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Where once we reviewed price protection provisions with a theoretical eye, in the current venture capital climate we have had to polish our slide rules and solve the complicated algebra associated with this often-used, seldom-understood concept. We have also had the bad fortune of informing founders and management of their dramatically diluted ownership stakes.
Anytime a company sells equity, its existing owners suffer dilution in terms of percentage ownership. So long as the price is going up, that is acceptable because the value of an investor’s ownership stake is increasing. A "down round" is a financing event in which the new securities are sold at a price per share lower than that paid in previous investment rounds (e.g. if a company initially sold Series A Preferred at $2.00 per share and subsequently sells Series B Preferred at $1.00 per share). Down rounds result in substantial dilution to existing stakeholders, both in terms of percentage ownership and value of their ownership stake. Traditionally, venture investors have protected themselves against down round pain by seemingly innocuous price protection provisions.
If your investors or lawyers have referenced one of the following terms, a down round may be in your future:
• Getting your pants pulled down
• Getting killed
• Wash out
• Monster mash
• The dilution solution
• Retroactive repricing
• Blue light special
• Cue the fat lady
• Voting the founders off the island
• ‘Deliverance’ round
• Death spiral round
• Force feed
• "Recapitalization" means the company’s post-down round capitalization after applying the applicable price protection formulas.
• "Price protection" (sometimes referred to as anti-dilution protection) is a standard venture capital investment term that protects investors in the event of a future lower priced financing.
• "Full ratchet" price protection is the effective repricing of the Series A price per share to the now-lower Series B price per share. Mechanically, the conversion ratio of Series A is adjusted so that each share of Series A will be convertible into two shares of common stock.
• "Weighted ratchet" price protection also adjusts the conversion ratio of Series A but takes into account the number of lower priced shares issued in proportion to the company’s capitalization. For purposes of calculation, weighted ratchet is more complicated. The mechanics of weighted ratchet work like this: Series A will be convertible into more than one but less than two shares of common stock, depending on variables like the size of Series B financing and the post-Series B option pool.
• "Carve-outs" are lower priced securities, such as options to employees and warrant-sweeteners to lenders, that do not trigger price protection.
Who bears the pain in a down round? Anyone that does not have price protection, which typically includes holders of common stock, optionees and holders of skinny preferred stock. When price protection is triggered, equity ownership is effectively redistributed to those with price protection and away from those without. For most of the 1990’s, a typical venture-backed financing included a weighted ratchet and a typical angel financing did not have price protection at all. Since the meltdown in the spring of 2001, full ratchet price protection has become the market norm. In a few inside-led down rounds, the terms of existing preferred stock have been amended to provide for retroactive full ratchets, a so-called "get-well" provision. Another variation on the theme is the inclusion of a "pay-to-play" provision that requires investment in the down round in order to take advantage of price protection.
Is this as bad as it seems? Maybe, maybe not. For VC funds that have no money left in their funds for follow-on investments, or "dry-powder," price protection has made the last two years somewhat bearable (no pun intended). For founders and management that have remained gainfully employed over the last two years, price protection has killed their early equity ownership stakes but has been de-fanged by additional option grants at the time of the new financing. Most new investors insist on "re-upping" management through additional stock option grants to insure that management will be motivated on a going-forward basis. From an equity ownership standpoint, the big-time losers are stockholders that are no longer employed by the company and not eligible for additional grants of equity. We see this most often with founders who have a relatively large equity stake before a down round financing but are no longer employed by the company. The "crushees" are left without a chance to get whole. We have seen instances where the price protection formula blows up – essentially, there is a point where the "crushees" have nothing left to crush.
While undeniably painful to the "crushees," down rounds are usually not contested at the time of their funding. Ironically, the conflict surfaces at the time the company makes good on its dreams and successfully exits. With big money on the horizon, the "crushees" are met with unwelcome news – a diluted ownership stake that is worth far less than any of them could have imagined. The seminal case on this point is out of the Bay area – the founders of Alantec Corporation sued their VC controlling stockholders/board of directors for fraud and breach of fiduciary duty based on the approval of a down round. The founders, who had owned 8% of Alantec prior to the down round, owned less than 1% immediately after. Alantec’s good fortune of a public offering and eventual sale for $770 million was too much to take for these "crushees" and a lawsuit ensued.
For better or for worse (depending on which side of the venture checkbook you see), full ratchet price protection is a part of every current venture deal. Only by raising money at increasingly higher valuations can down rounds be avoided. Unfortunately, given the circumstances of the last two years, this has been the exception rather than the rule.
This article was published in the June 2002 issue of the Triangle TechJournal.