Down Round Financings - How to Navigate the Complexity and Keep Your Equity
The Challenge: Your rapidly growing company needs capital to fund the burn rate until the company can get to cashflow positive. If the company needs cash to survive, and the valuation is less than prior rounds then a new financing will be a“down round” with potentially severe consequences to the founders, management, option holders and early investors. Do you have the tools and expertise to navigate this process and protect your share of the company in a future liquidity event?
Three Causes of Dilution: There are three potential dilutive impacts from a down round that can materially and adversely impact management, founders and other common shareholders and option holders.
New Financing Round - investors have significant leverage to demand favorable terms such as liquidation preferences, most favored nations clause or other terms that adversely impact existing holders share of proceeds in a future liquidity event.
Anti-Dilution Adjustments for Existing Securityholders - Typically preferred holders (and sometimes warrant holders) have anti-dilution protections that increase their share of the proceed of a liquidity event upon a down round, shifting the dilution impact to the common.
Option Repricing Program - to retain key employees often requires repricing options, which likewise reallocates upside of a liquidity event to selected option holders.
Complexity of the Process: The company’s management needs to understand the impact of each of these three causes of dilution and how they can reduce the negative impact on their share of the proceeds of a future liquidity event. The challenge is how to manage this “three ring circus” to get the best outcome.
Legal Expertise. Clearly an experienced and competent attorney is indispensable, but their skill is crafting and negotiating the documents, not building, and managing complex financial models needed to see the actual impact of the deal terms. The best legal memo won’t show the impact of a down round on management’s share of a future liquidity event. To ensure your attorney is focused on the right issues, he or she needs to understand the actual financial impact of various provisions and terms of each of the three inter-related transactions.
Cap Table Modeling Expertise. Financial models are indispensable to understanding the impact of these three causes of dilution. However, most models are designed to provide “fully diluted” results, not the impact of the actual legal provisions applied at a future liquidity event, which is when it really matters. What is needed is a robust and flexible solution to enable management to coordinate with counsel an effective strategy with full knowledge of the financial implications of each of the three transactions and the ability to model the best economic deal.
Capital Waterfall Scenario Modeling Solution
This Solution provides a comprehensive process to empower management and their counsel to structure the best outcomes to preserve their equity. The key features include:
“Pro Forma vs Rational Investor” The Scenario Modeling Engine measures the actual distribution waterfall of a merger transaction based on the legal provisions contained in the warrants, preferred stock, options, and convertible notes. A "Pro forma cap table" shows the potential number of shares to be issued upon exercise of derivative securities whereas the Scenario Modeling Engine shows the actual application of these legal provisions with the Rational Investor Algorithm functionality. The result is a more realistic assessment of what each securityholder will receive upon a liquidity event, rather than a pro forma as of the closing of the financing transaction.
Flexible, Insightful Reports. The Scenario Modeling Engine produces scores of reports providing valuable insights. These reports can be generated for each of the three types of dilution events- new financings, anti-dilution adjustments and option repricing. The reports slice this data at the Class Level, for a group (such as management) or individual securityholders.
Validation Backup Reports. As several iterations of the Reports will often be needed to develop an appropriate strategy in the Down Round Financing scenario, the Reports include various validation reports to show the variances between the data or assumptions used for a particular instance, ensuring a clear understanding of what is impacting the share of each securityholder.
Navigating the complexities of a down round requires not only good lawyering, but also a robust and flexible financial model to illuminate the implications of the legal documents. Capital Waterfall has developed the most accurate cap table scenario modeling solution for C suite executives and their advisors to make real time, strategic decisions at critical points in the company’s capital lifecycle.