For many startup founders, raising capital can be a necessary and exciting but also challenging endeavor. In particularly, when a company’s valuation decreases from its previous equity fundraising round, raising funds in a “down round” presents additional complexities. While a down round may certainly not be ideal and it presents additional hurdles of navigating investor relations, it is sometimes essential for survival and growth. In this post, we will explore key considerations for founders navigating a down round, including investor-friendly terms, board dynamics, and restructuring mechanisms such as cram-down financings and pay-to-play provisions.

Investor-Friendly Terms in a Down Round

Investors in a down round often demand more stringent terms to compensate for the increased risk associated with their investment in the company. Some of the most common investor-friendly provisions include:

  1. Participating Preferred Stock: This gives investors both a preferential return and participation in upside returns, allowing them to recover their investment (often with a multiple) before common stockholders receive any payout. After that, they also participate in the remaining proceeds as if they held common stock, effectively double-dipping on returns. This structure can significantly dilute common shareholders in an exit.
  2. Higher Liquidation Preferences: Investors in down rounds may seek a 2x or greater liquidation preference, meaning they receive twice their investment before common shareholders get paid in an exit event. Note that this ratio is typically 1x in a standard increased valuation equity round.
  3. Senior Preferred Stock: A newly created senior class may be introduced, ranking above the prior investors in liquidation or distribution, meaning the senior series of preferred will be paid its “liquidation preference” prior to any other series of preferred and the common as well, to the extent necessary.
  4. Investor-Controlled or Balanced Board: Investors may push for board control, either through a majority or equal representation between founders and investors. Note that founders (i.e. common stockholders) usually retain board control in a standard increased valuation equity round. An investor controlled board can mean that founders are then able to be fired by the investors if they/the board feel the founders are not properly managing the company.
  5. Super Pro-Rata Rights: Some investors may request super pro-rata rights, allowing them to purchase more than their proportional equity share in future rounds, potentially further diluting existing shareholders.
  6. Redemption Rights: Investors may negotiate mandatory redemption rights, giving them the ability to force the company to buy back their shares after a set period, putting financial pressure on the company. Note that redemption rights in venture capital financings outside of down rounds are highly unusual and we tend to advise to almost never give such rights to investors unless it’s necessary to complete a down round financing.
  7. Blocking Rights on Future Financings: Investors may demand the right to approve or block any future financing rounds, giving them significant control over the company’s fundraising strategy. While this is also typical in many up round financings, it’s pretty much expected in every down round financing.

More Aggressive Restructuring: Cram-Down Financings, Pay-to-Play, and Recapitalization

When a company is in more difficult financial situations and necessitates a down financing round, more aggressive financing structures may be required, including:

  1. Cram-Down Financing: A scenario where new investors dictate harsh terms that significantly dilute and/or change the rights of shares held by existing shareholders, in essence “cramming down” new and potentially unfavorable terms on such shareholders, and sometimes wiping out prior preferred shareholders’ rights altogether. These financings are often seen when companies have no viable alternative to continue operations.
  2. Pay-to-Play: Existing investors are required to participate in the new round up to a specific amount of investment, often times to maintain their preferred stock status; otherwise, they get converted into common stock or a lesser class of preferred stock, effectively penalizing those who do not reinvest.
  3. Recapitalization and Rights Offerings: In a recapitalization, the company restructures its capital “stack” structure, often consolidating previous preferred stock and resetting terms or sometimes essentially wiping the existing cap table clean and generally resetting ownership across the board at the time of the financing. A rights offering typically accompanies such recapitalizations (it helps the company comply with corporate governance and fairness rules), which allows existing shareholders to participate in the new financing round, sometimes at a discounted price, to minimize dilution.
  4. Debt-to-Equity Conversion: If the company has outstanding debt, a down round may involve a debt restructuring, where creditors convert debt into equity, sometimes at a steep discount to the new financing round.
  5. Structured Equity or Warrants: Investors may ask for structured equity instruments that behave like a mix of debt and equity, or they may receive warrants (the right to purchase shares at a fixed price in the future) that provide such investors, who are taking a reasonably large risk investing in a struggling company at times, with a bigger piece of the company’s upside to incentivize them to take such a risk.
  6. Inside-Led Rounds and Management Reinvestment: Down round financings often require existing investors to lead the round (sometimes called an “inside round”), and founders may be expected to invest personal funds to demonstrate commitment.

Tips for Founders in a Down Round

  1. Prioritize Long-Term Survival: A down round may not be ideal, but securing capital to sustain and eventually grow and scale the business should be the main goal in mind. At times the decision comes down to whether to accept the potentially harsh terms of the financing, or to let the company fail, and when this is the case priorities of founders and management understandably shift.
  2. Negotiate for Fair Terms: Push back on excessive liquidation preferences, aggressive dilution, and governance provisions that may hinder future flexibility where possible. The message to the investors should be that reasonable terms are in the best of all parties’ interests, as overly stringent terms can limit the company’s ability to raise future capital and scale accordingly and can reduce incentives for management to continue building in the way the investors hope and expect.
  3. Align Existing Investors: Engage with current investors early to secure their support and explore alternatives to minimize dilution, such as bridge financing or structured equity.
  4. Protect Key Talent: Consider implementing retention plans, such as option pool refreshes, to keep employees incentivized despite potential dilution.
  5. Be Transparent: Maintain open communication with stakeholders, including employees, about the company’s financial position and the rationale behind the financing. This is particularly important for down rounds where some stakeholders may be put in difficult or less ideal situations, and proactive communication helps ease some of that pressure.

Conclusion

A down round is rarely a founder’s first choice, but with careful planning and negotiation, it can provide the necessary capital to sustain and grow the business. Founders must be prepared for tough investor demands, potential dilution, and governance shifts. Engaging experienced legal counsel and financial advisors early in the process is critical to securing a structure that balances investor needs with the long-term viability of the company.

Despite the challenges, many successful companies have gone through down rounds and emerged stronger. The key is to approach the process with transparency, strategic negotiation, and a clear path toward future growth.

At Bowery Legal, we specialize in guiding startup founders through a down round. If you need assistance, or have any questions on the topic, don’t hesitate to reach out to our team for help!