The ’Next Round Pricing’ Strategy

How do you price a new ‘down’ round of financing for a VC backed company when the only game in town is the original VC investors and the result could be excessively dilutive to the minority shareholders? Most VCs assumed they satisfied their fiduciary duty by inviting all shareholders to participate in the down round - but maybe not writes Joe Barlett.

Some years ago, a then-student of mine and I published an article suggesting that directors representing venture capital investors in a troubled company were leaping to unjustified conclusions when they structured so-called 'down' rounds (also known, when the results are excessively dilutive of the minority shareholders, as 'washout' or 'burnout' or 'cramdown' rounds) of financing. In a typical situation the directors nominated by the VC investors dominate the proceedings at the Board level and, accordingly, they fix the price of the down round, their dominance due to the fact that they are the 'only game in town,' i.e., the only investors who are willing to put additional cash into the company. Until fairly recently, the VC Directors had assumed they satisfied their fiduciary duty to the common shareholders (the parties suffering the excess dilution washout round), by inviting those shareholders to participate in the down round. The fact that many of the same could not or would not was deemed to be irrelevant: You either 'played' or you 'paid.' Kevin Garlitz and I pointed out that there was case law (although not a lot), and a specific arbitration proceeding which suggested that the 'play' or 'pay' defense was not a complete answer to the fiduciary duty issue.

The article, and the cases on which it was based, caused a stir amongst VC investors, as they looked for ways to protect themselves, in a washout round, against conflict of interest charges when they participated in what was known as the 'inside trade' and advantaged themselves of the expense of the minority investors. If the company ultimately tanks, then there are no damages and no one to complain; if, on the other hand, the company subsequently prospers, the aggrieved minority may well attack the venture capitalists and insist on a greater share in the proceeds as of the date of the liquidity event. And, Garlitz and I forecast the grievants would be, not infrequently, successful.

If 'play' or 'pay' is not the complete answer, the question arises: 'What is?' The difficulties in satisfying the fiduciary duty standards of the Delaware Chancery and Supreme Court are obvious. There is not much money around with which to pay for a fairness opinion: There may be no disinterested directors able to review the transaction as a 'special committee' of the board; and, even if some board members are arguably 'disinterested,' often there isn't time – payroll is coming up and there is no money in the bank. There is, indeed, no time to solicit outside bids, and no real prospects even if time were available; if the insiders will not play, no one else will.

At a Master Class Forum I was giving recently under the aegis of Burt Alimansky's New York Venture Group, an interesting proposal surfaced in the course of the discussion. One of the participants suggested that the VCs could protect themselves against a successful allegation of fiduciary duty violation if they were to adopt a 'next round pricing' strategy. Usually, next round pricing surfaces in a very early stage or seed financing, when the parties are either far apart on price or unsure that they can arrive at a fair price because of the immaturity of the company. Next round pricing consists of a bridge loan which converts at a price (i.e., a company valuation which drives the conversion price) calculated as a function of the pre-money valuation established in the next succeeding round – presumably a more scientifically arrived-at company valuation. In this case, the creative suggestion was to adopt 'next round pricing' so as to avoid the fiduciary duty issue. The VCs would use a bridge note or convertible stock (any derivative instrument will do) and establish the conversion or exercise price as a function of the price arrived at in the next round.

This is a device that is worth considering. However, as the participant suggested in our dialogue, it may not have much currency. The VCs refused to adopt that suggestion in the case cited and my guess is that they will refuse to adopt it in many, if not most, of the instances in which it is raised. The reason is obvious: The VCs are willing to do the washout round if and only if the common stock is going to be diluted to the point of insignificance. In the typical case, the assumption of the VC investors is that they should be entitled to start with a clean slate; in fact, these transactions are often called 'restarts.' The management and the common shareholders are 'at fault' for the sorry state of the company and it is up to the investors to come to the rescue. Thus, the investors enjoy the right and authority to establish the respective ownership interests on a going forward basis as they deem in their discretion appropriate, given the current state of play. Those individuals who are deemed key to the future success of the company will be restored to health with cheap restricted stock and options; all the others will be sent packing because they have no future role in the company, particularly if they do not play in the round.

'Next round pricing,' it appears, could be quite successful in avoiding the fiduciary duty issue delegated from that result. However, the next round price could be a very aggressive round, if the company bounces off the floor and starts an impressive upward climb. Accordingly while the suggestion is likely as a technical matter to be a corrective, there is the real possibility that it will not fly in the field.