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Down rounds and anti-dilution clause mechanism: The corporate loop

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When a private company raises additional capital by way of issue of shares of such company at a price lower than the previous round of funding is referred to as down-round funding.

Down rounds and anti-dilution clause mechanism: The corporate loop
Authored by Prem Rajani and co-authored by Karen Isaac
While we cannot foresee a clear path on easing the spread of the novel coronavirus, the exacting pandemic has led corporates to re-strategise, contemplate business choices, seek fundraising, alter business models and take a step towards a new era of digitalisation.
As India is skin-deep in the economic and monetary loop, to remain afloat, many corporates have resorted to down-round funding.
The continual capital inadequacy has left little to no choice with aspiring business heads as well as small and medium enterprises globally who are struggling to make a mark in the corporate world. The downward slope witnessed in the Indian as well as international markets, has led numerous entities to route towards lower enterprise valuation.
Down-round protection and anti-dilution clause mechanism
When a private company raises additional capital by way of issue of shares of such a company at a price lower than the previous round of funding is referred to as down-round funding.
Essentially, in down-round funding, the valuation at a round of (current) financing (pre-money) is lower than it was at the previous round of financing (post-money).
An existing investor can suffer dilution in two forms, either by way of
(a) a stock dilution wherein the shareholding of an existing investor is potentially reduced, or
(b) an economical dilution that is caused due to the decrease in the economic value of an existing investor’s shareholding pursuant to the acquisition of shares by a new investor at a lower price.
To secure the interest of the initial (existing) investors and bridge the pricing gap per share on account of low firm valuation, the initial investors ought to have a mechanism to prevent them from such dilution.
A built-in anti-dilution clause acts as a corrective mechanism and ensures an existing investor compensation by way of issuance of additional stock in the event a company elects for down-round funding.
An anti-dilution protection armours existing investors from potentially losing their investment value by correcting the conversion price between the convertible securities and common stock.
This conversion price can be adjusted in two ways on the adoption of the anti-dilution mechanism, namely
(a) full-ratchet adjustment or
(b) weighted average adjustment mechanism.
The full ratchet anti-dilution adjustment mechanism ensures the existing investors to maintain their ownership percentage, should a down-round take place, by compensating the total economic dilution suffered by an existing investor.
A weighted average adjustment mechanism is derived by the application of a mathematical formula that neutralises the economic dilution by weighting the valuation of the company before the down-round and the total increase in the capital at a subsequent round.
A weighted average adjustment mechanism can further be sub-divided into a broad-based weighted average adjustment mechanism and a narrow-based weighted average adjustment mechanism.
An absence of a down-round clause exposes the existing investor to a decline in its ownership percentage as well as a downfall in the valuation of their holding.
Alternatives to down-rounds
In the private equity world, since a down-round is considered as a taboo, there are certain ways that a company can consider to navigate the unwelcoming down-round. We have set out below such few alternatives: 
  • Cost-cutting: cost-cutting by the company can be a temporary fix and may deter the need for an immediate external fundraise by the company;
  • Resort to bridge financing: If the company is facing a short term cash crunch, the company can resort to a convertible note financing whereby such convertible notes can convert in the next round usually at a discount to the price determined at such subsequent round;
  • Seek a waiver. Many founders seek recourse to renegotiation of the terms of the contract entered into by the company with an existing investor, and it is commonly seen that a good management negotiation skill can result in the existing investors waiving their anti-dilution right, saving the downfall for the founders.
  • Although, the alternatives mentioned above may not be a permanent solution to escape a down-round, should a down-round take place the protection made available to the existing investors depends on the drafting of such clause in their respective investment contracts?
    While finalising the investment contracts, the investors must take into consideration certain keynotes pertaining to the anti-dilution clause to ensure that the existing investor will be suitably compensated with additional shares in the case of a down-round.
    From the point of view of an existing investor, secured protection may be deduced in the form of a ‘full ratchet’ protection that reduces the conversion price of the existing shares to match the reduced price paid by the new investors in the down-round.
    As a general practice, the full ratchet mechanism is not preferable as the same dilute the founders considerably. A more common practice is to incorporate the ‘weighted average’ anti-dilution protection that regulates the impact of anti-dilution upon its enforcement.
    Key takeaways for Founders and Investors
    As far as a founder is concerned, as opposed to a full ratchet anti-dilution mechanism that provides little to no flexibility to the founders; a broad-based weighted average anti-dilution mechanism, on the other hand, does not lead to a large conversion rate adjustment and may be considered as a preferred option. On the other hand, a full ratchet mechanism provides sizeable value protection to the existing investors, thereby proving detrimental to the founders.
    A careful analysis of clauses pre-investment with strong negotiation skills can render the ball in one’s court and act as a game-changer should a down-round be undertaken by the company dodging the corporate loop.
    —Prem Rajani is Managing Partner, Rajani Associates and Karen Isaac is Associate, Rajani Associates. The views expressed are personal
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