The Down Round: What Happens When the Unicorn Bubble Pops

As the venture capitalists are wont to say, ' I get cut, you bleed.' JL

Steven Solomon reports in the New York Times:

The goal will be to see not whether a billion dollars can be created, but rather whether any value can be salvaged as the unicorn bubble pops.

The unicorn wars are coming, as the downturn in the market will force these onetime highfliers to seek money at valuations below their earlier billion-dollar-plus levels, known as “down rounds.” Whether you are a spectator or part of the blood bath, here is what you can expect in the coming clashes among employees, founders and investors.

Common Versus Preferred

The biggest battle in the down rounds will be between the common and the preferred shareholders.

The fight will be a result of the way that the venture capital investments are structured. Employees and founders often hold common shares that sit below preferred shares held by the venture capitalists. The preferred shares typically have liquidation preferences and rights against being diluted, while the common shareholders have no such protections. The preferred shares are convertible into common shares at a price per share that reflects the valuation of the company at the time of the investment.

Liquidation preferences provide that the preferred shareholders receive a minimum payment if the company is sold. They can even be set off in an initial public offering, as was the case in the Square I.P.O.

Anti-dilution rights provide that when the new money comes in at the lower valuation, investors from prior rounds get compensated. The compensation is that the conversion price for their preferred shares into common is reset at the lower value.

These two rights will pack a punch to the common shareholders. If the valuation goes down below the liquidation preference, the common shareholders will have their entire investments wiped out. Even if this does not happen, the anti-dilution rights will come out of the hide of the common shareholders.

A down round hits employees and founders hard, evaporating the worth of their hard-won shares.

Because of this, the directors on the board of a unicorn will have to be careful to avoid a lawsuit. When Good Technology was recently sold at less than half its prior valuation, the value of the common stock was destroyed. The employees got nothing. Not surprisingly, there is now a lawsuit pending, with common shareholders, mostly employees, claiming that Good’s board failed to try to salvage the value of the common shares.

The Good common shareholders may have a case. In a famous Delaware court decision, J. Travis Laster, the vice chancellor, ruled that when a company is sold, the board has to consider the interests of both the preferred and common shareholders. You can’t just wipe out the common stock without seeing if there is worth there.

So, expect boards to tread carefully when considering down rounds. The board will try to paper over the problems by allowing all of the shareholders, including employees, to invest in the down round.

There may also be some halfhearted attempts to get preferred shareholders to waive their anti-dilution rights, but the waiver has to be unanimous, so don’t expect it to happen often. Boards will also hire financial advisers to show that this is all fair to the employees and there was no other choice but to do the down round and reduce the value of the common stock. Expect the financial advisers to always find that this is the case.

Employees Versus New Money

This leads to the second battle. Silicon Valley is a place where failure is held up as a virtue. Employees aren’t going to stick around long if they see their equity stake wiped out. They will move to the next start-up and take their chances there.

The down round is a “lemon” signal to the market that the company’s business plan is not working out. And one of the thorniest issues in dealing with down rounds is how a former unicorn keeps its employees after destroying the value of their shares.

In some cases, the employees will be out of luck and left with nothing. This is more likely to happen if the company is sold at a lower valuation than if it raises money in a down round. But even if the common stock has some value, it is likely to be worth much less and certainly not a billion dollars.

Jawbone, for example, recently did a down round at roughly half its previous $3 billion financing, carving out additional common shares for employees to make up for their loss. Foursquare also did a recent down round and publicly stated it was raised on “employee-friendly” terms, implying a common stock issuance. The preferred shareholders, however, will still have to be paid first for the employees to collect on their new common shares. These actions may end up being more about public relations than an actual payout.

If stock incentives are often no longer an option, since all of the stock worth anything is held by investors in the preferred category, cash bonus plans or other incentive plans that pay cash in the event of a success may be necessary. The problem, of course, is that it just isn’t as good as cold-hard stock with its potential for a big payout. So expect some hard bargaining and companies searching for ways to win back the loyalty of their employees.

These efforts are likely to fail. No one likes to be told that, after winning the lottery, they have to give up the money. And so, it is no surprise that some companies do not survive down rounds, not because of finances, but because they can no longer keep their employees.

New Money Versus Old

Then there will be the battle between the new money and the old, as the preferred-stock holders, who invested at the top of the market, duke it out with the new down-round investors.

The old money may sit back and rely on the anti-dilution rights and liquidation preferences to protect themselves from the new money. In most cases, this should be enough and the old preferred shareholders should be O.K. so long as the company value does not go off a cliff.

But if the company is desperate, the new money may try to insist on seizing control of the company. The new money may also insist on super-contractual protections, like more aggressive anti-dilution rights and higher liquidation preferences that put it in a superior position to the old preferred money.

Founders Versus Everyone

Like the employees, the founders will suddenly find that all that money they thought they had has evaporated. The new money will now be in the position to decide whether to keep the founders. If the founders stay, they will own a far smaller stake in the company, but will likely be working harder. The owners will have to move forward managing an enterprise that is set back on its heels, burdened with the down-round label. This is a tough task, and one that is harder for a 20- or 30-something with a bruised ego.

It all means that interesting times are coming to Silicon Valley. As the unicorns instead become donkeys, lawyers will be dusting off their files as they seek to structure these down rounds and avoid all-out warfare. In the negotiations, the lawyers will be trying to balance all these interests and slice up a smaller pie among unhappy employees, investors and founders.

The goal will be to see not whether a billion dollars can be created, but rather whether any value can be salvaged as the unicorn bubble pops.