Down Round

How a down round works

A down round is a financing priced below the previous one. The comparison that legally matters is price per share, not valuation. A company can raise at a higher post-money valuation and still trigger anti-dilution protection if it issues shares below the conversion price of an existing series, because share counts change between rounds through option pool expansions, SAFE and note conversions, and secondary issuances. The charter measures the new issue price against the conversion price of each outstanding preferred series, one series at a time.

Three mechanical consequences follow.

First, ordinary dilution. New shares are issued, so every existing holder owns a smaller percentage. At a lower price, more shares are issued for the same dollars, so the dilution is larger than it would have been at the old price.

Second, anti-dilution adjustment. Preferred stock converts to common at a conversion price, which starts equal to the original issue price. Anti-dilution protection lowers that conversion price when cheaper stock is issued, so each preferred share converts into more than one common share. The market standard in venture financings is broad-based weighted average, which adjusts in proportion to how much cheap stock was issued. Written in words: the new conversion price equals the old conversion price, multiplied by the sum of shares outstanding before the issuance plus the shares the new money would have bought at the old price, divided by the sum of shares outstanding before the issuance plus the shares actually issued.

CP2 = CP1 × (A + B) ÷ (A + C)

CP1 is the conversion price in effect immediately before the issuance. CP2 is the adjusted conversion price. A is the shares deemed outstanding immediately before the issuance. B is the number of shares that the total consideration received would have purchased at CP1. C is the number of shares actually issued. Variable names and the precise definition of A vary between charters, so the operative language is always the company's own certificate of incorporation.

The variants differ only in what goes into A and how aggressive the reset is.

• Broad-based weighted average. A includes common outstanding plus all preferred on an as-converted basis plus options and other convertible securities. The large denominator moderates the adjustment. This is the standard form in NVCA-pattern charters.
• Narrow-based weighted average. A counts a smaller set, often only the outstanding preferred as converted. A smaller A produces a bigger adjustment in the investor's favour.
• Full ratchet. CP2 is simply set equal to the new issue price, regardless of how few shares were sold. One cheap share can reprice an entire series. Aggressive, and usually resisted.

Third, pay-to-play. Some financings condition the anti-dilution benefit, and sometimes the preferred stock itself, on participating in the new round pro rata. Investors who do not participate see their preferred convert to common or to a shadow series stripped of protective rights. This concentrates the round on investors willing to put in new money, which is generally the company's objective in a difficult financing.

Anti-dilution does not protect against percentage dilution, and this is the point most often missed. It protects the price, not the ownership. Every preferred holder still owns less of the company afterwards; the holder with protection simply owns relatively more of what remains, and the extra shares they receive come out of the common stock.

Worked example

Suppose a company raised a Series A at 2.00 dollars per share and is now raising at 1.00 dollar per share. These figures are hypothetical.

Before the new round: 6,000,000 shares of common outstanding, 1,500,000 options in the pool, and 4,000,000 shares of Series A preferred issued at 2.00 dollars, so CP1 is 2.00 dollars. A on a broad basis is 6,000,000 plus 1,500,000 plus 4,000,000, or 11,500,000 shares.

The new round raises 5,000,000 dollars at 1.00 dollar per share, so C is 5,000,000 shares.

Step one, compute B. The new money would have bought 5,000,000 divided by 2.00, or 2,500,000 shares at the old price.

Step two, apply the formula. CP2 = 2.00 × (11,500,000 + 2,500,000) ÷ (11,500,000 + 5,000,000), which is 2.00 × 14,000,000 ÷ 16,500,000, which is 2.00 × 0.8485, or 1.697 dollars.

Step three, the new conversion ratio for Series A. Original issue price 2.00 divided by CP2 of 1.697 equals 1.1786. Each Series A share now converts into 1.1786 common shares, so 4,000,000 Series A shares convert into 4,714,286 common shares, an extra 714,286 shares created for the Series A at no additional cost.

Step four, compare with full ratchet. Under a full ratchet, CP2 would be 1.00 dollar, the conversion ratio would be 2.0, and the 4,000,000 Series A shares would convert into 8,000,000 common shares, creating 4,000,000 extra shares. The same round, the same price, more than five times the adjustment.

Step five, who pays. In both cases the additional shares dilute the holders with no protection, which is the founders, the employees holding options, and any common held by earlier angels.

Where it shows up

The certificate of incorporation is where the adjustment lives and operates. In NVCA-pattern charters, the terms of each preferred series include the conversion rights and, within them, the adjustment for issuance of additional shares of common stock below the conversion price, along with the definitions of the shares counted in the calculation and the carve-outs. The carve-out list matters as much as the formula: shares issued under board-approved equity plans, on conversion of existing preferred, in connection with equipment leases or bank financings, and in acquisitions are normally excluded, so they do not trigger an adjustment.

The term sheet is where it is negotiated. A term sheet on the NVCA model pattern carries an anti-dilution provisions line specifying broad-based weighted average, narrow-based weighted average, or full ratchet, and a separate pay-to-play line if one is included. The charter then implements whatever the term sheet selected.

The stock purchase agreement and the closing documents record the price per share and the resulting capitalization, and the amended charter is filed with the state at closing.

Board and stockholder consents authorize the new series, the amended charter, and any conversion of existing preferred under a pay-to-play. Because a down round is often a self-interested transaction for directors affiliated with participating investors, boards typically document a process and involve counsel early rather than at signing. Whether a Delaware court would review such a financing under the business judgment rule or under the more demanding entire fairness standard turns on the facts, principally whether a majority of the approving directors were disinterested and independent, so it is a question for the company's own counsel rather than a rule that applies to every down round.

Where employee option strike prices sit above the new common value, a repricing or new grants require a fresh determination of fair market value, so a 409A refresh usually follows.

Common mistakes

• Comparing post-money valuations instead of price per share. The charter tests price per share against the conversion price.
• Assuming anti-dilution protects ownership percentage. It protects the conversion price. Protected investors are diluted too, just less, and the difference is borne by common.
• Forgetting the carve-outs. Option pool increases approved by the board, and shares issued on conversion of existing securities, generally do not trigger an adjustment.
• Ignoring SAFEs and notes in the calculation. Outstanding convertibles convert at the round and change the share count that everything else is measured against.
• Treating a pay-to-play as automatic. It has to be in the documents, and imposing one usually requires the consent of the class it penalizes.
• Skipping the 409A refresh. A priced round, especially a down one, is a material event, and options granted afterwards on the old fair market value carry tax exposure for employees.
• Structuring around the optics. Accepting a senior preference, a multiple liquidation preference, or a ratchet to preserve a headline valuation transfers value from common to the new investor in a form that is harder to see and harder to unwind than a lower price.

Related terms

A down round is the event that triggers anti-dilution adjustment in the terms of preferred stock, and the extent of the adjustment depends on how the liquidation preference and conversion mechanics were drafted in the term sheet. The result is dilution recorded on the cap table, and the comparison that defines the round is between the new pre-money valuation and the prior round's post-money valuation on a per-share basis.

Frequently asked questions

What is a down round?

A financing in which a company issues stock at a lower price per share than in its previous round. The price comparison, not the headline valuation, is what triggers the contractual consequences, principally the anti-dilution adjustment in the company's charter.

How is broad-based weighted average anti-dilution calculated?

The adjusted conversion price equals the old conversion price multiplied by the sum of the shares outstanding before the issuance plus the shares the new money would have bought at the old price, divided by the sum of the shares outstanding before the issuance plus the shares actually issued. Written as CP2 = CP1 × (A + B) ÷ (A + C). Broad-based means A includes common, all preferred as converted, and options, which moderates the adjustment.

What is the difference between weighted average and full ratchet anti-dilution?

Weighted average scales the adjustment to the size of the cheap issuance, so a small down-priced issuance produces a small adjustment. Full ratchet resets the conversion price to the new issue price regardless of size, so a single share sold cheaply reprices the entire series. Weighted average, in its broad-based form, is the standard in NVCA-pattern venture documents; full ratchet appears mainly in distressed financings.

Does anti-dilution protection stop investors from being diluted?

No. It adjusts the price at which preferred converts to common, which gives protected holders additional shares. Every holder still owns a smaller percentage after the round. The additional shares issued to protected holders come at the expense of common stockholders, meaning founders and employees.

What is a pay-to-play provision?

A term that conditions an investor's rights on participating in the new round pro rata. Investors who decline are penalized, most often by having their preferred convert to common or to a shadow series without protective provisions or anti-dilution. It appears most often in down rounds and recapitalizations, where the company needs existing investors to fund rather than to hold.

What happens to employee stock options in a down round?

Options with a strike price above the new fair market value of common are underwater and carry no immediate value, though they remain exercisable at that price until they expire. A priced round is a material event for valuation purposes, so a new determination of fair market value is normally obtained, and the board may consider new grants or a repricing, both of which have tax and accounting consequences.

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