Legal Issues Of Down Rounds

By Shantanu Surpure

  • 17 Nov 2008

The world is currently going through a financial crisis not seen in decades. Stock markets around the world have plummeted and major financial institutions have disappeared. The turbulence has affected the venture capital industry as well. In particular, valuations have become depressed.

Depressed valuations result in reduced expectations for entrepreneurs and possible opportunities for venture capital funds in new transactions. Existing portfolio companies, however, may find it challenging to raise additional funds and therefore the current investors may have to step in to support the company while at the same time seek additional investors.

Such an environment may result in “down rounds” whereby investors subscribe for shares from a company at a lower valuation than that placed upon the company by earlier investors. Down rounds may result in substantial dilution to the founders, employees and (potentially) to existing investors. In an extreme situation, the existing shareholders may be “washed out” or “crammed down” such that their shares or options are not worth much.


Investors, however, may have some protection in the form of anti-dilution protection which usually takes the form of “weighted average” or “full-ratchet” protection. Weighted average attempts to calibrate the holding based on the size and price of the dilutive round and exempts issuance of certain classes of stock (such as ESOPs) from anti-dilution protection. Full ratchet, in contrast, is a more draconian approach as it gives the investors the full benefit of the new lower price, as if they had made purchase at the later lower-priced round.

The reality of many down rounds, however, is that in a “pay to play” scenario, the existing investors may be under pressure from potential new investors to waive some or all of their anti-dilution protections, particularly if they are not participating in the new round.

In India, the use of anti-dilution mechanisms is still new and has yet to be thoroughly tested. In particular, the valuation certificates attached to Form FC-GPR for new issuances of shares may become an issue in down rounds as the down round price is at a lower valuation than the previous financing rounds.


Anti-dilution mechanisms have been tested internationally however and carry their own legal risks, some of which are applicable to the Indian scenario. In particular, Board members who are representatives of venture-capital investors may face a conflict of interest in considering the terms of a down round. This is because such directors may negotiate the terms of the down round on behalf of their venture-capital investors and also have to approve the transaction in their role as a director of the company.

There are potential conflicts between shareholders who are protected from dilution (not only through anti-dilution ratchets but also by their ability to invest in new rounds through pre-emptive rights) and shareholders who do not have such protections.

Interestingly, the legal risks in a down round financing are more likely to occur if the portfolio company actually succeeds in weathering the environment and results in a positive liquidity event. The shareholders whose holdings were diluted may have an incentive to bring a suit against the Board of directors and controlling shareholders.


The Alantec Case

In the California Superior Court case of Kalashian v. Advent VI Limited Partnership (the “Alantec case”), several leading venture capital funds were sued by the founders of Alantec Corporation for fraud and breach of fiduciary duty after approving a down round.  The founder shareholding was reduced from an initial 8% to less than 1%.

The company later went public and was sold for $770 million. The founders claimed they had lost $40 million as the investors had fraudulently manipulated the stock by issuing new shares at a discount to the market price, triggering anti-dilution protections, issuing shares to the company’s new management to obtain shareholder approval and refusing to let the founders participate in funding rounds.


The defendant venture capitalists defense was that the company was facing bankruptcy and that no other financing was available. The case was ultimately settled for a reported $15 million. The Alantec case is illustrative of a situation where interested director venture capitalists faced legal action in a down round financing.

Methods of limiting the conflict and legal risk could be to utilise a committee of disinterested directors to approve the transaction, obtaining approval of all fully informed shareholders and/or obtaining an independent valuation to set a fair price for the financing. In any case, it is important to consider and evaluate the legal risks and issues that occur in a down round financing.


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