2022 - The Year of the “Down Round”? Impact of VC Funding Risks
a deep dive into vc funding with anti-dilution Provisions
2021 is going down in the books as a time when “cash was cheap.” The government stimulated the economy with over $5 trillion dollars. The Federal Funds Rate dropped from 1.58% to 0.05% in early 2020 and have stayed below 0.1% since then. In 2021’s booming venture market, VCs dumped $330 billion in the US, more than a 100% increase from 2020. It was a great year for startups looking to get funded. It felt like money was being handed out like candy. Tiger Global itself deployed over $9B in 2021. They almost did a deal every day in 2021.
Tiger Global made a growth investment nearly every day of the calendar year - courtesy of Crunchbase.
With early-stage companies raising excess cash, we saw more and more startups employing a strategy of growth at any cost to acquire customers with little emphasis on a path to profitability. I’m looking at you 15-minute grocery delivery startups in NYC. There are more than a handful, and we are not sure how many of them are going to survive. We just witnessed Instacart cut its valuation by 40% and Fast close its doors after a $102 mm raise last year.
Now that markets are experiencing sobering downward pressure to start 2022, Wall Street is expecting seven rate hikes for the year, and inflating input costs (both labor and hard goods) are chewing into pocketbooks. Startups will have a harder time raising their next round. Multiple compression from 20x+ in 2021 to multiples akin to the pre-covid environment today makes achieving valuations at 2021 levels seem like a pipe dream. SVB just released its “State of SaaS” report. Revenue multiples continued to expand from 2019 to 2021 across A, B and C rounds.
While 2021 was the year of never before seen valuations, we think 2022 could be the year littered with dreaded down-rounds as down and flat rounds have been at a four-year low.
Down Rounds
Down-rounds are generally bad news. They have severe implications on optics and publicity, which can be painful for early-stage startups. From a financial perspective, existing equity investors are in danger due to the higher dilution. As a result, investors have standardized anti-dilution clauses in term sheets and stock purchase agreements. Though ownership dilution will occur any time new shares are issued, anti-dilution clauses provide enhanced protection to minimize the impact of new investors buying shares of the company at a lower price than in prior rounds.
Given the current landscape, hearing more about down rounds could be inevitable. While they can’t be avoided, founders should be prepared and understand their options. In fact, they can even be a strategic tool for managers looking to reset the option pool at a lower strike price.
Anti-Dilution Clauses
Warning: Before we go further, we assume that you are familiar with the topic. If you need a refresher, please read this quick primer from Point Nine Land.
Anti-dilution clauses mitigate the dilution existing investors would experience from a down round. Functionally, additional shares are issued when an investor converts its preferred stock into common stock. Mechanically, the investor’s conversion price is lowered as if the pre-money on prior rounds were done at a lower valuation. There are two common ways to calculate this adjusted price per share after a down round: 1) Broad-based weighted average and 2) Full Ratchet.
Example
In January 2021, Noodle Networks raised its Series A for $10 mm with Penne Partners, who led the round at a $40 mm pre-money valuation ($50 mm post-money valuation), valuing the company at 20x its 2020 ARR of $2 mm. Penne holds 20% of the shares outstanding upon converting its investment from preferred stock to common.
Noodle Networks’ monthly cash burn is $0.5 mm and now it has only 6 months of runway, which is too close for comfort. The founder of Noodle has reached out to several VCs to test the markets for a $20 mm raise. The general feedback is a 10x ARR valuation multiple, which is now $4 mm => $40 mm pre-money valuation, and a 10% option pool refresh since Noodle granted all of its options over the past 14 months.
Here is what the dilution would look like before factoring in the Anti-Dilution clause.
The new potential investor would own 33% of Noodle if you include the new option pool.
[New Investor Ownership] = [Series B Proceeds] / ([Pre-Money Valuation] + [Series B Proceeds])
33% = $20 mm / ($40 mm + $20 mm)
Broad-based Weighted Average
Broad-based weighted average is typically more friendly to founders (barring not having an anti-dilution clause). The target share price is calculated by weighting the previous rounds’ prices by the fully diluted share count and the down round price by the number of shares to be issued in the down round. Effectively, this reduces the overall fully diluted share price to be the weighted average share price between all rounds of funding including the down round.
Broad-based weighted average launguage according to the NVCA is here (page 25).
The calculation is CP2 = CP1 * (A+B) / (A+C)
Where
CP2 is the Conversion Price in effect after the down round completes.
CP1 is the Conversion Price in effect before the down round.
A is the number of fully diluted shares of Common Stock outstanding before the down round.
B is the number of shares of Common Stock that would have been issued in the down round if the price was equal to the existing price.
C is the number of new shares of Common Stock issued in the down round.
Example
Let’s build on the Noodle Networks’ scenario to examine the impact of an anti-dilution clause on investors’ ownership.
Let’s assume the following:
Noodle has 50 mm shares outstanding (O/S) on a fully diluted basis with all options issued from the prior round’s pool => A = 50 mm.
Of the 50 mm shares O/S, 5 mm were for the option pool (10% of FD shares) and Penne Partners owns 10 mm shares (20% of FD shares), and the remaining 35 mm common shares are held by the founder, employees, and seed investors.
Penne paid $10 mm for 10 mm shares => CP1 = $1.0000
If there were no down round, the Series B investor would invest $20 mm at CP1 ($1.0000) => B = 20 mm.
Noodle has 50 mm shares O/S and will issue another 8.98 mm shares to cover the option pool refresh at 10% of the post-Series B cap table. A $40 mm Series B pre-money divide by 58.98 mm shares (50 mm + 8.98 mm) => C = 29.49 mm. Note: The quickest way to calculate C is by using iterative function (File > Settings > Calculations > Iterative calculation = On).
CP2 = CP1 * (A+B) / (A+C)
CP2 = $1.0000 * [( 50 + 20) / (50 + 29.49)]
CP2 = $0.8806
With a broad-based anti dilution clause, Penne’s CP2 is now equal to $0.8806 vs when it did the deal at $1.000. To get to this price, more shares will be issued to Penne when it converts its Series A stake from preferred to common. Since it invested $10 mm that translates into 11.36 mm shares, or an incremental 1.36 mm common shares.
See the chart below. Without the A-D clause, Penne’s stake would have been reduced from 20% to 11.1% (including the 10% option pool refresh). The A-D protection offsets that dilution to increase its stake from 11.1% to 12.4% (11.1% + 1.5%).
Without the A-D clause, Penne’s stake would have been reduced from 20% to 11.1% (including the 10% option pool refresh).
Full Ratchet
Full Ratchet Anti-Dilution offers the most dilution protection for the most recent investors and heavily disadvantages founders. In this situation, existing investors who bought stock in past rounds at higher valuations are protected to reduce their effective share price to the same price as the down round. Essentially, this is a free put option for the existing investors who invested under a Full Ratchet Anti-Dilution clause.
Full Ratchet Anti-Dilution language according to the NVCA is here (page 26).
Example
Now, let’s run through Noodle Networks’ scenario using full ratchet anti-dilution instead of broad-based anti-dilution.
Noodle has 50 mm shares O/S. Under broad-based weighted average they had to issue 8.98 mm options to cover the option pool refresh. Under full ratchet, they will need to issue more options (9.39 mm).
CP2 = [Series B Pre-Money Valuation] / [Fully Diluted Shares Outstanding + New Option Pool]
CP2 = $40 mm / (50 mm + 9.39 mm)
CP2 = $0.6735
Under a Full Ratchet, the CP2 is further reduced to $0.6735 compared to the Broad-based of $0.8806. Penne would now be allocated 14.85 mm shares on its original $10 mm investment, resulting in an incremental 4.85 mm common shares.
Using the chart below, the A-D clause, Penne’s stake would have been reduced from 20% to 10.6% (including the 10% option pool refresh). The A-D protection increases its stake from 10.6% to 15.8% (10.6% + 5.2%).
Penne’s stake would have been reduced from 20% to 10.6% (including the 10% option pool refresh)
Dilution & Down Round Calculator
Down rounds are always complicated because of the various moving parts with the design around Anti-Dilution clauses or prior funding history. We, at Acctuate, have built this Dilution & Down Round Calculator template to help you understand the effects of your next funding round and calculate how much of your ownership you will retain post a down round.
Case Study
To show the Dilution & Down Round Calculator in action, we laid out the example with Noodle Networks.
On the Anti-Dilution Overview tab, we have included room for you to enter the inputs to calculate the A-D impact. There is a section for convertible notes issued at a discount in case those were a part of your prior round. This tab also provides a high-level overview of the key metrics in your analysis.
The Charts tab offers an overview of the ownership breakdown under various Series B pre-money valuations.
Dilution & Down Round Calculator (view the calculator)
The Detailed_Ouput tab provides a deeper dive into the breakdown of the metrics shown in the Anti-Dilution Overview tab.
The Detailed_Ouput tab in our downround calculator provides a deeper dive into the breakdown of the metrics shown in the Anti-Dilution Overview tab.
Practical Use Cases
The inevitability of tighter markets does not leave founders empty handed in their battle for raising capital. Because there is a high likelihood that the next few years will leave founders less room to negotiate on valuation and deal terms, we think that it is incredibly important to explore the details of your term sheet to identify your leverage points and be prepared for your next round.
After playing with the down round calculator and internalizing the mechanics of the Anti-Dilution clause, you may find that your situation is too complex to be handled by what we have provided. We welcome you to contact us info@acctuate.com to provide feedback and make further inquiries.
DISCLAIMER: Models provided are as-is with no representations or warranties by Acctuate. They are not legal advice and Acctuate disclaims any responsibility for any negative consequences from using these materials. However, we will take your praise and appreciation.