Burnouts & Cramdowns

It is the age of the downround, and Joe Bartlett reports from the trenches in which venture capitalists and entrepreneurs fight each other over valuations.

In today's extremely choppy venture capital economy (some good news and a lot of bad news), deals are getting done but at prices which are heavily discounted from the valuations encountered when the feeding frenzy was at its zenith in 1999 and early 2000. Often the financing is the second, third or higher round of venture financing (Series B, C or D); and it is called a 'down round' in the jargon of the trade. Let me illustrate with a typical down round scenario in order graphically to make the point of this piece.

Assume an early stage company incorporated in 1998, which accomplished an angel round of financing in 1998 at a pre-money valuation of $3m. Assume a Series A Round in late 1999 at a pre-money valuation of $5m, with the VC's putting up $5m, so that the post-money valuation is $10m and the stock is split fifty-fifty. Thus, the VCs own 50% on an 'as converted' basis and the common stockholders own 50 per cent. For purposes of simplicity, I am assuming a straight convertible preferred versus a participating preferred and ignoring for the moment the dilutive effect of the employee stock option plan.

Then we come to 2001 and the company needs another $5m. The VCs propose to 'follow on' their existing investment but they are unwilling to do so at a pre-money valuation of $10m. Circumstances have changed, the market is down for both public and private equity and, despite the continuing promise of the company, the VCs propose a $5m round at a pre-money valuation of $5m. This gives them half the company yet again, meaning that they wind up with 75 per cent of the company and the common shareholders are diluted to 25 per cent. Had the pre-money valuation been $10m, the VCs, for their new $5m, would have taken a third and, therefore, wound up with a total of 67 per cent.

When the board is presented with the proposal, the founder objects because she thinks the company has made great progress and at least the round should be at the same price as the earlier round. The VCs however, are adamant and there is no other source of financing. The VCs say to the founder and the other common shareholders: 'If you want to play in this round, you are welcome.' However, they do not have the resources and elect to pass. The round goes through and lo and behold the company prospers. At the end of 2001 it is sold for $100m.

The founder and some of the other common shareholders then sue the VCs, on the theory that, as controlling shareholders they had a fiduciary duty to treat the common shareholders fairly in the course of the down round, and they did not. The complaint alleges that there were no independent directors to review the financing proposal for the down round; no outside opinions were sought from investment bankers, no outside bids were solicited, and the price of the down round was unfair to the non-controlling shareholders.

The VCs howl that the complaint is ridiculous, the common shareholders were given an opportunity to play in the round, plus there was no money in the treasury to pay an investment banker to give a fairness opinion and there was neither time nor opportunity to auction the round to firms other than the insiders. In fact, it is a cardinal rule of venture capital that, if the insiders will not themselves play, then nobody will play. The round salvaged the company and the common shareholders made out just fine, thank you very much.

The question arises: Who wins based on the state of the law today? If you talk to 100 venture capitalists, I suspect that at least 80 of them would find the question trivial; the venture capitalists undoubtedly win on these facts. If you do not play in a round, you pay. The only time the VCs should be vulnerable is if they did not offer the other shareholders the opportunity to participate. It is not their fault that the common shareholders had neither the wherewithal nor the inclination to play.

Counsel for the common shareholders, on the other hand, point to a host of Delaware cases which impose fiduciary duties on controlling shareholders when they do an inside trade. There is 'enhanced scrutiny' of these transactions unless protective measures are instituted (a committee of disinterested directors, a fairness opinion, an auction process), none of which were followed in this case. Again, who wins?

The fact is, as pointed out an article published sometime ago by one of my students and me,1 there is respectable authority for the proposition that, in the case cited, the common stockholders will win. The cases are fact specific, of course, and there is no authoritative precedent interpretation of the law. However, there is enough of a case to be made, based on principle and authority, for the non-controlling shareholder position that, in my view, the VCs in the down round had better watch their step. If the down round is part of death spiral, then there is no plaintiff to complain, everybody is a loser. However, if the down round is in effect a 'salvage round,' or as it is sometimes called a 'restart,' and the company climbs back up to the Elysian Fields it originally aimed at, then there is the possibility of significant claims by the minority for a greater share of the pie… particularly when the good news follows rapidly on the heels of the down round.

1Bartlett & Garlitz, 20 The Journal of Corporation Law, 'Fiduciary Duties in Burnout/Cramdown Financings,' 4 (Summer 1995).