The financial press has been reporting that investors are concerned that the United States economy may be heading toward a recession.  In light of this and other factors creating uncertainty in the financial markets, investors are questioning the valuations that companies achieved during the heady times of 2020 and 2021, and are indicating that if a company needs to raise funds, they may need to consider a “down round” financing. A down round financing is when a company’s valuation is lower and its shares are sold at a lower price per share than the company’s most recent financing round. 

A down round should be a company’s last option not only because it signals that the company’s value is decreasing, but also because of the many other implications it can have, such as an increase threat of stockholder litigation based on claims of breach of fiduciary duty in connection with common provisions that tend to dilute the ownership of the common stockholders. 

Prior to considering a down round, companies should first explore other alternatives, such as:

• Extending the previous financing round

• Doing a flat round where the company will sell its shares at the same price per share as its most recent financing round

• Undertaking debt financing

• Leveraging licensing and other commercial relationships

• Cutting expenses

If the above options are not available or not sufficient, then the company may consider a bridge financing (i.e., a convertible note) that sets the valuation for conversion at an amount equal to the valuation used in the next equity financing round.  If after exploring the other options available to it, a company decides to proceed with a down round, then it should implement the steps outlined below.

What steps should the company ensure to follow in a down round?

In order to minimize the risk of a negative outcome in litigation from stockholders who believe they have been damaged by the terms of the down round financing, the courts have established a number of procedural and substantive steps that a company’s board of directors should take in connection with approving a down round financing.  These recommended steps are the following:

1. Carefully document the company’s efforts of having sought alternative sources of funding and how the board of directors arrived at the conclusion that the down round was its best option.

2. Appoint a special committee of disinterested board members to review, negotiate and approve the terms of the down round financing.

3. Find an outside third-party investor to lead the round, but be mindful of the broad interpretation of conflicts of interest when determining if such outside third party is truly independent.

4. Engage in a rights offering whereby existing stockholders are afforded the opportunity to participate in the down round financing.

5. When feasible, obtain a third-party valuation or fairness opinion immediately prior to the financing to show that the valuation utilized for the financing is reasonable and fair.

6. Disclose the terms of the financing to the stockholders as well as any potential conflict of interest and obtain the approval of a majority of the disinterested stockholders.

7. Hold live meetings with the board instead of written consents to create space to hold deliberations.

8. Carefully document the deliberations of the special committee and the board with respect to valuation of the proposed down round financing.

9. Require or strongly encourage participating investors to seek their own counsel with respect to likelihood and scope of potential liability.

Financing is the life blood of growing companies.  In uncertain times, companies may need to raise money at a lower valuation than the valuations in their prior rounds.  Before undertaking a down round financing, companies should consider the issues raised by this article and consult with their legal counsel.