Down rounds, anti-dilution and pay-to-play

A down round happens when a startup raises money at a lower price per share than its previous round. Sometimes the company has stumbled. Sometimes the market has fallen or the last round was priced too high. Either way the consequences reach beyond the headline number: earlier investors may get extra shares, employees' options may be underwater and the board has to run a careful process. Cooley GO puts it plainly: "Down rounds are frequently viewed much more harshly than flat or up rounds."

This page is general information, not legal, tax or financial advice. The examples are hypothetical and simplified. Down rounds raise serious fiduciary and tax questions, so work with experienced counsel from the start.

How anti-dilution protection works

Preferred stock converts into common stock at a conversion price, which starts equal to the price the investor paid. Anti-dilution protection lowers that conversion price after a down round. The investor keeps the same number of preferred shares, but each one converts into more common shares. Cooley GO explains that the adjustment "increases the number of shares of common stock each share of preferred stock is convertible into."

The two main forms:

• Broad-based weighted average. The common form. The adjustment depends on both the new price and how much money is raised at it. The formula is CP2 = CP1 x (A + B) / (A + C), where CP1 is the old conversion price, A is the shares outstanding before the round on a broad basis, B is the shares the new money would have bought at CP1 and C is the shares actually issued.
• Full ratchet. The conversion price drops all the way to the new price. A tiny round at a low price can trigger a huge adjustment. It is rare in early stage deals.

"Broad-based" means A includes options and other convertible securities, not only issued shares. A narrow-based formula uses a smaller A, which gives a bigger adjustment. Read the definition in your charter.

Worked example: the same down round three ways

The numbers below are hypothetical. A company sold 2,000,000 shares of Series A preferred at $2.00, raising $4 million. Before the new round it has 12,000,000 fully diluted shares, including the Series A. It now raises $3 million of Series B at $1.00 per share, issuing 3,000,000 new shares.

Under broad-based weighted average: CP2 = $2.00 x (12,000,000 + 1,500,000) / (12,000,000 + 3,000,000) = $1.80. The Series A now converts at $1.80, so its $4 million converts into about 2,222,222 common shares.

The weighted average adjustment costs everyone else about one point. Full ratchet doubles the Series A's share count and takes about eight points from founders and employees. In a real deal the Series B investor would usually insist on its full 20 percent after any adjustment, so the round would be priced to account for it. That pushes even more dilution onto common holders.

Pay-to-play

A pay-to-play provision ties preferred rights to continued support. Existing preferred holders must buy their share of the new round. Those who do not are penalized, typically by having some or all of their preferred stock converted to common. The NVCA model certificate of incorporation includes optional pay-to-play language, available from the NVCA model legal documents page.

Continuing the hypothetical: the Series B terms ask existing Series A holders to fund $1.5 million of the round in proportion to their Series A holdings.

Pay-to-play rewards investors who keep backing the company and moves the preference stack in their favor. It can also split an investor group, so expect hard conversations.

Employees, options and 409A

A down round usually leads to a new 409A valuation with a lower common stock value. Employees holding options with higher exercise prices may be underwater. Companies sometimes reprice options or grant new ones to keep the team. Repricing needs board approval and may need stockholder approval under the plan. It also has tax effects, including on whether options keep incentive stock option treatment. Our equity and stock options guide covers ISOs and 409A. Our valuations guide explains how 409A values are set.

Board process and approvals

Down rounds are often led by existing investors who also sit on the board. That creates conflicts: the directors approving the price are also buying at it. Lawyers usually recommend steps such as these to make the process fair:

• Seek outside offers to show the price reflects the market.
• Let disinterested directors or stockholders approve the deal.
• Offer every existing holder the chance to invest on the same terms, often through a rights offering.
• Keep careful minutes of the alternatives considered.

The deal will also need the votes set by the charter, often including separate approval by each series of preferred. Our startup boards guide explains board composition and protective provisions.

Alternatives to a down round

Cooley GO lists several. A bridge financing on a convertible note can buy time to reach a milestone. A company can raise at a flat price with tougher terms, such as a larger liquidation preference or warrants. Cooley GO warns that "providing these rights could result in the holders of common stock being worse off than they would have been in a down round scenario." Venture debt is another option for companies with strong backers. Cutting burn to extend runway is the option that does not dilute anyone.

What Palo Alto founders typically ask

Is a down round the end of the company?

Not necessarily. A down round resets the price, but companies can recover and later raise at higher prices. The bigger near-term risk is losing employees, so be open with the team about the plan.

Can we ask investors to waive anti-dilution?

Yes. Cooley GO notes that founders regularly negotiate waivers or partial reductions. A lead investor in the new round often supports a waiver because the adjustment dilutes it too.

Who should we call first?

Your lawyer, before you sign a term sheet. Our startup law firms guide lists firms with Palo Alto offices.

Frequently asked questions