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Navigating Anti-dilution in a funding round with down-round valuation

Accel India
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It is no secret that the entire ecommerce and internet start-up ecosystem is staring down an uncertain future due to a funding squeeze in the market. While many would argue that the business models were flawed to begin with, in defence of ecommerce businesses, it was the same market that made some of these deep discounting businesses the success stories of the decade.

The funding crunch could well be the result of macro factors impacting the globe and this is a ripple being felt on Indian shores. But, whatever be the cause, the current funding squeeze has necessitated investors to ask their investee companies tough questions on the business model and to portray a defined path to profitability.

The current environment should not be perceived to be the end to a good beginning for the start-up phase in India, but should be viewed as an opportunity to re-evaluate and correct expectations. In this process, many players may have to make tough decisions and also some unavoidable sacrifices.

One such possible scenario is to raise funding from investors at a reduced valuation that correctly reflects the market perception. Raising funds by way of a ‘down round’ is not uncommon in global markets, but occurs rarely in India.

A down round is basically when a company raises fresh funds from investors at a valuation lower than the valuation at which it raised its most recent round. Investors and Indian founders may shy away from this prospect due to the negative publicity that such an exercise would generate.

But, in reality if a business is going to run out of cash in the near 6 months, it should certainly be looking to raise funds albeit at a lower valuation.

Apart from the negative publicity that this may generate, investors and founders need to be mindful of the legal agreements that have been signed by them in the previous fund raising rounds. There could be potentially damaging anti-dilution provisions in the existing agreements which could trigger all sorts of complications in a down round. Founders would do well, to have these reviewed carefully and understand the implications for them in case of a down round funding.

Prior to initiating any down round of funding all angel investors and founders should carefully understand the nature of the anti-dilution rights provided to institutional investors in the company. A full ratchet dilution provision can be brutal for founders and ESOP holders, if the company proceeds to raise funds by way of a down round.

The extent of dilution could be such that the founders and ESOP holders will be left with literally no skin in the game. Secondly, there could be investors who may have invested in early stages of the company and later investors will have anti-dilution rights which may get triggered leading to dilution of early stage investors.

Understanding Down Round

An example would explain the situation aptly:

Series C funding at valuation of ₹300 per share (investor with anti-dilution)

Series D funding at valuation of ₹400 per share (investor with anti-dilution)

Most recent funding at valuation of ₹500 per share (investor with anti-dilution)

Proposed down round funding at valuation of ₹450 per share

Investors who participated in Series C and Series D stage will not get any anti-dilution protection. But the investor who invested at Rs. 500 per share will trigger an anti-dilution protection and will be entitled to receive shares at the marked down price of Rs. 450 depending on which form of anti- dilution it secured for itself.

In such a scenario it is important for all parties to come together to renegotiate some of the provisions in order to salvage the business. Existing investors may also be better off investing in the down round in order to prevent their stake from getting diluted disproportionately due to the anti-dilution protection of one of the existing investors.

Consequences

Commercial aspects are one part of the challenge in these situations. Investors with anti-dilution rights should also ensure that implementation of these anti-dilution rights in the form they are envisaged are compliant with prevailing Indian laws. As with most ‘imported’ M&A concepts the anti-dilution as prevalent in western jurisdictions cannot be implemented without tweaking it for Indian regulatory conditions.

Indian companies cannot issue shares to residents or non-residents without receiving consideration. In the case of a foreign investor, shares can be issued only for monetary consideration, which has to be above the fair market value (FMV). Foreign investors who hold convertible securities should be able to give effect to their anti-dilution by re-adjusting the conversion price of their securities to accommodate for the down round price.

However, this would be possible only if the FMV of the shares at the time of issuance of the convertible securities was below the price at which shares are proposed to be issued in the down round. The complications for Indian investors and investee companies begin with the tax implications associated with issuing shares at a price below or above the prevailing fair market value. This is currently an issue that most companies with venture and angel investment are grappling with.

It is not uncommon, to use template documents from western markets for Indian deals. Hence investors, investee companies and all participants should be mindful of the commercial and legal implications under Indian law of the various provisions in such documents. A down round is only one of the instances that are envisaged. As the venture capital market and the start-up ecosystem matures in India, we may witness the real life play of other concepts such as liquidation preferences, drag sale, etc.


 

Contributor | Ajay Joseph is a partner at Lakshmikumaran & Sridharan, Mumbai. He focuses on all aspects of Corporate & Commercial laws with emphasis on corporate acquisitions.


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