September 21, 2023
In recent quarters, the startup ecosystem has suffered from a sharp decline in VC funding and deal count. Q1 2023 saw the slowest quarter for venture capital raised and deal count since 2017. Q2 2023 showed signs of improvement, with venture capital raised increasing over Q1 but still down year over year. A stagnant IPO market has also perpetuated the challenges for startups in securing funding.
In these challenging times, down rounds have become more prevalent and don’t appear to be going away. Down rounds are when startups raise capital at a lower valuation than the previous round of funding. According to Carta, nearly 20% of all venture investments in the first half of 2023 were down rounds, the highest proportion since 2018.
Why does this matter?
Down rounds are generally negatively received. It typically signals that the company is experiencing difficulties and is desperate to raise capital. A lower valuation may make it harder to raise money in the future. Employees could see their equity awards negatively impacted, affecting employee morale. VC funds may also need to write down the value of the securities in their portfolio.
What causes down rounds?
There are several reasons for down rounds. Traditionally, if the company was not performing well or to expectations, this could result in a lower valuation. However, the recent down rounds are also attributable to factors outside the company’s control, including rising interest rates and tightening of general funding conditions. In today’s environment, investors are more risk averse. We have also recently seen a market reset in valuations for high-multiple companies.
What are the implications?
A key implication of a down round is the potential triggering of anti-dilution protection features in financial instruments such as warrants, convertible notes, convertible preferred stock, and equity awards. This means that if shares get sold at a lower price than the investor originally paid, the anti-dilution feature will limit the impact on their share value and ownership percentage. Down round protection features typically lower the conversion or exercise price of the instrument, which results in an increase in shares upon conversion or exercise. These types of features offer incremental benefit to the investor over standard anti-dilution clauses for stock splits, etc. There are two main types of down round protection features commonly attached to preferred shares:
- Full Ratchet: This fully protects the investor and allows them to convert their preferred stock into shares of common stock equal to the amount invested divided by the price per share in the current round. As a result of this feature, the founder’s ownership percentage can be severely impacted.
- Weighted-average: This results in shares of preferred stock being convertible to additional shares of common stock, but at a smaller magnitude based on the size and price of the down round relative to the company’s outstanding capitalization. This is usually more common and distributes the dilution more evenly across all shareholders.
What is the accounting for down round features?
The accounting guidance related to down round features (i.e., a reduction of conversion/strike price to the current lower issuance price) was recently updated by ASU 2017-11. Under the new guidance, entities will no longer consider a down round feature when determining whether an instrument is indexed to the entity’s own stock. As a result, the down round feature itself does not cause an equity-linked instrument to be accounted for as a liability. An instrument previously classified as a liability due to a down round feature may now be classified in equity. Furthermore, an embedded feature that was bifurcated and accounted for as a derivative due to a down round provision may now qualify for a scope exception from that treatment.
An entity is required to recognize the effect of a down round feature in an equity-classified financial instrument when it is triggered (i.e., when the exercise price is adjusted downward). At that time, the value of the down round feature is recognized as a deemed dividend, which reduces income available to common shareholders for basic EPS. It essentially reduces the numerator in basic EPS.
The impact will be measured as the difference between the instrument’s fair value using the pre-trigger price and the reduced exercise price. A valuation will likely be needed to calculate the change in the instrument’s fair value when a down round is triggered.
Companies are required to disclose any terms that may change the conversion or exercise prices of financial instruments, including down round features. These disclosures should not only describe the feature, but also its effect when triggered. When a down round feature is triggered, companies are required to disclose this fact and the associated adjustment recognized in EPS.
Managing a down round
Sometimes down rounds are necessary for the company to continue operations. Companies that have had down rounds can still go on to successful exits. Companies must be transparent about the down round and how they plan to use the funding. It is also critical that the company manage its cash and reduce costs. To help offset the impact on employee equity awards, companies may consider issuing additional equity awards or restructuring their stock options by repricing or exchanging them so that they are not underwater.
