What is meant by a Down Round?
A Down Roundis when a financing round is conducted at a pre-moneycompany valuation that is lower than the company valuation of the lastfinancing round.
A Down Roundis best explained with an example:
Example
XZG AG has a share capital of CHF 600,000.00, divided into 1,500,000 ordinary shares, 2,500,000 preference shares A and 2,000,000 preference shares B. All shares have a par value of CHF 0.10. In addition, XZG AG has authorized capital in the amount of CHF 100,000.00, divided into 1,000,000 registered shares with a par value of CHF 0.10 each.
The preferred shares A were issued in a Series A financing round at an issue price of CHF 1.00 (total investment of CHF 2,500,000.00). The preferred shares B were issued in a Series B financing round at an issue price of CHF 2.00 (total investment of CHF 4,000,000.00). The ordinary shares were subscribed for at the incorporation and the authorized capital was created in the course of the Series B financing round.
Due to the economic development, XZG AG requires new capital in the amount of CHF 1'000'000.00.
For this purpose, the Company is issuing 2,000,000 new Preferred Shares C at an issue price per share of CHF 0.50 (total investment CHF 1,000,000.00). The Series C financing round is thus a Down Round.
What is the problem of a Down round?
In the case of a Down Round, the price paid for one share in the company is lowerthan the price paid by the previous investors for one share in the company, i.e.,the value of one share in the Company falls below the level of the original shareprice.
To protect investors from such price dilution,financing round documentation regularly contain protective clauses (so-called Down Round protection clauses).
What is a Down Round Protection Clause?
With a DownRound Protection Clause, a retroactive valuation adjustment iscontractually agreed so that existing investors are fully or partiallyprotected from the negative effects of a DownRound.
If the DownRound Protection Clause takes effect, existing investors are given theopportunity to subscribe for a certain number of additional shares in theCompany at par value, i.e., theinvestors affected by the Down Roundhave the right to subscribe for additional shares at par value.
The number of shares to be allocated to theprotected investors at par value can be determined in different ways.Essentially, a distinction is made between two methods, the full ratchet method and the weighted average method.
How does the Full Ratchet methodwork?
The fullratchet method represents the most favorable form of dilution protectionfor the investor. Under this method, the investor is entitled to acquire asmany new shares in the company at par value until he is in the same position asif he had acquired his existing shares in the company at the (lower) valuationof the Down Round. The investor is thus subsequently placed in the sameposition as if he had made his total investment at the price of the Down Round.
Thegeneral formula for calculating the shares to be allocated to the investor isas follows:
Example
If the Down Round Protection clause in the initial example provides for a full ratchet method, the Protected Investors have the following rights:
- The Series A investors have the right to acquire 2'500'000 new company shares at par value. Based on their initial investment of CHF 2'500'000, they have the right to a total of 5'000'000 shares, whereas they already hold 2'500'000 shares.
- The Series B investors have the right to acquire 6'000'000 new company shares at par value. Based on their initial investment of CHF 4'000'000, they have the right to a total of 8'000'000 shares, whereas they already hold 2'000'000 shares.
N is calculated according to the above formula and can be summarized as follows:
How does the Weighted Average methodwork?
The weightedaverage method is less far-reaching than the full ratchet method. For example, the price P is not simplycalculated based on the issue amount of the DownRound; instead, the volume of the previous financing rounds and the Down Round is also taken into account todetermine the average price P.
There are two variants of the Weighted Averagemethod, the so-called Broad BasedWeighted Average method and the NarrowBased Weighted Average method.
The most founder-friendly calculation method isthe BroadBased Weighted Average method. When calculating the average price P,the following formula is applied:
Example
In the initial example, the average price P for investors A and B would be calculated as follows:
- The average price P for the Series A investors is calculated by dividing the investment I of CHF 8,000,000.00 (= CHF 1,000,000 from the Down Round plus the theoretical investment if all 7,000,000 shares were subscribed at the price of CHF 1.00) by the number of outstanding shares (including authorized capital) after the Down Round (= 9,000,000 shares). This results in an average price P of CHF 0.89.
- The average price P for the Series B investors is calculated by dividing the investment I of CHF 15,000,000.00 (= CHF 1,000,000 from the Down Round plus the theoretical investment if all 7,000,000 shares were subscribed at the price of CHF 2.00) by the number of outstanding shares (including authorized capital) after the Down Round (= 9,000,000 shares). This results in an average price P of CHF 1.67.
Based on these average prices, the value N and thus the shares to be allocated to the protected investors at par value can be calculated as follows:
If the Down Round Protection Clause in the initial example provides for a Broad Based Weighted Average method, the protected investors have the following rights:
- The Series A investors have the right to acquire a total of 312,500 new company shares at par value.
- The Series B investors have the right to purchase a total of 400,000 new company shares at par value.
Finally, the Narrow Based Weighted Averagemethod is a solution in the middle. When calculating the average priceP, only the investments made by the investors in the respective financing roundconcerned are taken into account.
When calculating the average price P, thefollowing formula is applied:
Example
In the initial example, the average price P for investors A and B would be calculated as follows:
- The average price P for the Series A investors is calculated by dividing the investment I, consisting of the investment amount of the investors concerned and the investment amount of the Down Round totaling CHF 3,500,000.00 (= CHF 1,000,000.00 from the Down Round plus the investment of the Series A investors, i.e. 2,500,000 x CHF 1.00) and the number of shares S, consisting of the sum of the shares issued in the Series A financing and the Down Round (= 4,500,000 shares). This results in an average price P of CHF 0.78.
- The average price P for the Series B investors is calculated by dividing the investment I, consisting of the investment amount of the relevant investors and the investment amount of the Down Round totaling CHF 5,000,000.00 (= CHF 1,000,000.00 from the Down Round plus the investment of the Series B investors, i.e. 2,000,000 x CHF 2.00) and the number of shares S, consisting of the sum of the shares issued in the Series B Financing and the Down Round (= 4,000,000 shares). This results in an average price P of CHF 1.25.
Based on these average prices, the value N and thus the shares to be allocated to the protected investors at par value can be calculated as follows:
If the Down Round Protection clause in the initial example provides for a Broad Based Weighted Average method, the protected investors have the following rights:
- The Series A investors have the right to receive 714,285 new company shares at par.
- The Series B investors have the right to acquire 1,200,000 new company shares at par value.
How can a down roundprotection clause be mitigated?
Founding teams are naturally keen to avoid Down Round Protection Clauses altogetheror at least to limit the duration or extent of the dilution protection of theinvestors. The reason is obvious: a Down Roundoccurs when the company value develops negatively. In this situation, the DownRound protection clause givesinvestors a right to adjust the valuation – to the detriment of thefounders.
However, depending on the situation and riskallocation, the parties involved may provide for a time limit on the protectionagainst dilution or a so-called pay-to-playarrangement.
The time restriction is about limiting thedilution protection to the next financing round, for example. In this case,investors would only be protected if the subsequent financing round isconducted at a lower valuation. Thereafter, the Down Round Protection Clausewould not be applicable anymore.
If a pay-to-playarrangement is agreed between the parties, the dilution protection is madeconditional upon the protected investors subscribing for new shares in thecompany at the issuance price of the DownRound, usually by exercising their subscription rights in full. If theinvestors do not exercise their subscription rights, it can be contractuallystipulated that they lose their dilution protection and, depending on thecontractual situation, also all other preferential rights.
A pay-to-playarrangement can at least indirectly force investors to finance the companyin the future, or it can create an incentive for investors to continueinvesting in subsequent financing rounds.
Conclusion
Down Round Protection Clauses can lead to a considerable dilutionof the founding team and should be checked with great caution. Further, thereis no limit to the complexity of such clauses as the number of investors andfinancing rounds increases. Accordingly, the negotiation of these contractualclauses is of great importance and the founding team should be aware of theirconsequences. A prior calculation of the scenarios is thereforeindispensable.
Disclaimer: Theinformation contained in this article is for general information purposes anddoes not constitute legal or tax advice. In specific individual cases, thepresent content cannot replace individual advice from expert persons.
