Structured and Down Rounds

Structured and Down Rounds

A “structured round” is a financing round where terms are tailored to offer additional downside protection for investors, often at the expense of founders and existing shareholders. These terms can include features like additional warrants, liquidation preferences, guaranteed returns, and pay-to-play provisions. Structured rounds are typically used in later-stage investments or when a company is perceived as struggling. While nearly absent from the venture capital lexicon for almost a decade, they’ve returned in full force over the past two years as late-stage companies reel from the heights of 2021.

Understanding Your Options

A company that has raised at a valuation higher than what it can merit today is faced with three options:

  1. Raise money at the same valuation as before but with dirty terms like a superior liquidation preference or guaranteed return (Structure)
  2. Take a clean round at a lower valuation (Downround)
  3. Do all you can to turn profitable
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While downaound can be a hard pill to swallow as a CEO, time and time again we believe a down rounds is better for existing shareholders than a structured round for two reasons: it resets the valuation to a market one and avoids burdening the company with onerous terms, a point first made by Bill Gurley back in 2016 in his article On the Road to Recap.

Structured Rounds

Not all Structure is created equal. Here are the most common asks, roughly ranked best to worst.

Term Description Effect
Warrants Investors will ask for additional options that convert to common stock, in essence increasing their ownership relative to what they paid at the round price. Warrants are the most benign form of structure. It’s a way for new investors to effectively get a lower valuation while allowing founders and investors to save face with employees and LPs.
Pay-to-Play A clause that incentivizes existing investors participate in the round—or they lose certain preferences or rights, most often the conversion of their preferred shares to common shares. While loathed by earlier investors, pay to play is actually a company and founder friendly provision: it enables the business to raise more capital, and, in the event investors do not participate, it reduces the overall liquidation stack.
Dividends / PIKs Stipulate the payment of a dividend on preferred shares (often called PIK for “paid in kind” dividend) Can get pretty dilutive pretty quickly. Make sure you’re on a path to sell the company.
Guaranteed IPO returns Ensures that investors receive a minimum return on their investment when the company goes public, regardless of the IPO price. Typically asked for in pre IPO situations as opposed to distressed situations. Not the end of the world—unless the expected IPO price is actually close to the liquidation stack of the company.
Series-based M&A vetoes Provides the lead investor in this round with the right to veto an M&A. This is an ask that typically comes from a strategic of some form. Case-by-case but generally pretty bad for future M&A
SAFE with Liquidation Preferences Investors invest at the same post money as the previous round via a safe, but demand a liquidation preference in the form of 1.2-2x (sometimes as high as 3-4x). This investment saves face but will reduce payouts to existing shareholders in an M&A substantially. Liquidation preferences are bad: they will ruin M&A payouts and set a precedent that future investors are guaranteed to follow. If you have to accept liquidation preference, you want to accept it via a SAFE with a liquidation preference that goes away on conversion to shares in the next equity financing. If the company turns around and raises an equity round, the liq pref will disappear.
Priced round with Liquidation Preferences Investors buy equity in the company via a priced round and institute a liquidation preference for their shares This is pretty bad. Once an investor in the cap table has liquidation preference, all future investors will have an equal or a higher liquidation preference. Consider a clean downround instead.

Downround

A downround is a standard priced round where the PPS is less than the PPS in the previous round. In a downround, existing shareholders who invested at a higher valuation are typically entitled to some compensation (called Anti-dilution provisions). The Anti-dilution are typically found in the Certificate of Incorporation.

Full Ratchet In a Full Ratchet, the conversion price of the investor’s preferred shares is adjusted to the price paid in the downround, regardless of the number of shares issued. This ensures that the investor’s ownership percentage remains the same as it was before the downround. Full Ratchets are very dilutive for founders and existing shareholders. Avoid them while you can.
Broad-Based Weighted Average The conversion price of the preferred shares is adjusted to a weighted average of the price paid in the previous round and the price paid in the downround taking into account all outstanding shares, including preferred and common shares, when calculating the new conversion price. This is a more moderate approach compared to a full ratchet. The effect can be mild, particularly if the downround is much smaller in size than the previous round. (This is the most common provision and the recommended one by the NVCA)
Narrow-Based Weighted Average Similar to a Broad-Based Weighted Average but only considers the preferred shares when calculating the new conversion price, which generally offers less protection to investors than the broad-based method.
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Although the Anti-dilution rights existing investors are baked into the Certificate of Incorporation, they are often re-negotiated as part of the downround. For example, if the downround is being led by the same lead of the previous round, the lead might ask to change the anti-dilution provision of their existing shares to Full Ratchet so their entire investment counts at the new valuation. So make sure to understand the difference between all three.

Conclusion

While down rounds can be a tough pill to swallow, they generally create fewer headaches for startups in the long run. They offer a key benefit: raising the next round becomes easier due to a cleaner capital structure. This is an important point: although most founders optimistically hope that a structured or down round will provide them with enough runway to turn the business profitable or secure an exit, this rarely proves to be the case.