DON’T GET STUCK IN DOWNROUND DOLDRUMS! RAISING VENTURE CAPITAL FUNDING DURING THE COVID-19 CRISIS

It will take some time before the full effects of the COVID-19 crisis on the venture capital eco-system are truly known and understood.  What is clear, however, is that many early-stage and growing companies will be operating in distressed circumstances during and for some time after the COVID-19 crisis and may need to consider raising funding from VC investors. 

Navigating a VC fund raising in these waters can be a tricky task.  At least one likely consequence of COVID-19 is that companies will see downward pressure on their valuations when attempting to raise funds, whether as a result of the direct or indirect effects of COVID-19 on their operations or market sentiment.  This raises a particular issue for companies that have already gone through a VC funding round previously and are now attempting to raise further VC funding.

A typical term in a VC investment is the inclusion of anti-dilution or 'downround' protections, which are a key form of downside protection for VC investors geared towards mitigating the risks and difficulties associated with accurately valuing early-stage or growing companies. 

These protections are triggered when the company raises equity funding at an issue price per share lower than the price per share at which the VC investor invested, otherwise known as a 'downround'.  Put differently, these protections are triggered if the company raises equity funding at a lower valuation than the valuation at which its existing VC investors previously invested.

If triggered, anti-dilution protections compensate the VC investor for the dilution it suffers as a result of the downround by issuing additional shares at nominal value to the VC investor, alternatively by upwardly adjusting the rate at which the VC instrument (typically convertible preferred shares) converts into ordinary shares.  

If a company has already received funding from a VC investor, it is probable that the company's constitutional documents contain anti-dilution protections for the VC investor.  Anti-dilution provisions typically include carve-outs, such as where share splits or other non-dilutionary share issuances are implemented, but these do not extend to 'force majeure' type events external to the business. 

Where such companies are looking to raise funding in a downround, they will need to carefully consider whether the anti-dilution protections will be triggered.

The key effect of the anti-dilution protections is that existing shareholders (other than the VC investors) suffer an additional dilution in order to compensate the VC investor for the downround.  The ultimate dilutionary effects on the existing shareholders' equity stakes will vary depending on the mechanism set out in the company's constitutional documents. 

It is therefore crucial that the founders and VC investors (both prospective and existing) carefully consider and understand the impacts of the downround and anti-dilution protections on the company's cap table.

From the founder's perspective, they would need to protect as much of their value in the company as possible - not only for themselves, but also for key employees holding equity in the business, for example, through employee share incentives schemes.  From the VC investor's perspective, consider whether founders and key management remain incentivised to grow the business if their equity stakes are excessively diluted.  Will the founders and key management still have sufficient "skin in the game" post-downround?  

Maintaining a focused and invested management team with good morale may prove decisive in weathering the COVID-19 crisis.  In this regard, the interests of the founders and VC investors are aligned to a significant extent and it may not always be wise for the full punitive effects of the anti-dilution provisions to be arbitrarily enforced.

Achieving an ultimately fair outcome should therefore be in all parties' interests and depending on the circumstances and level of cooperation between the parties, there are various potential structuring options one could consider to mitigate the effects of the downround.  Expert legal advice should be sought as early as possible in the process to assist to ensure the full range of options has been considered.