Since the beginning of 2022, the venture capital ecosystem in Brazil and in the world has been going through a shortcut of resources available for the financing of investment rounds in startups.

Despite the steady increase in resource indicators invested in recent years and the extraordinary performance in 2021, the new context of the sector brings important challenges arising, among other reasons, from the fear of a post-pandemic economic recession, increased interest rates, increased inflation and the intensification of geopolitical disputes around the globe.

In a scenario of greater scarcity such as this, participants in the venture capital environment should be well prepared to address any reductions in startup valuations in future investment funding rounds (known as down rounds).

What does it mean go through a down round?

The term down round is used to designate an investment round in which the value per share of a startup is lower than that of the previous round. The factors that cause this devaluation in the valuation of the startup may be the most diverse. They range from the frustration of assumptions and metrics established in the previous round for evaluating the calculation, such as the non-achievement of a certain monthly invoicing value, to macroeconomic aspects, such as those mentioned above.

Who’s affected the most in down rounds?

Down rounds may affect the startup, its investors and other stakeholders in different ways, depending on the reasons that imposed the need to reduce the value per share.

Regarding the startup itself, the down round may affect its ability to conduct future fundraising rounds, as well as its power to attract and retain talent, especially if the valuation adjustment was due to internal factors of the startup, and not from the macroeconomic context.

With respect to investors who have allocated resources to the startup in previous rounds, in addition to possible dilution if the appropriate mechanisms are not present or are not triggered, the down round may result in the need to adjust the projections (yield) carried out by venture capital funds, which may affect the ability of such funds to carry out new fundraising.

Beneficiaries of long-term stock-based incentive programs, such as stock option plans, may also be affected, to the extent that the reduction in the value per share of the startup may lead to a reduction in the shareholding that these beneficiaries would receive in the future.

Key contributors may also be affected if the startup has its business reputation influenced by the down round.

What are the main consequences of a down round?

The practical result of a down round is usually the triggering of contractual provisions established in the documents that regulate the previous rounds of investment in the startup.

As it well known, in return for the contribution of funds provided by investors, preferred shares with special rights are issued by the startup and attributed to the investors. At the sole discretion of the investors, such shares may be converted into common shares, based on a particular exchange formula or relationship.

As the investment of venture capital funds in startups is based on the protection and appreciation of the acquired shares, investors have developed contractual mechanisms that aim to protect their investments against possible devaluation.

If new investments are made in a startup based on a lower value than the last round, the admission of a new investor will not only result in the dilution of investors who have previousky paid a higher price for the shares, but in dilution different from that which could have been expected. To avoid such a situation, before making their investments, venture capital funds negotiate with the startup founders an anti-dilution contractual mechanism.

The anti-dilution clause

A well-established mechanism for the protection of venture capital is the anti-dilution clause. The purpose thereof is to deliver to former investors (existing before the new round of investment, such as Serie A investors, for example) new shares issued by the startup that ensure the maintenance of the value of the investment, thus avoiding the economic effects of the down round.

There are two types of anti-dilution mechanism:

  • Full ratchet: this clause establishes that the former investor shall have the right to receive, free of charge, a certain number of shares necessary to fully compensate the dilution suffered in the down round. Thus, for each dollar devalued, the investor will receive the number of equivalent shares based on the value per share of the down round, which is lower than the price per share paid by the former investor. As a result, the full ratchet is considered the most favorable to the former investor of the startup and the most unfavorable for the founders and other shareholders who do not benefit from the same protection.
  • Weighted average: this clause establishes that the former investor will have the right to receive, free of charge, a certain number of shares necessary to neutralize the economic impact of the dillution, but does not offer full protection. The number of shares granted will be calculated based on the average value per share established for the round of the shareholder of the antidilution right.

There are two ways of applying this clause: the form called narrow-based weighted average (NBWA) takes into account only the new shares that will be issued at the time of calculation, while the broad-based weighted average (BBWA) considers the share capital on a fully diluted basis (i.e., computing all shares that would be issued based on current securities and agreements, including subscription bonuses, purchase options, etc.).

The BBWA modality, therefore, has a less dilutive effect for the founders and other stakeholders, as a smaller number of new shares should be issued to the former investor compared to the NBWA modality.

Some startups adopt mechanisms that encourage, or even force, their investors to participate in future investment rounds with lower value per share. These clauses are called pay-to-play and establish the replacement of the former investor's preferred shares with shares of the down round and, where appropriate, penalties if the former investor does not participate in the down round.

As it has already been said, the activation of the anti-dilution mechanism tends to generate negative impacts for the founders, other investors who do not benefit from the same anti-dilution protection and, eventually, the beneficiaries of long-term stock-based incentive programs, as they will not be protected by the anti-dilution clause and, consequently, will bear the dilutive effects of the round down-round Alone.

If the anti-dilution mechanism is triggered in the last round before an IPO, the investors that acquires the shares at the IPO will also participate in the impact of the antidilution. This was also one of the reasons wework dropped its IPO in 2021.

Role of management in down rounds

The need to carry out a down round will be deliberated by the company's management, both at the c-level, usually occupied by the founders of the business, who have technical qualification for the development of the startup, and at the board level, usually composed of  founders and representatives appointed by the investors.

Venture capital practice in the United States has shown that the approval of down rounds can be judicialized due to the existence of possible conflicts of interest at the time of approval of the rounds.

In this context, it is important to bear in mind that members of the startup management must act in compliance with the fiduciary duties established by the law. Precedents of conflict of interest in the United States occurred in situations where:

  • the manager is a representative of a venture capital fund who is participating in the down round;
  • the manager participated directly in the down round;
  • the manager has a close relationship with the participants of the down round; and
  • the manager receives economic benefits due to the down round.

Preparation is key

It is extremely important that startups perform a careful analysis of their business and the impacts that will be caused by the down round to identify the possible outcomes and thus avoid unwanted surprises.

The management should also produce clear and complete documents, capable of under course the effective need to carry out a down round and prove that all precautions have been taken in the decision-making process of the startup.

In this way, startups and other industry participants who are prepared and well advised are more likely to easily go through times of economic turmoil such as the ones currently ongoing.