What deal terms appear in down round and highly dilutive financings?

Takeaway: Some of the deal terms that show up in down round financings are participating liquidation preferences, more stringent protective covenants, redemption rights, more aggressive investor positions on board composition, and sometimes pay-to-play provisions.

Down round and highly dilutive financings can be challenging for startups and their existing investors, as they involve raising capital at a lower valuation or issuing a significant number of new shares, respectively. Both situations can lead to the dilution of existing stockholders' ownership stakes. In these types of financings, it's crucial for startups and their investors to understand the specific deal terms that may come into play. This post will provide an overview of some common deal terms that appear in down round and highly dilutive financings.

Full rachet anti-dilution provisions

In down round financings full rachet anti-dilution provisions start to show up. These provisions fully protect existing investors from the dilution of their ownership stakes by adjusting the conversion price of their preferred shares. Full rachet anti-dilution provisions adjust the conversion price of an investor's preferred shares to the lowest price per share issued in the down round, regardless of the number of shares issued.

Liquidation preferences

Liquidation preferences determine the order and amount in which investors are paid out in the event of a liquidity event, such as an acquisition or the company's sale. In down round and highly dilutive financings, investors may negotiate for a higher liquidation preference, which gives them a greater claim on the startup's assets and proceeds in case of a liquidity event.

Pay-to-play provisions

Pay-to-play provisions require existing investors to participate in a down round financing to maintain their anti-dilution rights and other preferential terms. If an investor chooses not to participate, they may lose their anti-dilution protection and have their preferred shares converted to common shares, leading to further dilution of their ownership stake.

Protective covenants

Protective covenants give investors veto rights on certain decisions made by the company. In down round and highly dilutive financings, investors may negotiate for additional protective covenants, such as the ability to block future financings, changes to the company's capital structure, or the issuance of new securities with equal or superior rights.

Board representation

Investors participating in down round and highly dilutive financings may also negotiate for increased board representation or observer rights, giving them more control over the company's strategic direction and decision-making.

Redemption rights

Redemption rights allow investors to require the company to repurchase their shares after a specific period, typically 5-7 years from the initial investment. In down round and highly dilutive financings, investors may negotiate for stronger redemption rights, such as the ability to redeem their shares at a higher price or on more favorable terms.

Conclusion

Down round and highly dilutive financings can be complex and challenging for startups and their existing investors. Understanding the specific deal terms that may be involved in these financings can help startups better navigate these situations and minimize the potential impact on their stockholders and overall business. It's essential for startups to work closely with experienced legal counsel and financial advisors to ensure they understand and can effectively negotiate these deal terms.