Freddy Fachler
Venture capital
Nov 14, 2024When a startup faces a "down round"—a financing round in which its valuation decreases compared to previous rounds—both the founders and venture capital investors (VCs) face significant challenges. This type of financing has become increasingly common: flat and down rounds for VC-backed companies hit a decade high in the first half of 2024, accounting for 28.4% of all deals, according to a U.S. Venture Capital Valuations Report published by Pitchbook.
In this context, it is essential for stakeholders to carefully evaluate and negotiate protection clauses that safeguard both ownership structure and control of the company. One of the most notable effects of a down round is the dilution of shareholdings, especially for the founders.
To mitigate these effects, VCs often include anti-dilution protections that adjust the price of their previous shares, minimizing the loss of ownership percentage. Below are the most common protection measures.
The most common clauses protecting investors include:
1. Weighted Average: This clause calculates an adjusted conversion price based on a weighted average of the previous price and the number of new shares issued, making it the most widely used protection clause today. Unlike Full Ratchet, explained below, Weighted Average is less severe and allows founders to retain a larger share of their ownership.
There are two variations of this formula:
- Broad-Based Weighted Average: This is the most common clause. It considers both the number of shares and price, including convertible securities such as options and warrants, which reduces the anti-dilutive adjustment.
- Narrow-Based Weighted Average: This applies a more restrictive weighting, excluding options, warrants, and shares in incentive plans, thereby benefiting investors more.
Example: If VCs acquired shares at $10 and the down round price drops to $5, the Weighted Average clause sets an intermediate adjusted price, such as $7, based on the total number of shares issued. This protection is used in approximately 60% of down rounds in the United States, as it better balances the interests of investors and founders.
2. Most Favored Nation (MFN) Clause: This clause, one of the most common in startup equity rounds, allows investors to adjust the price of their shares to the most favorable level offered in future rounds, thus mitigating the dilution of their stake.
A third mechanism, which has fallen out of favor due to its strong negative impact on other investors and founders, is the Full Ratchet protection.
In this clause, if a down round is conducted at a lower price than previous rounds, the purchase price of preferred shares is automatically adjusted to the lowest price of the new round, allowing VCs to maintain their ownership percentage.
Example: If VCs acquired shares at $10 per share in a previous round and the down round price drops to $5, the Full Ratchet clause modifies the previous share price to $5, allowing the original investor to retain their stake without significant dilution. Although this adjustment effectively protects VCs, it can severely impact founders and other shareholders, whose stakes are diluted.
Protections for Founders
In addition to VCs, founders can also attempt to negotiate specific protections to mitigate the impact of dilution, although these are uncommon since founders, as those responsible for the company's operation and performance, are generally expected to bear the impact of dilution in a down round.
The most common protection for founders is the implementation of Vesting agreements, typical in investment round terms, through which founders can gradually receive new shares at no cost as certain agreed parameters are met. For example, a founder may negotiate a three-year vesting schedule for additional shares, securing their long-term commitment. This is particularly important so that, despite dilution and the impact of the down round, the founder’s motivation remains intact.
Additionally, there are other clauses such as “Founder Re-Up” or “Top-Up”, in which founders may receive an additional share package to offset the dilution caused by the down round, or a Customized Anti-Dilution Protection—a version of the Weighted Average clause known as “Founder-Friendly Weighted Average”, which adjusts the anti-dilution mechanism to protect founders from excessive dilution. However, these clauses are rarely, if ever, used.
Corporate Governance Protections (for VCs and Founders)
In the corporate governance arena, both VCs and founders seek to negotiate shareholder agreements and special bylaws to ensure their influence on the Board of Directors and in key company decisions. It is also common to agree on specific classes of preferred shares, which grant additional or exclusive voting rights to VCs, as well as clauses that limit veto rights of one party over the other.
In a down round, this power balance becomes especially important, as VCs may request veto rights over strategic decisions such as the issuance of new shares, capital structure, or liquidity events. Conversely, founders may seek to negotiate restrictions to maintain some control over the company's direction, aiming to limit VC veto rights to decisions that significantly affect the capital structure and protect the interests of both parties.
Conclusion
Establishing clear rules and maintaining a respectful governance relationship helps prevent conflicts and ensures that both founders and investors retain an active and balanced role in the company’s management, even in complex situations such as a down round. Such agreements not only protect the economic interests of both parties but also foster trust, transparency, and a shared long-term vision.
The current venture capital environment, marked by increasing volatility, suggests that down rounds will become more common. With proper preparation and a shared long-term vision, startups and VCs can turn these situations into recalibration opportunities rather than setbacks, balancing interests in the face of down round challenges while preserving a shared vision.
Transparency, adaptability, and cooperation will be key for startups and VCs not only to survive but to thrive together in an increasingly competitive innovation ecosystem.
