Down rounds and Cram Downs: How to Rescue Your Startup in a Bear Market
So you're a startup founder who raised venture funding but hasn't reached profitability yet. You could be in hot water when looking for more funds. So what are your options?
Besides bootstrapping, selling the company, or declaring bankruptcy, you have two main routes: a down round or a cram down (also called a “pay-to-play” or recap). So double down. To put it simply, sometimes you have to go down before you go up.
Down Round vs. Cram Down
A down round means raising money at a lower valuation than before. Doing this dilutes current stockholders. If this dilution is too much, you'll need a "cram-down."
A cram down is a down round with a twist. It punishes investors who don't chip in for the new round by slashing their liquidation preference and maybe even reducing their ownership stake through a reverse split. The message is clear: "invest or get demoted."
Liquidation preference is the order in which investors get paid when the company is sold or liquidated. For example, if an investor put in $1 million with a 2x liquidation preference, they get $2 million back before anyone else sees a penny. A cram down shakes up this hierarchy.
Both down rounds and cram downs aim to reboot your startup and attract fresh investors. Think of it as emergency surgery for a failing patient.
Agreeing to a Cram Down
For a cram down to take place, there's a process that usually involves a few key steps:
Initiation: Typically, the startup founders or the existing board initiate the conversation. They reach out to the main or majority investors to discuss the financial state of the company and propose a cram down as a solution.
Discussion: The founders and the investors then discuss the terms, which usually involve converting preferred stock to common stock, diluting shares for non-participating investors, and possibly issuing new stock at a lower valuation.
Consent: After the terms are hashed out, they need to be approved. This usually requires consent from a majority of the preferred shareholders, sometimes even a supermajority depending on the company's charter.
Execution: Once everyone's on board, the agreements are put into writing. Finally, the new funding round takes place, based on the agreed-upon terms, and the cram down is officially executed.
Majority stockholders typically agree to a cram down because they believe in the company’s future and plan to participate in the new round, which allows them to maintain or increase their influence over the company.
Executing the Cram Down with a Pull-Up
In order to execute a cram down, you need to take the following steps:
Conversion: Turn current preferred stockholders into common stockholders at a 1:1 ratio. This negates their liquidation preference. Usually, you don't need to amend the charter, but you do need shareholder approval.
Down Round: A new investor comes in with preferred stock at a lower valuation.
Optional Pull-Up: Add a pull-up to sweeten the deal. If a cram down is punishment for investing, a pull-up is a reward for investing. This allows the newly-converted common stockholders to convert back to a new series of preferred stock with lower liquidation preferences.
Keeping Management Incentivized
Stock options can keep your team invested despite dilution. Make sure to do this after closing the round and updating the 409A valuation. Any outstanding options will adjust to this new value.
Avoiding Legal Pitfalls
Down rounds and cram downs led by existing investors can make legal waves. The board often has competing interests. While existing investors may be leading the down round to maximize their returns, this can sometimes lead to actions that wipe out minority shareholders. Management, on the other hand, wants to hold on to as much equity as possible, which can also dilute minority shareholders. Often, everyone on the board has a conflict of interest.
The usual drama? Existing VCs invest at low valuations, the company succeeds, sells, and then common stockholders who got diluted cry foul. To steer clear of lawsuits:
Look for outside investors before taking inside money, maybe even hire a banker.
Grant new shares to the management only after closing the inside financing.
Let all existing stockholders participate if they wish, and seek their approval.
Document all board decisions and get legal advice on fiduciary duties.
By following these tips, you can save your startup without getting penalized. And that's your roadmap for navigating a bear market.
Avoiding Other Pitfalls
Let’s take real-world examples.
Citizen, a mobile app that sends users location-based safety alerts in real time.
Earlier this year, Sequoia, one of Citizen's earliest and largest backers, declined to "pay to play” and left the startup’s Board.
Foursquare, a local search-and-discovery mobile app
Foursquare went through a down round in 2016, significantly reducing its valuation. However, they used this opportunity to secure new investment and refocus their business strategy. Foursquare had not only survived but was thriving as a location technology platform.
Keys to Success
Clear communication with stakeholders
Refocusing business model
DISCLAIMER
Please note that the information provided here is for informational purposes only and should not be considered legal or tax advice. It is essential to consult with a tax advisor or legal expert to understand the specific details and applicability of this information to your situation.