A recent Troutman Pepper Locke alert discusses a board’s obligations when a venture-backed company is considering a down round (raising funds at a lower valuation than a prior financing). Because these deals mean greater-than-anticipated dilution for existing holders — and potential shareholder opposition even when the down round is the best, or even the only, available option — they are often designed to encourage existing holders to participate, which “encouragement” can take the form of a carrot or a stick.

Such features may include pay-to-play or pull-up mechanisms, compulsory conversions, warrant coverage, or super-priority liquidation preferences, all of which can present turbulent waters for a board of directors to navigate . . .

The investors leading a down round financing often view themselves as backstopping the company at a time when others won’t, and expect to be compensated accordingly. On the other hand, management may focus on maintaining their jobs as a primary driver and their equity stake as a secondary driver. Other key stakeholders often include new investors, who may be looking for an opportunistic investment, and non-participating existing equity holders, who will be diluted and who may or may not be engaged and supportive of the transaction. The board of directors considering such a transaction should pay careful attention to its fiduciary duties as it works to bring this diverse set of stakeholders together.

Here are a few tips from the alert regarding decision-making and processes.

Informed Decision Making

Seek out alternatives: The board should consider and seek out alternative options, including bridge loans, simple agreements for future equity, convertible note offerings, mergers, asset sales, or other transactions that may be less offensive to non-participating equity holders.

Research: The board should review current market terms for similar transactions in the same or similar industries if possible, and use these as a guideline in establishing financing terms for the down round.

Process

Fair value: The board should establish a fair price for the down round. While not required, getting a 409A valuation from an independent and reputable third-party valuation firm is effective in supporting the company’s position that the pricing of the down round was appropriate.

Independent committee: If possible, the board should establish a committee of independent and financially disinterested board members to evaluate and negotiate the terms of a down round and approve the transaction.

Conflicts of interest: Any board actions involving interested directors should have the interested directors recuse themselves, and any written resolutions should clearly acknowledge which directors are interested. Transactions involving interested directors can receive extra scrutiny on review and have their own set of approval provisions within the Delaware General Corporation Law and other state laws; it is imperative to follow those provisions.

The article also addresses documentation, equity holder considerations and compliance.

– Meredith Ervine