A down round is a round of financing that values a company at less than in an earlier round. This can happen for various reasons, including too-lofty valuations assigned in initial financings. Sometimes, companies might find themselves struggling to find new outside investors and the only capital available in a down round is from existing investors. In these situations, the participating investors’ ability to both set the investment terms and make the investment can create tension with directors and other early investors who might see the participating investors as trying to unfairly dilute their equity positions. Directors who are associated with the inside investors might also be perceived to have a conflict of interest with regard to their approval of the down round.
Under these circumstances, good corporate governance procedures are critical to protect directors and the company from liability and lawsuits that could arise from disenchanted shareholders. Here are a few practical tips for how to prepare for an insider-led down round financing.
Document The Process
It’s important that the minutes of meetings of the board of directors reflect all the updates of the financing, including the board’s rationale for considering a down-round, various alternatives it has considered, and efforts it made to recruit outside investors. Companies sometimes fail to create a verifiable record, which can lead to problems down the road. The better the documentation of the process, the more protection from potential lawsuits. Along those same lines, it can be wise for board members to hold more than just one meeting dedicated to the decision to proceed with a down round financing.
Approval By Independent Directors and Disinterested Directors
In an insider-led investment round, special care must be taken with respect to approval of the transaction. The actions of the board of directors are generally governed under a rule known as the business judgment rule, which creates a presumption that decisions made by directors will be given deferential treatment by the courts if it was made in good faith. However, that presumption can be rebutted by a plaintiff where, as here, there is a violation of a fiduciary duty, such as the duty of loyalty, which is implicated in such conflict transactions.
As a result, stockholders might be able to void a transaction if the board’s decision was influenced by conflicting financial interests of its directors. Under corporate statutes in Delaware and California, the board can avoid such an attempt if it can show that the independent directors of the board or the stockholders of the company approved the disputed transaction. The company should also secure approval from disinterested directors or a majority-in-interest of the shareholders unaffiliated with the insider investors to help mitigate the risk of litigation.
Disclose Financing Terms
It is also important in a down round to give complete disclosure of financing terms and any conflicts prior to any approval. Particular consideration must be given to the benefits for inside investors and factors that could impact non-participating shareholders, management and employees.
Consider A Rights Offering
Companies should accompany or follow up the insider-led financing with a rights offering to all shareholders, allowing them to participate on the same terms as the insider investors. This is arguably the most important step in an insider-led down round. If all shareholders are offered the same opportunity to invest as the insiders, it is difficult to argue that members of the board breached their fiduciary duties. Delaware case law generally holds that in such a case, it is a shareholder’s volitional act of not participating that causes any undue dilution. If all shareholders participate pro rata in the financing on the same terms, no one would be diluted. The disclosure of information statement provided to the company’s shareholders should summarize the financing terms and also solicit the interest of potential investors.
Board members found to have breached their fiduciary duties to the company or its shareholders can be held personally liable. This can be a serious threat, as many companies don’t have directors’ liability insurance and might not have the funds to fight a lawsuit. While there is no fool-proof solution to remove all risks of litigation in an insider-led down round, the steps outlined can help diminish the risk.