We are pleased to introduce a new Ropes & Gray podcast series, The Sponsor’s Edge: Insights on Growth and Venture Investing, which explores a variety of subjects of importance to growth and venture fund sponsors. This series will feature attorneys from a number of practice groups at Ropes & Gray, including private funds, venture investing & emerging companies, and restructuring, as they examine issues germane to growth and venture fund sponsors in the current investment environment.
On this opening episode, asset management counsel Catherine Skulan hosts the first of a two-part conversation between Brad Flint, partner and co-lead of Ropes & Gray’s venture investing & emerging companies practice, and Raj Banerjee, a senior associate in that practice. Brad and Raj discuss down rounds and their alternatives, including recapitalizations when a down round isn’t enough. Their discussion also sheds light on evolving and emerging terms that are becoming increasingly common in today’s deal landscape.
Please stay tuned for the second part of their conversation, where they will cover the emergence of additional terms and investor protection mechanisms recently taking root in the market.
Catherine Skulan: Hello, and welcome to this Ropes & Gray podcast. I’m Catherine Skulan, counsel in the Ropes & Gray asset management group in San Francisco. I’m joined today by two colleagues, Brad Flint and Raj Banerjee. Brad is partner in our Boston office and co-lead of Ropes & Gray’s venture investing and emerging company practice. Raj is a senior associate in our venture investing and emerging company group and is also in our Boston office.
Today’s discussion is part of a series of podcasts hosted by a cross-practice group of Ropes attorneys, where we look at the near-term challenges faced by growth equity and venture fund sponsors, together with long-term opportunities that we see for them. We’ll cover a variety of topics, but to start the conversation, I’ll invite Brad and Raj to delve into the challenges faced by companies and sponsors dealing with what has been a quite choppy and generally slow market, and the solutions that have emerged to deal with those challenges. Over the course of two episodes, they will speak to down rounds and their alternatives, including recapitalizations when a down round isn’t enough. They’ll also cover the emergence of other terms and investor protection mechanisms recently taking root in the market. Join their discussion as it sheds light on evolving and emerging terms relevant to these topics that are becoming increasingly common in today’s deal landscape.
Brad, would you like to kick it off?
Brad Flint: I’m happy to, Catherine—thank you. First up, we’ll start by talking about down rounds. These are an almost inescapable reality for many VC-backed companies in this economic climate, and one that companies grapple with from both economic and optical perspectives. In recent years, we’ve witnessed a significant rise in the use of less traditional mechanisms that allow founders and investors to bridge valuation gaps and complete down-round financings in a manner that achieves both of their goals. Just to be clear, a valuation gap exists when founders feel strongly about at least optically achieving a flat or higher round valuation, but the investors feel strongly about a lower valuation under current circumstances. One of the mechanisms used to bridge a valuation gap is to price a round at a flat preferred stock price per share—meaning, the same price per share as in the prior round—but also issue penny warrants exercisable for a number of shares of additional stock set at a fixed ratio compared to the number of shares of preferred stock issued by the company in the new financing. This structuring permits the appearance of a flat round, at least in terms of the preferred stock price per share, while achieving an economically lower price per share by virtue of the additional shares underlying the warrants. The founders get what they want in terms of the optics of avoiding a down round as measured strictly by the price per share of preferred, and the investors get the benefit of their bargained for down round valuation through a combination of the new preferred stock and the associated warrants.
Raj, could you maybe describe a bit more about this warrant coverage in detail?
Raj Banerjee: Of course. This strategy involves leveraging penny warrants—meaning, warrants exercisable for a penny per share, or de minimus consideration—for shares of the company’s common stock to enhance the investors’ potential upside while mitigating downside risks through normal liquidation preference rights in the preferred stock. All of the investors’ normal liquidation preference, anti-dilution protection, and other downside rights and protections remain tied to the preferred stock issued to them at the artificially higher price per share. By adjusting the number of common stock shares exercisable under the warrant relative to the number of new shares of preferred stock issued—meaning, the “warrant coverage” ratio—companies can effectively create a discount (and a lower effective company valuation) relative to the actual per share price paid for the new preferred stock.
Brad Flint: Exactly—thank you, Raj. To illustrate that, we can point to an example of how this might work. Imagine two parties agreeing on a down round valuation, with the agreed valuation set 25% lower than the previous round price. In that valuation circumstance, a company could issue 25 shares of common stock, exercisable under penny warrants, for every 75 shares of preferred stock that it issues for cash. The preferred stock price per share remains unchanged from the prior round from an optics perspective, but since the investors are entitled to receive additional shares of common stock for de minimus consideration, the blended price paid by investors for the package of securities reflects the agreed 25% lower valuation. The liquidation preference, which represents the investors’ priority return in the event of a company’s liquidation or sale at a lower valuation, would still reside within the preferred stock but at that artificially high valuation level. However, the introduction of additional common stock through penny warrants provides that additional upside potential that gets you to the blended valuation.
Raj Banerjee: On the topic of dilution of ownership—the effectively lower valuation of the combined preferred stock and warrants would still have the same dilutive effect on existing shareholders as if the new preferred was sold at the blended (or lower valuation) price per share, and so it would trigger anti-dilution protection for the earlier, higher-priced series absent a waiver. The key point here is that this warrant coverage method is a means of addressing an optics issue in the context of a valuation gap, and not a means of avoiding the economic dilution of a down round. So far, the discussion has primarily focused on warrant coverage for common stock, but we’ve also occasionally had conversations around warrants for preferred stock. Brad, could you explain the different objectives for warrants for preferred, in contrast to those for common stock?
Brad Flint: Of course—thanks, Raj. When using warrants for common stock, the goal is to create a package of securities that mirrors the situation an investor would be in if they had invested solely in preferred stock at the “correct” price reflective of the down round valuation. That approach allows companies to maintain a balanced structure, preserving the preferred stock’s liquidation preference and other downside protections—albeit, tied to an artificially inflated valuation, which is modestly good for the new investors and modestly bad for the existing shareholders—but potentially providing additional upside through the additional common stock ownership represented by the warrants.
On the other hand, warrants for preferred stock achieve a different outcome. By issuing more preferred shares under the warrants, you artificially increase the liquidation preference above the actual investment amount, potentially substantially (depending on the ratio). This approach would also lead to artificially high anti-dilution protection as well. While warrants for preferred are occasionally used as a result of specific business negotiations, it’s important to recognize that they represent a fundamentally distinct approach compared to common stock warrant coverage.
Raj Banerjee: Speaking of other approaches, another concept we’ve seen to potentially bridge valuation gaps is the synthetic secondary. Although this approach hasn’t been implemented as widely as the penny warrant coverage approach that we’ve been discussing, it presents an intriguing option, particularly in the tech sector where founders often hold substantial stakes in their companies.
The concept of a synthetic secondary involves structuring a transaction in which new investors purchase common stock, usually from the founders, alongside the new preferred stock at a discount—say, 10% to 50%—to the price of the new preferred stock, creating a blended price for the shares. Traditionally, in secondary transactions involving the sale of common stock from founders to investors, the common stock would be acquired at the same price or at a more modest discount compared to the preferred stock. However, recent trends have seen a more significant discount being applied to achieve an effect similar to the effect of penny warrant coverage.
Brad Flint: It is also important to note that while this approach lowers the blended stock price paid by investors in a manner similar to the penny warrant approach, the resulting liquidation preference in the preferred shares would not align with the actual investment allocation. Since a portion of the investment is directed towards purchasing existing common stock with no liquidation preference, only the portion of the total investment allocated to the purchase of the preferred stock would contribute to the liquidation preference of the preferred shares.
To address this discrepancy, deals structured in this manner typically include a liquidation preference per share in the preferred that exceeds the typical 1x of original issue price. This ensures that all the invested funds are covered, and that the investor receives the same liquidation preference amount that they would have been entitled to if they had only purchased the preferred stock in the first place.
In our experience, the synthetic secondary is still more of a theoretical concept than a widely implemented strategy. It doesn’t have quite the same mathematical flexibility provided by penny warrant coverage and it’s limited by the amount of common stock that founders are able and willing to sell and the price that they are willing to sell it at. However, in appropriate circumstances, it can serve as a bridge, allowing companies and investors to reach a valuation that satisfies both parties without resorting to a traditional down round with a potentially significantly lower preferred share price than the previous round.
Catherine Skulan: Thanks, Brad and Raj. This has been a very interesting and helpful conversation, but unfortunately, that’s all the time we have for today. Thanks very much for sharing your insights into some creative alternatives to down rounds that you’ve been seeing in your practice. I look forward to hearing from you in our next installment, where you’ll be talking more about the traditional means of bridging valuation gaps and some other deal terms and investor protections that have gained traction in this higher-risk investment climate.
For our listeners, please visit www.ropesgray.com for additional news and commentary from Ropes attorneys in the growth and venture space, including growth and venture fund fundraising, transactions and regulatory issues impacting growth and venture fund sponsors. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. If you’d like to learn more about any of the topics we discussed today, please do not hesitate to contact us. Thanks again for listening.
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