It has been nearly a decade since down rounds in venture capital – effectively one where the value of the startup has declined even though more money has gone into the business – were common. Silicon Valley Bank’s State of the Markets report identified only about 2% of rounds going into the end of March were down rounds.
It was, therefore, helpful to have a ringside seat as moderator yesterday to hear from two experts, Ian Goldstein and Evan Bienstock, both partners at law firm Fenwick & West, on what to do in these tricky situations.
Dror Futter, a partner in the Rimon law firm, has written some excellent recent posts for first-timers (and more advanced ones such as on retrospective pay-to-plays) on down rounds but there is no shortage of interest in the topic among corporate venturers who have to often manage potential conflicts between fiduciary duties to portfolio companies and alignment with their parent company.
Fortunately, there are now hundreds of CVC units with more than a decade’s track record and thousands of investors who have been through these types of tough decisions.
Still, Bienstock and Goldstein made it clear CVCs need to keep in mind a few key issues:
- Conflicts analysis. Be focused on carefully managing conflict issues. Litigation risks rise (sometimes significantly) in a down-market and CVCs are deep-pocketed potential targets.
- Financing Conflicts and Potential Acquisition Conflicts. Be mindful not only of conflicts arising from leading or participating in a financing transaction, but if the CVC parent may participate in an acquisition process for the portfolio company as an alternative to, or shortly following, a financing the sensitivity on the conflicts analysis increases significantly
- Controlling Stockholder Considerations. Be mindful of the various levers of control that you may have over a portfolio company and how you exercise those levers of control. A CVC with a minority stake in a company may back itself into being viewed as a “controlling stockholder”, resulting in the application of fiduciary duties to the CVC itself and potential exposure directly to the portfolio company/other stockholders if transaction is “unfair”
- Board or observer seats. Consider in advance how you would address a situation where you are being asked to give up your board seat or observer seat if you are not participating in a financing or if the new lead investor/syndicate desires to restructure the board materially as part of a recap or other restructured company
- CVC side letters. Consider in advance how you would address a situation where you are being asked to give up a material side letter right (for example right of first offer/notice) if you are not participating in a financing or if the new lead investor/syndicate insists on such changes as part of a recap or other restructured company.
More broadly, their summary identified key actions for down-market financing structures they “require careful attention as they can be complicated, risky and adversarial”:
- Evaluate your portfolio and plan ahead. Evaluate your portfolio companies and their cap tables and transaction documents for a clear picture of the current “lay of the land”, with a particular focus on your portfolio companies that will need to complete financings in the next six to nine months.
- Advanced thinking and planning by a CVC team around portfolio companies that will likely need such a financing in the next six to nine months will be time well-spent
- Communicate and strengthen relationships. Increase your cadence of communication with your portfolio company CEOs and with your main co-investors.
- Strong, collaborative relationships will help anticipate issues, facilitate completing/approving difficult financing structures and reduce related risks
- Pay attention to impact on key employees. Down-market financing structures often have significant impact on value of the common stock. Careful consideration must be given as to how to re-incentivise the key employees of the company who will drive the business forward.
- Fill vacant board seats now. Many independent director seats remain vacant on portfolio company boards. Consider filling those seats now as independent directors can be valuable facilitators in getting difficult financings completed and reducing risks associated with insider rounds.
- Importantly, this is also a valuable opportunity to increase gender and other diversity in the board room
- Good process is critical. Use of independent board committees; engaging outside financial advisors; conducting an extensive search for alternative sources of financing; negotiating for better terms; establishing a detailed record of the search, evaluation and approval processes (including holding meetings and not just acting by written consent); providing for adequate disclosure to stockholders; properly addressing conflicts of interest; obtaining all necessary corporate approvals (and obtaining where possible disinterested stockholder votes); providing for rights offerings – are all tools to mitigate risk
- Much of the above becomes more difficult if a deal is under significant time pressure – plan ahead
- Have a bias towards simplicity. Although initial objectives may be to streamline cap tables as part of a down-market financing, it is easy for complexity to creep back into the picture through different pull-up, pull-through and other pay-to-play and recap structures.
- Complex capitalisation structures may create problems down the road; aim for ongoing alignment of interests among various stockholder constituencies and attempt to maintain a streamlined capitalisation structure
