Down-rounds: The Point of No Return or an Opportunity for Correction?

The Point of No Return or an Opportunity for Correction? Down-rounds as a Potential Solution for the Challenges Faced by Hi-tech Companies

Simon Marks, Adv. and Adi Rafaeli, Adv.

For several years investments into the tech industry flowed easily, and at high valuations. 2023 and early 2024, on the other hand, has seen a drop in fundraising activities and an increase in fundraisings at lower valuations – the so-called “down-round”. This trend is particularly acute for start-ups in the biomed sector, given their longer path to product development, sales and profitability compared to tech companies in other sectors.

For most tech companies, raising funds in a down-round is perceived as a last resort and is something directors and shareholders will be reluctant to do. More often than not, it is a founder’s worst nightmare. When faced with the possibility of a down-round, it is therefore advisable to first explore all other available alternatives.

Considering Other Alternatives

An initial step prior to seeking external funding is to cut expenses and manage resources more efficiently. This will not only demonstrate responsible management to existing (and any potential) investors but will also ensure that funds invested in the company are effectively deployed. In addition, due to current market conditions, the time taken to find an investor and to complete the investment process is likely to be longer than in previous years; companies therefore need to manage their finances appropriately to ensure they will have sufficient breathing space to complete this process.

Another option is to raise funds using alternative investment instruments such as a SAFE or convertible loan. Such approach will provide immediate access to funds and enable the company to delay a decision on its valuation to a later date.

A further option to consider, is to raise funds at the same valuation as the previous round, a so called “flat-round”. While this may not be ideal, it is nevertheless preferable to a down-round.

Despite the above, it is evident, when looking at the transactions that took place over the past year or so, that companies are increasingly required to raise money via down-rounds. While a down-round will invariably have a negative impact on both the morale of management and employees, as well as the company’s image vis a vis investors and partners, it does not necessarily signify the end of the road. It is therefore crucial to know how to manage a down-round transaction in the best possible way.

Incentivising Key Individuals

First, it is essential to consider the impact a down-round will have on founders and other key personnel. Down-rounds typically result in the introduction of new dominant shareholders, and in most cases will trigger anti-dilution protections held by existing investors. While the anti-dilution mechanism will no doubt mitigate damage to such existing investors, it will inevitably reduce the ownership stake of the company's first shareholders (i.e. founders and early investors), as well as employees with share options, whose shares often lack similar protections against dilution. The disincentivising effect on the very people who are the core of the company's development and operations, has the potential to deal a fatal blow to the company's future. As, despite the influx of funds, there may not be anyone left in the company to drive it forward. Decision makers would be wise to ensure that key individuals are properly rewarded, and that the company’s post-money share option pool is increased so that such key individuals can be adequately incentivised.

Cleaning up the cap table

Second, a company can use the down-round as an opportunity to “clean up” its cap table. The investors who lead the down-round will typically take an aggressive position, demanding extensive rights in the company, while having limited flexibility towards existing shareholders who do not participate in the round. This presents the company with an opportunity to reduce or entirely remove the preferred rights, including veto rights, attached to the existing preferred shares, thereby enabling the company both to simplify its capital structure while significantly diluting the influence of departing founders and employees, as well as those shareholders who are no longer active. As part of this process, the new investor may look to introduce a “pay to play” mechanism, which incentivises existing investors to participate in the current and future fundraisings, while penalising them if they do not. Taking such actions will ultimately facilitate smoother decision-making and distribution of funds going forward.

Continued Dialogue with the Shareholders

Third, down-rounds will often trigger a conflict between a company’s shareholders and its directors. Whilst shareholders will inevitably prioritise their own interests, the directors are bound to put the company's well-being first. It is therefore essential that proper corporate governance is followed, and full transparency is applied to all decision-making. The company’s board of directors should undertake a thorough assessment of the economic benefit of the fundraising, while considering the company’s strategic aims, and alternative funding options. To the extent such assessments can be carried out by independent external experts, even better.

It is also important to have an in-depth understanding of the company's constitutional documents, including its articles of association and any shareholders’ agreement, to ensure all required corporate approvals are obtained, and to be prepared for any obstacles that may arise. It is also important to fully document all decisions. This will guarantee directors adhere to their fiduciary duties under law, and will protect them and the company against potential lawsuits. Additionally, all relevant information should be communicated to the company’s shareholders. Such actions will facilitate a meaningful dialogue with shareholders and minimise the risk of future disputes; it will also allow shareholders an opportunity to participate in the fundraising process, if feasible. A consensus among decision-makers on the necessity of a down-round and the way it is implemented will enable the company to move forward as opposed to merely treading water until the next fundraising round.

Down-rounds are never ideal, and clearly, where there is a viable alternative, such alternative should be considered. However, where the company has no choice but to do a down-round in order to survive, the decision-makers will clearly benefit from doing their homework and properly preparing before the round, as well as ensuring full compliance and transparency during the round. This will not only protect them and the company but will also enable the company to gain the maximum possible benefit from the situation.

*Simon Marks, Adv. is a partner and heads the High-Tech and Venture Capital practice and Adi Rafaeli, Adv. is an associate in the High-Tech and Venture Capital practice at Epstein Rosenblum Maoz (ERM) – Israel.