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Mergers &
Acquisitions
The Downer of “Down Round”
Financing
By Andy Smith, CPA/ABV, ASA, CVA, CMA, and Senior Managing Director,
Valuation Services at The McLean Group.
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Summary: Down round financing is a round of financing where
investors purchase stock from a company at a lower price that
prior investors paid. The devaluation of the company stock is
necessary to attract funding to continue operations, but results
in the dilution of ownership for existing owners. Therefore, Andy
Smith explains, it’s essential that board members understand the
financial terms and fiduciary duties in a down round, and educate
themselves on how opinions or other third party valuation analysis
can be provided to help support the reasonableness of the terms of
the down round. |
When the economy turns down, many existing investors are faced with the
decision between going out of business or diluting their ownership through
a “down round” of financing.
Down round financing is a round of financing where investors purchase
stock from a company at a lower price that prior investors paid. The
devaluation of the company stock is necessary to attract funding to
continue operations, but results in the dilution of ownership for existing
owners. The lower valuation can be extremely dilutive to existing
shareholders, if investors do not structure down round anti-dilution
protection.
Down round anti-dilution protection is often incorporated into the terms
of preferred stock purchase agreements to provide investors with
additional stock if the company issues new shares at a lower price. This
protection is typically structured in two ways, weighted average and
full-ratchet. Both of these are designed to protect the investor against
decreases in the company’s value.
The two forms of anti-dilution protection allow the conversion price of
the preferred, typically the original price paid, adjusted downward upon a
down round at less than the original conversion price. As a result, the
original investors receive extra shares of common stock upon the
conversion of the preferred stock for no additional consideration.
The weighted-average approach, which is the more traditional of the two,
results in an adjustment to the conversion price based on the average
issuance price. The full-ratchet protection provisions gained more
traction after the tech bubble in 2001, and is potentially far more
dilutive than the weighted-average. It protects investors by adjusting the
conversion price to the lowest price per share at which the company sold
shares in the down round, regardless of the number of shares issued.
If the preferred shareholders are protected, then what happens to the
common shareholders in a down round? The existing common shareholders, who
are already watching the value of their investment decrease with the
company’s performance, will typically face further dilution and
devaluation in a down round of financing.
Down round financing can create a perception of unfair dealing based on a
number of factors, including potential conflicts of interest of the board
of directors and the perceived leverage of the original financial
investors. Therefore, it is essential that board members understand the
financial terms and fiduciary duties in a down round. Fairness opinions or
other third party valuation analysis can be provided to help support the
reasonableness of the terms of the down round.
Andy Smith, CPA/ABV, ASA, CVA, CMA, Senior Managing Director,
Valuation Services at The McLean Group. Mr. Smith manages The McLean
Group’s business valuation practice. The McLean Group is a middle market
investment bank. In addition to mergers and acquisitions, the firm
performs business valuations for public and private companies for
transaction, financial reporting, stock option plan, and tax purposes. For further information see
www.mcleanllc.com
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