If a company has decided, after exploring other options, to proceed with a down round financing, it should implement specific measures to mitigate potential legal risks associated with the deal.
Establish an Independent Committee: Form a committee comprising independent and disinterested directors to assess and approve the down round financing. Ideally, this committee should also include representatives from the diluted stockholder classes.
Seek a Disinterested Lead Investor: Aim to secure a new, disinterested investor to lead and set the price for the round. Opting for a down round led by existing investors and insiders might suggest a lack of objectivity compared to a new investor leading the round.
Draft an Information Statement: With guidance from legal counsel, prepare an information statement directed to stockholders:
- Clearly state that all capital-raising avenues have been explored, and a down round is deemed appropriate following a thorough review of circumstances.
- Quantitatively describe the antidilutive effects of the down round, fully disclosing the negative impacts on current investors.
- Offer all existing accredited investors the opportunity to participate pro rata.
Solicit stockholder approval for the financing.
Secure Written Approvals: Where possible, obtain written approval from the independent directors, a majority of stockholders, and a majority of the diluted stockholder classes. However, note the risk if the diluted classes reject the deal, which could leave a negative mark on the record.
Consider Third-Party Valuation: As part of the board's evaluation, contemplate obtaining an independent third-party valuation. Yet, this option may be costly and perceived as self-serving.
Negotiate Pro-Company Terms: To demonstrate good faith and arm's-length negotiation, seek additional terms favorable to the company, such as:
- Lowering liquidation preferences,
- Removing participating preferred features,
- Introducing pay-to-play provisions,
- Diluting protective veto provisions,
- Increasing the employee pool on a post-money basis, or
- Enhancing terms from the previous financing round.
Thorough Documentation: Document the financing and approval process meticulously. Board minutes should provide a clear record of:
- Market checks,
- External financial advice,
- Evaluation of strategic alternatives,
- Approval by special committees,
- Efforts to safeguard diluted stockholders, and
- Other steps taken throughout the financing process.
In Summary,
While down rounds pose challenges both in business and legality, taking these actions can help mitigate their negative impacts. Down rounds can be emotionally taxing, so it is crucial to explore all viable alternatives and take necessary steps to minimize liability exposure.
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