During an economic downturn, startups may need to consider a bridge financing or down round to help weather the storm. Startups should consider the following key questions when deciding on such a transaction.
Directors have fiduciary duties of care and loyalty. The duty of care requires the director to exercise care in making decisions that are in the best interests of the company and all of its stockholders. The duty of loyalty requires the director to put the interests of the company and all of its stockholders above the interests of the director or the appointing stockholders.
- The Board should be thoughtful and thorough in its decision making, including by consulting with management and advisors.
- The Board should discuss any significant corporate action and evaluate alternatives.
- Any decisions should be made in the best interests of the company and all stockholders.
- The Board should maintain minutes of meetings to establish the record of its informed analysis and decision making.
- Directors should disclose any conflicts of interests and consult outside counsel on recusal.
- If a transaction is led by existing investors who are represented on the Board, the Board should consult outside counsel on how to run a fair process, ensuring that the transaction is “entirely fair.”
If a company is facing insolvency and at risk of being unable to meet its obligations, the Board’s fiduciary duties are to the company’s creditors instead of stockholders. The analysis for when the fiduciary duties change is complicated and should be discussed with outside counsel.
Delaware law provides for a heightened standard of review when transactions involve controlling or dominant stockholders or directors, with the standard being entire fairness. The directors are required to demonstrate their utmost good faith. Fundamentally, a transaction is “entirely fair” if it mimics a hypothetical arms’ length negotiated transaction. The standard has two component parts — “fair dealing” and “fair price” — although the analysis is more fluid in practice and looks to all aspects of the transaction. The Board must have a basis for a fair valuation that is arrived at pursuant to a fair process. This may involve a market check, the appointment of an independent committee to negotiate and approve a transaction, due diligence on the part of the Board and majority of minority stockholder approval. The Board should also consider a rights offering to enable all stockholders to participate in the financing on the same terms as the lead investors.
Generally yes, but controlling investors or minority investors who have veto power may have fiduciary duties to the company and other stockholders. If such investors act in a manner that is to the detriment of the company and its other stockholders, their actions will create a risk of stockholder litigation. In the Basho case, the Delaware Court of Chancery found that a minority stockholder had fiduciary duties that it violated because it played “hardball” to block new financings by the company and forced the company into a financial crisis.
Convertible debt is preferable when (1) speed / low transaction cost is desired, especially for a small round or in a distressed situation, (2) there is no lead investor to negotiate a valuation and terms, and/or (3) the company prefers to defer pricing for the investment.
In a distressed situation, investors may require:
- More severe valuation caps and/or discounts for note conversion
- A penny warrant for x% of the investment as an equity kicker (as an added discount to the pricing in the deal)
- A security interest in a convertible note financing
- Waiver of anti-dilution protection by existing stockholders upon conversion
Investors should carefully consider and discuss these terms with counsel.
In an equity financing that is done at a valuation below that of any prior equity round (i.e., a “down round” situation), investors may require:
- A penny warrant for x% of the investment as an equity kicker (as a discount to the pricing in the deal)
- Enhanced or participating liquidation preference
- Accruing dividends
- Pay-to-play provisions
- Redemption rights
- Additional protective provisions
- Waiver of anti-dilution protection by existing stockholders
Investors should carefully consider and discuss these terms with counsel.
Companies deciding whether to conduct a bridge financing should ensure that they have discussed with outside counsel the following important provisions and how they will impact the company down the line.
- Companies should discuss any discounts or valuation caps that will impact the conversion of the debt. If a valuation cap is set too low (and the company expects and upturn in its fortunes prior to its next equity financing), the noteholders could experience a windfall at the expense of the existing investors and management.
- The maturity date for the notes is important to discuss, particularly if the company is unsure of when it will experience an event that will see the notes convert into equity. If the maturity date is too soon, the company may run into issues if the noteholders expect their notes to be paid in full upon maturity.
- Any change of control premiums and how such premiums to be paid to the noteholders could impact the company’s existing stockholders upon liquidation.
- If the lenders expect to take a security interest in the company’s property in connection with the bridge financing, the company should discuss the potential risks with outside counsel prior to agreeing, particularly if this comes up when the company is negotiating the term sheet.
Pay-to-play provisions are designed to offer the company’s current investors with strong incentives to participate in future financing rounds. Often, the provisions are structured to require existing stockholders to participate pro rata in a future financing or otherwise lose their preferential rights, as these provisions most frequently automatically convert such investor’s preferred stock into common stock upon non-participation. Pay-to-play provisions are rare in early rounds, but may be used later on, especially if the company is going through a down round. Investors tend to be wary of management desire for the inclusion of pay-to-play provisions, but lead investors in down rounds may require such provisions to be included so as to motivate the other investors in the company to participate.
Anti-dilution protection is a right for existing stockholders who purchased shares at a higher price to receive more shares on as-converted to common basis (i.e., increase their ownership of the cap table) upon the occurrence of a down round. There is no additional issuance of shares or increase in the liquidation preference for the existing stockholders. Instead, the conversion price of the higher-priced stock is adjusted so that each share is convertible into more than one share of common stock. The result is that in an exit event or an IPO, the holders of such shares may receive a higher portion of the proceeds on an as-converted to common stock basis. In a down round, the company should consider negotiating a full or partial waiver of anti-dilution to incentivize new investors and avoid dilution of management. Typical anti-dilution provisions include broad-based, weighted average anti-dilution, although certain companies may have full ratchet anti-dilution provisions included in their certificates of incorporation.
The equity held by management may both be diluted by a financing at a lower valuation and go under water if valuation falls below exercise price of grants. The company should consider a management incentive plan, re-pricing of existing grants, refresh grants with lower exercise prices, waiver of anti-dilution or other measures for retention purposes when determining how to handle these valuation scenarios that may occur during down rounds.
It is imperative that startups considering a bridge or down-round financing think through the key issues and work closely with counsel before deciding on a path forward.