Investors

Down Rounds Syndrome: A Roundtable Discussion

Down Rounds Syndrome: A Roundtable Discussion 2001-11-23 Staff Writer <i>This week Letter from America is by David J. Blumberg of Blumberg Capital.</i><br><br><a href=http://www.privateequityonline.com/LetterAmerica.asp?ID=1851>Part 1 of this article</a> looked at "Down

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This week Letter from America is by David J. Blumberg of Blumberg Capital.

Part 1 of this article looked at “Down Rounds Syndrome” and the lessons it provides for all parties in the private equity process. So what are the leading legal practitioners prescribing today? I am a venture capitalist, not an attorney, so I consulted with a “blue ribbon” panel of attorneys to get their opinions on various issues. The panel included:

Following is a list of terms common in most private equity deals. I spoke with the attorneys listed above about these terms, and asked their opinions on the current use and fairness of these provisions. Their comments shed light on the issues surrounding these terms, and which terms are the most valuable to investors.

Down Financing Rounds
Michael Sullivan says in down rounds, remember to:

  1. Give all classes of shareholders the right to participate (except for unaccredited investors as that can create SEC problems).
  2. Protect the transaction from challenge by getting the approval of objective shareholders or disinterested Board of Directors members.
  3. Obtain a fairness opinion or outside valuation, however the problem is cost and time.

Also, if a financing transaction is challenged in court (generally DE and CA), the burden of proof is on the insiders who benefited from the down round. Joe Bartlett recalled that in 1989 First Boston was getting out of the VC direct investing business and two large, well-known VC groups did a serious down round in which First Boston was squeezed down through non-participation. Later, the portfolio company was turned around, did well and went public. First Boston sued and won principal and damages. Similarly, Testa Hurwitz reported a recent deal where the down round terms proposed by the preferred owners were subject to class votes and the common revolted at what were considered onerous terms and killed the deal.

The problem with these down rounds is the potential resentment, de-motivating impact, and divergence of management interests. The “investors' golden rule” says, “Those who have the gold rule”, but that rationale can also kill the goose that lays the golden eggs – motivated employees. This is a team business that requires motivation of, and participation by all. It is about long-term relationships, common goals and support in tough times. There is a limit to what money can do.

Cheryl Reicin adds during such tough times investors' reputations are made or lost (i.e., how do you treat folks in downtimes is more important than in glory days).

Alex Lynch says entrepreneurs are asking to get preferred stock options, which opens some tricky accounting issues, so consult your CPA.

At present there is little recrimination to down rounds in the courts. But, after the rebound comes, watch for lawsuits from those who will say “I was squeezed out unfairly”. Remember that Delaware law is the friend of smaller holders and the trend of corporate governance law is towards holding Directors to higher standards of fiduciary responsibility.

Recapitalization / Restructuring:
Michael Sullivan has coined the “Sullivan Simplification Principles”. In cases where you have a complex equity structure with previous ABCDE rounds, they can be crunched into a new Series 1 (all sharing the same investor rights), after which the next round is called Series 2. This simplifies the capital structure and minimizes conflicts between series.

Internal Rounds or Rights Offerings:
Jeff Zimman says that rights offerings may be combined with short-term (6-month) warrants, which provide the company with more cash upon exercise, without creating overhang. Cheryl Reicin notes that when management teams participate in rights offerings, it shows commitment. However, leave out unaccredited investors, or risk SEC issues.

Zimman reported a deal he knew of in which A&B rounds had invested $11M at $42M post money valuation. At the recent financing, the Certificate of Incorporation was amended so that prior anti-dilution provisions didn't apply. Next the company did an internal auction to fill Series C in which $2.5M bought 80% of company.

Another deal, reported in January 2001 Red Herring, was Flooz.com in which investors simply forced the company to revalue itself downwards. David Sorin recommends doing the lower revaluation internally – before going out to new investors.

Price Protection or Anti-Dilution:
Sorin reported that one year ago, almost all the deals he was doing for clients were based on weighted average anti-dilution provisions, whereas nearly all are full ratchet today.

In contrast, Bartlett said his ratio one year ago was 75% weighted average and 25% with no price protection at all, whereas today the ratio is 90% weighted average and 10% full ratchet. Bartlett says the full ratchet provision is useful to deal with volatility and uncertainty, but it is not meant to be an ironclad eternal protection for investors.

Most attorneys I spoke with do not favor full ratchet clauses. They are seen as unfair to common shareholders / smaller prior investors, and not proportional. Yet the VC clients are calling for full ratchet provisions ever more frequently. It is seen by them as unfair to protect all prior investors versus management if there is only a small follow on round.

A report co-authored by Cooley Godward and The Stanford Graduate School of Business recommends using full ratchet clauses when the due diligence between term sheet and contract shows the company to be overvalued and in need of cash sooner than had been forecast. In that case, a short-term (6-12 month) full ratchet can be used effectively to protect investors.

Pay to Play:
Cheryl Reicin says this type of clause is being employed more and more frequently. It says that if an investor doesn't participate in the next down round, their preferred series converts to a new series with the same rights except for no anti-dilution protection.

Warrants for Bridge Loans:
Joe Bartlett says that the premium was traditionally a flat fee of 15-25% of the total or perhaps up to 5% warrant coverage per month. However, I know of a recent 'tip top-tier' VC deal where the insiders gave themselves 25% warrant coverage per month on bridge while deal was closing.

Cheryl Reicin told me of a deal in which one VC is asking for 5% of the company per month while the other VC says that such dilution will deter future investors and kill the morale of employees. My firm recently walked away from an investment that gave 33% warrants to the previous investors for a bridge averaging 3 months, because we felt the premium was extreme given the modest change in the company during that time period.

Redemption Clauses:
The clause allows investors to say, “Show me the money,” but in practice it is almost never used. It was traditionally meant to protect investors from the curse of the “Living Dead” portfolio companies, who choose not to aim for liquidity, but simply enjoy the lifestyle benefits of running an enterprise. In reality, it is more threat than useable weapon. Usually it is available 5 years after investment, and each subsequent round tends to push the series out on the time horizon. Sullivan and Zimman hadn't seen it used in 14 and 15 years of practice respectively, and Joe Bartlett had never seen it invoked in 40 years of practice.

Demand Registration (pre-IPO):
They are almost never invoked. It is almost inconceivable that VCs could force a firm go public against its will, and according to Joe Bartlett, “only rookie attorneys fight” for these rights. Post IPO registration rights are a different story and are valuable for VC investors who need to obtain liquidity when there is a public market for the shares.

Liquidation Preferences:
The general term is Participating Preferred, but this is also known as “double dipping”. The traditional standard term was 1X preference, meaning first return investors principal and interest, then share profits on equal footing at 1:1 conversion into common.

As in the Carol Emert article, we are seeing demands for 2, 3, 4 and even 5X ratios. These high-end numbers are onerous and divisive, and they should be used only sparingly. The attorneys I spoke with were unanimously opposed to the high multiple provisions. Historically, they are almost always cut back to give some more to management and employees.

Joe Bartlett of says the traditional liquidation preference was meant to protect against bankruptcy or trade sale, but some VCs are now also asking for the preference ratio when converting from preferred to common shares when going IPO. Bartlett believes it is overreaching, and he calls such a security a “supercharged preferred”.

Preferred Dividends:
Cumulative dividends mean the Board of Directors never needs to declare, but they accrue and convert in-kind to benefit of investors over the years upon conversion. In contrast, non-cumulative dividends lapse unless declared annually. They are rarely declared, but can serve to block the common from declaring a dividend to itself.

Traditionally, said Michael Collins, 8% non-cumulative coupons are more common on the West Coast. In contrast, the newer and more common East Coast standard is cumulative at 10-12% per annum. This difference is attributed to the fact that East Coast investors are more financially oriented investors.

Staged or Milestone Financing:
I spoke with Attorneys Sullivan, Reicin, and Sorin, and all were unanimous in saying that milestones protect investors better than anti-dilution provisions, but that the pressure of huge institutional limited partners require VCs to continue to invest rapidly. The negative side is that milestones may divide interests and overly focus management attention on peripheral goals.

Friends and Family Shares:
During the height of the IPO frenzy some VCs began demanding directed shares prior to and upon IPO. Due to SEC problems, most clauses were written as “best efforts” endeavors. Today, there are no IPOs so the problem has subsided.

Vesting:
In the recent past during the bull market, companies pressured for shorter terms, while investors are now pressing for longer vesting periods. Sorin of Hale & Dorr is seeing significantly more re-vesting of management shares and clauses that require forfeiture unless key milestones are met.

Up The Ladder Warrants:

Part 1 of this article looked at “Down Rounds Syndrome” and the lessons it provides for all parties in the private equity process. So what are the leading legal practitioners prescribing today? I am a venture capitalist, not an attorney, so I consulted with a “blue ribbon” panel of attorneys to get their opinions on various issues. The panel included:

Following is a list of terms common in most private equity deals. I spoke with the attorneys listed above about these terms, and asked their opinions on the current use and fairness of these provisions. Their comments shed light on the issues surrounding these terms, and which terms are the most valuable to investors.

Down Financing Rounds
Michael Sullivan says in down rounds, remember to:

  1. Give all classes of shareholders the right to participate (except for unaccredited investors as that can create SEC problems).
  2. Protect the transaction from challenge by getting the approval of objective shareholders or disinterested Board of Directors members.
  3. Obtain a fairness opinion or outside valuation, however the problem is cost and time.

Also, if a financing transaction is challenged in court (generally DE and CA), the burden of proof is on the insiders who benefited from the down round. Joe Bartlett recalled that in 1989 First Boston was getting out of the VC direct investing business and two large, well-known VC groups did a serious down round in which First Boston was squeezed down through non-participation. Later, the portfolio company was turned around, did well and went public. First Boston sued and won principal and damages. Similarly, Testa Hurwitz reported a recent deal where the down round terms proposed by the preferred owners were subject to class votes and the common revolted at what were considered onerous terms and killed the deal.

The problem with these down rounds is the potential resentment, de-motivating impact, and divergence of management interests. The “investors' golden rule” says, “Those who have the gold rule”, but that rationale can also kill the goose that lays the golden eggs – motivated employees. This is a team business that requires motivation of, and participation by all. It is about long-term relationships, common goals and support in tough times. There is a limit to what money can do.

Cheryl Reicin adds during such tough times investors' reputations are made or lost (i.e., how do you treat folks in downtimes is more important than in glory days).

Alex Lynch says entrepreneurs are asking to get preferred stock options, which opens some tricky accounting issues, so consult your CPA.

At present there is little recrimination to down rounds in the courts. But, after the rebound comes, watch for lawsuits from those who will say “I was squeezed out unfairly”. Remember that Delaware law is the friend of smaller holders and the trend of corporate governance law is towards holding Directors to higher standards of fiduciary responsibility.

Recapitalization / Restructuring:
Michael Sullivan has coined the “Sullivan Simplification Principles”. In cases where you have a complex equity structure with previous ABCDE rounds, they can be crunched into a new Series 1 (all sharing the same investor rights), after which the next round is called Series 2. This simplifies the capital structure and minimizes conflicts between series.

Internal Rounds or Rights Offerings:
Jeff Zimman says that rights offerings may be combined with short-term (6-month) warrants, which provide the company with more cash upon exercise, without creating overhang. Cheryl Reicin notes that when management teams participate in rights offerings, it shows commitment. However, leave out unaccredited investors, or risk SEC issues.

Zimman reported a deal he knew of in which A&B rounds had invested $11M at $42M post money valuation. At the recent financing, the Certificate of Incorporation was amended so that prior anti-dilution provisions didn't apply. Next the company did an internal auction to fill Series C in which $2.5M bought 80% of company.

Another deal, reported in January 2001 Red Herring, was Flooz.com in which investors simply forced the company to revalue itself downwards. David Sorin recommends doing the lower revaluation internally – before going out to new investors.

Price Protection or Anti-Dilution:
Sorin reported that one year ago, almost all the deals he was doing for clients were based on weighted average anti-dilution provisions, whereas nearly all are full ratchet today.

In contrast, Bartlett said his ratio one year ago was 75% weighted average and 25% with no price protection at all, whereas today the ratio is 90% weighted average and 10% full ratchet. Bartlett says the full ratchet provision is useful to deal with volatility and uncertainty, but it is not meant to be an ironclad eternal protection for investors.

Most attorneys I spoke with do not favor full ratchet clauses. They are seen as unfair to common shareholders / smaller prior investors, and not proportional. Yet the VC clients are calling for full ratchet provisions ever more frequently. It is seen by them as unfair to protect all prior investors versus management if there is only a small follow on round.

A report co-authored by Cooley Godward and The Stanford Graduate School of Business recommends using full ratchet clauses when the due diligence between term sheet and contract shows the company to be overvalued and in need of cash sooner than had been forecast. In that case, a short-term (6-12 month) full ratchet can be used effectively to protect investors.

Pay to Play:
Cheryl Reicin says this type of clause is being employed more and more frequently. It says that if an investor doesn't participate in the next down round, their preferred series converts to a new series with the same rights except for no anti-dilution protection.

Warrants for Bridge Loans:
Joe Bartlett says that the premium was traditionally a flat fee of 15-25% of the total or perhaps up to 5% warrant coverage per month. However, I know of a recent 'tip top-tier' VC deal where the insiders gave themselves 25% warrant coverage per month on bridge while deal was closing.

Cheryl Reicin told me of a deal in which one VC is asking for 5% of the company per month while the other VC says that such dilution will deter future investors and kill the morale of employees. My firm recently walked away from an investment that gave 33% warrants to the previous investors for a bridge averaging 3 months, because we felt the premium was extreme given the modest change in the company during that time period.

Redemption Clauses:
The clause allows investors to say, “Show me the money,” but in practice it is almost never used. It was traditionally meant to protect investors from the curse of the “Living Dead” portfolio companies, who choose not to aim for liquidity, but simply enjoy the lifestyle benefits of running an enterprise. In reality, it is more threat than useable weapon. Usually it is available 5 years after investment, and each subsequent round tends to push the series out on the time horizon. Sullivan and Zimman hadn't seen it used in 14 and 15 years of practice respectively, and Joe Bartlett had never seen it invoked in 40 years of practice.

Demand Registration (pre-IPO):
They are almost never invoked. It is almost inconceivable that VCs could force a firm go public against its will, and according to Joe Bartlett, “only rookie attorneys fight” for these rights. Post IPO registration rights are a different story and are valuable for VC investors who need to obtain liquidity when there is a public market for the shares.

Liquidation Preferences:
The general term is Participating Preferred, but this is also known as “double dipping”. The traditional standard term was 1X preference, meaning first return investors principal and interest, then share profits on equal footing at 1:1 conversion into common.

As in the Carol Emert article, we are seeing demands for 2, 3, 4 and even 5X ratios. These high-end numbers are onerous and divisive, and they should be used only sparingly. The attorneys I spoke with were unanimously opposed to the high multiple provisions. Historically, they are almost always cut back to give some more to management and employees.

Joe Bartlett of says the traditional liquidation preference was meant to protect against bankruptcy or trade sale, but some VCs are now also asking for the preference ratio when converting from preferred to common shares when going IPO. Bartlett believes it is overreaching, and he calls such a security a “supercharged preferred”.

Preferred Dividends:
Cumulative dividends mean the Board of Directors never needs to declare, but they accrue and convert in-kind to benefit of investors over the years upon conversion. In contrast, non-cumulative dividends lapse unless declared annually. They are rarely declared, but can serve to block the common from declaring a dividend to itself.

Traditionally, said Michael Collins, 8% non-cumulative coupons are more common on the West Coast. In contrast, the newer and more common East Coast standard is cumulative at 10-12% per annum. This difference is attributed to the fact that East Coast investors are more financially oriented investors.

Staged or Milestone Financing:
I spoke with Attorneys Sullivan, Reicin, and Sorin, and all were unanimous in saying that milestones protect investors better than anti-dilution provisions, but that the pressure of huge institutional limited partners require VCs to continue to invest rapidly. The negative side is that milestones may divide interests and overly focus management attention on peripheral goals.

Friends and Family Shares:
During the height of the IPO frenzy some VCs began demanding directed shares prior to and upon IPO. Due to SEC problems, most clauses were written as “best efforts” endeavors. Today, there are no IPOs so the problem has subsided.

Vesting:
In the recent past during the bull market, companies pressured for shorter terms, while investors are now pressing for longer vesting periods. Sorin of Hale & Dorr is seeing significantly more re-vesting of management shares and clauses that require forfeiture unless key milestones are met.

Up The Ladder Warrants:
After a tough down round, Joe Bartlett emphasizes the need to re-motivate entrepreneurs and key management. When a company exceeds expectations and there is a successful liquidity event, management can structure warrants to be exercised at increasing values to reward management for the successes.