’ve got the lay of the land, start thinking in terms of the players: who brings what to the table, in terms of promise and baggage. The simplest down round scenario – let’s call it the Ordinary Course scenario - is a pro rata capital injection by the current investors with no changes to the business Team. Nothing really changes except the investors average down their price, and the Team takes a dilution hit.
In the Ordinary Course scenario, the investors have a common perspective on the deal (as they are all participating, pro rata) and the Team is stable (everyone is considered to have more or less the same relative value proposition as they did at the last round). It’s a common enough down round scenario when the company gets a bit behind schedule and needs a little more runway, which together might have made for a flat round or even extension of the prior round but for the dip in the market generally. It’s a scenario we are going to see play out a lot over the next year or so.
The Ordinary Course down round is pretty straightforward, involving as it does a united investor group (looking for lower valuation and perhaps some modest goosing of other deal terms) and a united Team (focused mostly on valuation but not disinterested in the other deal terms). What makes this scenario more often than not benign is that the investors, while interested in averaging down their price, know that they can’t go so low as to not leave enough upside for the Team, and the Team knows that while they don’t want to give too much on valuation, a pro rata inside round in-the-hand is, like a bird in-the-hand, worth two modestly better deals in-the-bush. Life is too short, so to speak, for either side to play too hard to get.
Hard Times Down Rounds. If the Ordinary Course down round is generally a dry, weary affair, when a down market and a depleted cash stockpile coincide with disappointing performance and Team turmoil, down rounds can become much more … stimulating. For our purposes we’ll assume that our startup, Newco, has had some serious mishaps, both in terms of real business/technical issues and perceived management issues. Current investors are mostly tapped out but variously open to considering a modest new investment with the right players, and on the right terms. A potential new investor, CEO candidate in-hand, is interested.
Welcome to the Hard Times down round scenario. The bookend to the Ordinary Course down round. The down round from the lower reaches.
In our generic example, the players fall into four categories. First, there is the new investor (the “New Money”). Next, the prior investors who, as noted, are not looking to double-down on their bet but might be tempted to pony up enough to call at the right price (the “Old Money”). Than the prior managers who are no longer considered essential going forward (the “Forsaken”). And, finally, the prior and new managers (mostly the new CEO) who are considered essential going forward (the “Blessed”).
In evaluating who “wins” the Hard Times down round, the key is appreciating that the legal rights of the various parties are secondary to the practical realities of the deal. The legal issues are better thought of as considerations than constraints.
In our Hard Times setup, the New Money and the Blessed have no legal rights whatsoever. At the same time, together (and that dynamic itself is a critical variable) they are sitting at the head of the table. On the other hand, the Old Money likely have the law on their side in the form protective provisions and possibly voting control at the Board and/or Shareholder level. Their practical negotiating power is sharply limited by their lack of appetite for either funding the company themselves or writing off the investment. Finally, the Forsaken; cursed with little in the way of either legal or practical leverage.
How all this plays out is, of course, a function of how each of the parties plays its hand. That said, those hands come with certain intrinsic merits that almost always shape the outcome.
Clearly, the New Money holds high cards, across a number of suits. The Golden Rule, and all that. The New Money’s practical leverage more than compensates for its dearth of legal leverage.
Ditto the Blessed. The new CEO-in-waiting arguably has the most leverage of all. That’s because the New Money’s interest in the deal is most often contingent, at least in the first order, on the new CEO playing ball. In that sense, the New CEO is a bit of a wild card from the perspective of the New Money.
The third party with real leverage – albeit limited, as we shall see – is the Old Money. They have the legal right to block any deal. And, in fact, they sometimes will. But when they do, it’s at a high cost: they either consign the deal to the dustbin of history, so to speak, or have to pony up more money than they’d like to put the company on life support while they look for another well-capitalized new investor to step up.
That leaves the Forsaken. Any practical leverage they have is moral. As, say, Belgium in 1918 and 1940, but without even a treaty to make a stand on.
Put all of this together and the “solution” to the various competing interests is in outline, if not in every detail, pretty clear. Valuation takes a serious hit, but at least the Old Money gets to average down its price and thus get some of that dilution back. The new CEO gets a big chunk of new equity, and anyone else considered valuable going forward gets an equity boost of some sort. The considerable dilution from all of this is born by the Forsaken. While everyone else will fill the chill of a down round, the Forsaken will feel something more like the deep freeze of a washout.
It’s been awhile since down rounds made up any significant portion of venture investment rounds. Those were the days, and they were heady days indeed. And, for now at least, they are over. While there will still be up rounds now and again to keep everyone interested, look for down rounds to take more than their fair share of the harvest. And get used to thinking about how your next round comes together in the dynamics of a down market.