Singapore: The Return of the Down Round

Introduction

Venture capital (“VC”) investments globally dropped to a six-quarter low in 2Q2022 amidst the global economic downturn, high levels of inflation, and rising interest rates.[1]

A weakened funding environment arising from poorer economic conditions in which investors have a lower appetite for risk is among the variables which may suppress a company’s valuation. Other factors include a company’s failure to meet growth milestones and the emergence of new competitors. Such factors may result in a longer period before investments can be realised, spurring investors to negotiate for lower pre-money valuations. As such, a down round may occur where a private company raises funds at a valuation which is lower than the post-money valuation in its previous round, resulting in a greater dilutive effect on existing shareholders.

Considerations for down rounds

Morale and public perception

A down round may suggest that the Company had been overvalued and will reduce investors’ confidence in the company's ability. Employee morale may also suffer in a down round, as the lower valuation results in a corresponding decline in the value of an employee’s share options, leading to fewer options being “in the money”. Preference entitlements negotiated by incoming investors in a down round also push employees further down the distribution waterfall, making them less likely to be compensated in a liquidation event.

Dilutive effects

A down round would also typically trigger anti-dilution protections held by existing preference shareholders. Such protections usually entitle preference shareholders to a larger share of the company’s pre-money shareholding upon the occurrence of certain events, such as a down round, which is achieved through a downward adjustment of the price at which the preference shares convert into ordinary shares.

While anti-dilution protections can cushion investors from the dilutive effects of a down round, the extent of the dilutive effects depends on the type of anti-dilution mechanism adopted by investors in their earlier funding rounds. A full-ratchet mechanism, which could be triggered by a single share issue, favours existing investors and results in the most dilution to ordinary shareholders, who are usually the company’s founders, while a weighted average mechanism, which is more common, distributes the dilutive effects of a down round more evenly.

The Company’s constitution and shareholders’ agreement would typically provide for exceptions to adjustments made during a down round. Such exceptions may include consideration shares issued pursuant to a merger or acquisition, the Company’s employee share option plan, or a bonus conversion.

Investor accounting

Down rounds are characterised by a lower valuation than the post-money valuation in a company’s previous round of financing. A down round would therefore result in earlier VC investors recording a “mark-down” in the value of such investments in their financial statements, which can affect the VC investor’s fundraising efforts and distributions to its general partners.

Potential liability

A down round raises issues of potential liability for a company’s directors and controlling shareholders.

Controlling shareholders, who may include prior VC investors, typically have board representation and may have control of the board. In a down round, the interests of controlling shareholders may not be aligned with those of minority shareholders. Exceptional rights negotiated by incoming investors in a down round are often to the detriment of existing minority shareholders who choose not to participate in the down round. Such terms include enhanced liquidation preferences, participation rights, full-ratchet anti-dilution mechanisms, redemption rights, cumulative dividends, enhanced reserved matters and pay-to-play structures. As a down round may adversely impact a company’s minority shareholders, its directors and controlling shareholders should be prepared for greater scrutiny of the decisions made in negotiating and approving the terms of the investment.

In many jurisdictions, minority shareholders whose interests have been unfairly disregarded may claim for a breach of the directors’ statutory or common law duties of, among others, skill, care, diligence and good faith, pursue their claims through a derivative suit, or sue for minority oppression. Such disputes will dampen further growth prospects and fundraising efforts of the company.

Directors and controlling shareholders can adopt certain precautions in conducting a down round. These include establishing a special committee of disinterested directors, actively exploring alternative funding options, engaging and communicating openly with existing shareholders early on, seeking the approval of non-participating shareholders, engaging an independent financial adviser to advise on the transaction, and maintaining clear and detailed records of the process. Directors and shareholders should also take care to comply with all notice provisions pursuant to the company’s constitution and/or shareholders’ agreement in connection with the down round.

Alternatives

Despite the current economic climate, there may be alternatives to a down round.

Strategic alignments

As alternatives to effecting a down round, companies may also seek alignments through joint ventures and strategic alliances to access capital and expertise, reduce spending, retain talent, and maintain strategic direction in an austere funding environment. Participating in joint ventures or strategic alliances would also enable companies to benefit from the capabilities and infrastructure of their partners and potentially broaden their market access and revenue base.

In looking to reduce operating costs, companies may also consider the reduction of outsourcing arrangements, particularly in lean economic times. Heavy reliance on outsourcing may eat away at a company’s profits, and certain tasks which had been outsourced can instead be automated or handled internally by the company’s employees.

Secondaries of existing shares

A secondary sale occurs when an existing shareholder sells his shares to another buyer. Unlike a primary funding round, no new shares are issued by the company, and the company does not receive any proceeds from the sale, which instead go to the selling shareholder. A secondary sale can be paired with a primary funding round, with the secondary sale offered at a discounted price, enabling the company’s headline valuation to be maintained.

Venture debt

Companies in need of funding in an austere funding environment can consider venture debt as an alternative to extend their runway until the market stabilises. These are typically effected at a quantum of up to 30% of the last financing round raised. In a venture debt transaction, the priority of debt over equity reduces the risk for lenders and consequently reduces the cost of capital for the company. It is typical for lenders to receive warrants on the company’s ordinary shares as part of the deal, as part of the equity upside.

Raising capital from existing shareholders

Warrants and rights issues of shares can also be granted to existing shareholders for a top-up. Such a grant of warrants or rights issues of shares is likely to trigger, where present, the right of first refusal (“ROFR”) of the company’s shareholders pursuant to its constitution or shareholders’ agreement. Where existing shareholders have a ROFR, and such ROFR extends to the grant of warrants or rights issues of shares, the company must first offer these to the existing shareholders before they can be granted to the lender. As the grant of warrants or rights issues of shares to the lender would result in shares in the company being issued to the lender, existing shareholders concerned over dilution may exercise their ROFR to double down on their initial investments.

Alternative sources of financing

Investors can also consider turning to other sources of funding, such as accelerators and corporate and strategic investors. In addition to capital contributions, corporate and strategic investors can provide companies with business mentorship, access to customer networks and can be early testers of a company’s products and services.

Curated structures

While more commonly found in private equity deals, some of the following features may make their way into venture down rounds.

As a risk-management measure, investments may be divided into multiple tranches to be paid out over time, with the later tranches made conditional upon the satisfaction of financial or performance milestones. The permitted use(s) for each tranche of funds is typically specified in the subscription agreement, giving investors control over how the investment proceeds are utilised.

Investors may seek to incorporate or emphasise redemption features in their investments. Shares issued with voluntary or mandatory redemption rights would require the company to buy the preference shares back from the investor at a fixed price either upon the election of the investors, after a certain amount of time has elapsed or upon the occurrence of certain events.

Investors may also require companies to commit to a guaranteed internal rate of return (“IRR”) pay-out upon the investors’ exit, whether incorporated in the liquidation waterfall or redemption price. Such guaranteed IRR pay-outs may come at the expense of earlier round investors who may not have brokered such rights and are left with a smaller share of the pie.

Conclusion

While down round financings often arise in situations where a company is in urgent need of capital, such financing methods should be carefully considered by the board of directors, and the relevant precautions taken and documented to ensure the transaction is not subject to unnecessary litigation risk. Where possible, a company’s board of directors should also carefully consider alternative methods of cost-cutting or funding to avoid entering into a down round.

This article is produced by our Singapore office, Bird & Bird ATMD LLP. It does not constitute as legal advice and is intended to provide general information only. Information in this article is accurate as of 4 October 2022.

[1] https://home.kpmg/xx/en/home/campaigns/2022/07/q2-venture-pulse-report-global.html

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