Don't Do a Down Round Until You Read This

FundraisingStartupsVenture Capital
Written By hm

Many founders who raised in the bubble of 2020-2022 are now facing the prospect of a down round as they look to raise again in a very different economic climate.

I realize beggars can’t be choosers, but beggars can be strategic. And there are a few things you should know when dealing with the reverberations from the term sheets of yesteryear.

Below is an edited transcript from a Closing Time podcast episode on the topic, with my friend and co-host, startup lawyer Michael Esquivel. We cover:

  • What valuations we’re seeing today, and how they compare to 2020-2022

  • What you need to consider as a founder when negotiating a down round

  • How to protect angels and early employees as much as possible

  • Strategies to minimize the impact on employee morale

  • What are "dirty terms" and why you should avoid them

Halle: How are the term sheets that were signed in the ZIRP days of 2020-2022 causing problems for founders today?

Michael: Today we're living in a very, very different world than the one we were living in just two years ago. The reality is that we are seeing valuations return back to more historic norms in terms of multiples and overall enterprise value.

When you think about what we saw during the pandemic, we had multiples that just exceeded historic norms. We saw companies that were raising money on a 100x multiples on ARR. We saw routinely 30 to 50x type multiples.

And if you look at what happened in the public markets over the last 24 months, we've seen a dramatic correction. The reality is that most of the comps in the public markets have had adjustments between 30-50 percent and in some cases significantly more. Those corrections in the public markets had to find their way into the private markets.

It's just a very, very different world. And I think the sooner we all come to appreciate the reality of that, I think the more comfortable we'll be moving forward as a collective industry.

Halle: What valuations are you seeing today?

Michael: You know, for solid companies, we're back to 3-6x. For really, really good companies maybe they're 6-10x. And for those supernova type companies, you're looking at 10-20x range, but we're still nowhere near some of the multiple ranges we were seeing in 2021 and early part of 2022.

Halle: I'm seeing a lot of companies that have really strong founders but haven’t grown into their valuations. And I'm seeing a lot of flat and down rounds. What does that mean for founders? What does that mean for existing investors? Who wins and who loses in these situations?

Michael: I'm also seeing a lot of down rounds in my practice. We're seeing them across the data that we are both collecting internally at Fenwick and the data we're seeing from third party providers. Flat is the new up is the way I like to think of it.

A down round is okay. The mistake I think we're seeing founders engage in at times is they're so focused on trying to keep that top nominal headline valuation number up, that they're engaging in the dreaded structured round, the dreaded dirty term sheet. I think you're better off as a company in the long run both for your employees and for the cap table to take your medicine, do a down round, but do it with clean terms.

Halle: Let me give you an example of something that happened to one of my portfolio companies. You know, angel investors, we really get screwed over the years. Of course it can turn out fabulously, but there are so many cases of recaps where early believers in the company are just completely wiped out.

And I had a situation with a founder who had a round that recapitalized the company. And for those that didn't participate in the round, our preferred shares were converted to common at a 10 to 1 ratio, which, you know, essentially wiped us out.

I talked to the founder about it, and they were like, you know, I had no choice. This is what the market gave me. I'm seeing this a lot. It can be demoralizing for founders, early investors, and early employees who've been working hard and are tired.

Michael: Look, no one's saying when I say take your medicine that it's going to be a fun experience, but you're still sick and you're still dealing with the hangover effect. But, here's the way to address it. I think if you structure a down round in a really significant recap style, like the one you alluded to a moment ago, you need to put a big option pool in place. 

I remind the investors who lead that because you've got to turn around after the fallout of the conversion. After the pay to play is executed, you now need to make sure that you've properly re incentivized those employees that are left, we want them to feel like they're part of the go forward mission and that through their hard go forward efforts, we can right the ship. And so I think it's important that when you do experience a down round as a founder, that you work hard to negotiate a large option pool so that you can turn around and take half of that increase and give it to the existing employees.

Halle: Is there any liability for the founders in doing that? You could imagine a previous employee, maybe an early employee who worked for four or five years, feels like, well, I'm not given more equity because I'm not there now, but this has diluted my ownership and could sue. Is that possible? 

Michael: I think it's something you should always be mindful of. Former employees, you want to try to do the best you can by them because they helped you get to whatever that point was in the life cycle that now, unfortunately, has brought you to this down round. But they certainly were contributors.

The way to protect yourself as a founder and as a board, and frankly, any of the investors on the board, you've got to go out there and make sure you've done a full market check that you have turned over every reasonable stone and looked at every reasonable opportunity. And if at the end of the day, the alternative is either shut the company down or engage in this very challenging down round situation.

Halle: I've been so burned as an angel investor. I feel like I take the biggest risk in the founder earliest on. Yet we're also the first to get screwed over in these situations.

Michael: It’s a fair observation. One thing that we often raise with founders to talk to the investors leading the down round about is do you want to try to carve them out of the pay to play? (Pay to play is a transaction where the previous investors have to invest their pro rata in the down round or have their equity suffer some penalty).

One way to protect angels is under Delaware law, you can set an objective standard and say the pay to play only applies to preferred shareholders that hold more than X shares. And you set that threshold so you protect those early angel investors.

Halle: So investors can can potentially protect themselves but then that really leaves employees as the ones who are at the biggest disadvantage. What advice do you have for employees that are working at companies going through a down round?

Michael: One, if it's feasible I always encourage my founders to think about offering to those employees that are accredited investors to give them the chance to participate as well. But they took the risk in joining a startup, and so they're already putting a lot of their personal financial wealth at risk by being part of the startup. So they may not have the capital. 

Two, let's get a big option pool in place. Let's make sure that they're getting equity at the new 409a, and a big slug of it to really incentivize them to take a breath, roll up the sleeves and get back to work. 

Three, something that oftentimes isn't considered the pay to play wipes out liquidation preference. Remember common sits at the bottom of the liquidation stack, meaning at an exit event, the preferred investors, if they're going to take their liquidation preference, they get their first money out.

But if the pay to play reduces the aggregate liquidation stack by the amount of which investors who do not participate get converted into common then the aggregate stack is now going down, and you're also reducing the fully diluted number by a significant amount because the fully diluted number of shares has gone down. So, you're reducing each non participating investor's stake by 90%, and you're taking that liquidation amount off the top, because they're now just common, sitting side by side with the employees.

So there are a few silver linings in an otherwise just horrible situation. But no one feels good. It's not a fun experience, but I can't emphasize enough that you're better off doing that, taking that pain in the near term to set up the company for long term success by keeping things straightforward and clean and simple.

Halle: What are clean terms? What are dirty terms?

Michael: What we mean by dirty terms are situations where in order to keep that top line headline valuation number high, investors are saying okay I'll give that to you. But in exchange I'm gonna want senior liquidation preference. I'm going to want a multiple liquidation preference on top of that. I may want a cumulative dividend structure. I may want a mandatory redemption. And I might even want a full ratchet, any dilution protection.

These terms, which on their face may not seem horrible, as you start to think about the implications of what it means for the business, it can be really, really devastating for the common shareholders. So the guidance I've given time and time again: if you have the choice between a clean term sheet with simple 1x nonparticipating preferred terms at a lower valuation, even if it's a down round versus a higher valuation, you're always better off. Even if it's just painful.

Halle: At the same time, the best way to negotiate is to have multiple term sheets from multiple firms. A lot of founders are really in a situation where they're forced to unsavory terms. But at least you can have the conversation and say, look, I would rather lower this valuation and remove some of these dirty terms than have such a complex agreement.

Well, Michael, thank you for letting me pick your brain on downrounds.

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