Keeping Your Head Up During Down Rounds

I am an angel investor in a company that is looking at doing a down round “pay to play.” How can I protect myself from being crammed down into Common?

Down rounds are going to become more common, so a timely question. The typical reasons why a new investor punishes non-participation from older investors are (a) to maximize new capital investment and (b) to eliminate older investors and their associated liquidation preferences and ownership. Of course, most early stage investors do not have capital to participate in future financings.

The best way to avoid being impaired yourself is to participate to the full extent of your pro rata investment in the new round. Even the most punitive down rounds typically protect investors who put in new capital. If you are participating, you might selfishly welcome harsh terms on others.

A down round need not convert non-participants to Common. My fund goes to great lengths to structure recapitalizations to preserve the liquidation preferences of junior rounds, even if the percent ownership decreases for non-participants. We want to maintain the good will of angel investors and other early stage investors. We often structure positive incentives for participation, like exchange of an investor’s earlier holdings into the new senior round as an inducement for participation, plus perhaps an enhanced liquidation preference on the senior round.

Although some, like us, prefer carrots over sticks, most funds do not. If you want to make an argument to a new investor to structure a less punitive deal, you will need to make the case that investment from current holders will be maximized with a gentler structure. In my experience, funds that offer extremely punitive term sheets are probably not all that interested in being friendlier, as destroying the economics of the earlier rounds is, for many new investors, exactly the point.

Earlier preferred classes of course have blocking rights, but exercising those without an alternative plan is effectively taking the same writeoff you would take anyway, as you are condemning the company.

Unless the company can find an alternate financing source, including from insiders, it is likely you will have little leverage to do anything to stop a down round.

See also: Course 4.110: Down Rounds  

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