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In the current challenging economic climate, with many publicly held Internet and technology companies once hailed as the pioneers of a new economy seeing their stock prices battered and their access to equity financing declining significantly — leading to a corresponding increase in the number of such companies that are being acquired at substantially reduced valuations or ceasing operations as a consequence — their smaller, once-promising privately held counterparts in the sector are facing an even greater challenge to growth and viability in the face of scarce capital and an increasingly difficult market for fund-raising. Not surprisingly, as liquidity has become more limited in the public markets and longer, and often less certain, time horizons are projected for an orderly and profitable exit by venture capital investors, venture and strategic investors have become significantly more cautious and restrained in their investments in private, high-risk enterprises than they had been recently — and in some cases, have withdrawn from or substantially reduced such investment activities. In many instances, such investors are focusing substantially all of their efforts on shoring up their current portfolio as opposed to seeking new investments, and, increasingly, the terms and conditions under which venture capital financings are being completed are considerably more aggressive than had prevailed in the boom period of the last several years as valuations have come down dramatically and the balance of power between entrepreneurs and financiers has shifted once again to the financiers. DOWN-ROUND FINANCINGS Many of the early-stage companies that have successfully raised capital under current market conditions have done so in what is known as a “down-round,” e.g., an equity financing at significantly reduced pre-money valuations from the valuations associated with their prior rounds of equity financing, and often with the participation primarily, if not exclusively, of current investors. Down-rounds, and their dilutive impact on capitalization, tend to raise to the surface issues and concerns for investors, founders and management, that are muted, or at least not implicated to the same degree, when financings are being completed in an upbeat environment and on increasingly higher valuations. The interplay between the need for, and cost of, capital for growth and survival, and the continuing necessity for investors, founders, management and employees to feel they have a meaningful equity stake in the enterprise and to perceive significant upside potential, intensifies in a down-round financing. In addition, members of the company’s Board of Directors have to discharge their fiduciary duties to act in the best interests of all of the company’s stockholders, and not act solely in their own personal best interest or that of the stockholder they may be a principal of or be designated to represent at the board level. A down-round puts particular pressure on such duties and responsibilities for an investor-designated director, who must also discharge his or her separate responsibilities to the investor fund of which he or she may be a principal or to the corporate investor of which he or she may be an employee, officer, director and/or a stockholder. The conflicts or potential conflicts of interest need to be recognized and addressed on a case-by-case basis in each given transaction. KEY CHARACTERISTICS A typical down-round financing is structured much as a standard venture capital round; investors generally purchase a newly designated series of convertible preferred stock from the company that will likely include provisions with respect to dividends, liquidation preference, conversion and related anti-dilution matters, voting rights with special serial or class voting provisions (generally referred to as “protective provisions”), and may include a provision for redemption (the foregoing being characterized as the “rights, preferences and privileges” of such series of preferred stock). In most cases, the form and language of the new series of preferred stock will be consistent with the form and language of the previously issued series of preferred stock, except for those specific rights, preferences and privileges that are implicated in a down-round financing (together with any other provisions that the inclusion of which the parties may negotiate). The key preferred stock provisions that will be implicated in a down-round financing are as follows: Liquidation Preference.This relates to the rights of the holders of a given series of preferred stock to participate in the proceeds available for distribution to stockholders upon a liquidation of the company, and is typically deemed to also apply upon a sale of the company (often referred to as a “deemed liquidation”). Preferred stock is generally entitled to receive distributions on a liquidation or sale in priority to the holders of common stock. While newly issued preferred stock in favorable conditions will, in the vast majority of cases, be “pari-passu” with other series of preferred stock (participating in distributions at the same level of priority but pro rata in proportion to the respective amounts invested, including declared/ accrued and unpaid dividends, if any), it is increasingly common for newly issued preferred stock in a difficult-to-raise, down-round financing, especially one in which existing investor participation is insubstantial, to be made senior in right of distributions to existing preferred stock, thereby according senior priority, as to all other outstanding preferred stock and common stock to investors in the down-round. Participation Feature.In connection with the liquidation preference, investors are increasingly negotiating for a “participation” feature. Holders of convertible preferred stock generally have a choice, in the case of a liquidation or sale, to either accept distributions in satisfaction of their liquidation preference or convert to common stock and be entitled to distributions alongside other common stockholders (and the choice typically depends on whether the holder of preferred would be entitled to receive more proceeds under one or the other scenarios). The participation feature permits the holder of such preferred to receive proceeds in satisfaction of the applicable liquidation preference and thereafter to participate in further distributions to stockholders on an “as if converted” to common stock basis, thus enabling the preferred holder to potentially receive its investment capital back and then further participate as if such holder were a common stockholder. Sometimes derided by issuers as “double dipping,” such participation feature is increasingly prevalent and reflects the increasingly higher cost to companies of attracting high-risk capital from venture capital and other private equity sources, particularly in a down-round financing. It is therefore important to note that in the event the company is subsequently acquired in a distress sale, there may be little or no proceeds available to distribute to holders of common stock after satisfaction of aggregate liquidation preferences of outstanding preferred stock, and the participation feature further reduces the remaining amounts, if any, available for holders of common stock. Anti-Dilution Protection.Convertible preferred stock routinely contains anti-dilution price protection, which functions to readjust the conversion rate at which preferred is convertible into common stock (and thereby also readjusts the number of votes per share associated with a share of preferred stock, in that a share of preferred stock normally has a number of votes per share equivalent to the number of shares of common stock into which such share of preferred is at the time convertible). Generally, anti-dilution protection takes the form of either a “weighted average” or a “full ratchet” adjustment. The “weighted average” provision adjusts the conversion price on a formulaic basis that takes into account the existing fully diluted capitalization and the total amount being funded in the round, as well as the per share price, while the “full ratchet” is the more onerous provision in that it drops the conversion price to the next round price without regard to any of the foregoing factors. Two crucial elements of a down-round financing are (i) the interaction of the anti-dilution provisions of existing preferred in light of the lower price per share being paid in the down-round, as compared to the prior round(s); and (ii) the characteristics of the anti-dilution protection afforded to the newly issued preferred stock. If existing preferred stock has so-called “full ratchet” anti-dilution protection, then such existing preferred stock will effectively be repriced to the down-round price (and thus convertible into common stock as if it were originally issued at the down-round price). The dilutive effect on the other holders of equity not entitled to such price protection (being at a minimum the holders of common stock) can be substantial and sometimes dramatically reduce the ownership position of such other holders of equity. Full ratchet anti-dilution protection is increasingly common for newly issued preferred in a down-round. Thus, the impact on capitalization and on the equity positions of existing stockholders and option holders is probably the single most critical component of a down-round financing. The application of the anti-dilution provisions can, in and of themselves, effect a recapitalization of a company. The key issue to be considered in determining pre-money valuation in a down-round is the impact upon the post-financing fully-diluted capitalization. Consideration will need to be given to whether the stock option pool for employees needs to be increased to offset to an appropriate extent the impact of the anti-dilution provisions and who will bear the dilutive effect associated with any such increase. The company, and the investors in the down-round, may determine to require, as a condition of funding, that existing investors waive the application of the anti-dilution protection to the down-round financing, in order to ameliorate the dilutive effect already attributable merely to the issuance of lower priced preferred stock. Those investors participating in a down-round which hold previously issued preferred may find themselves conflicted, in that they would prefer not to waive the anti-dilution protection for their existing preferred, especially because they are placing additional capital at risk, yet they may not be comfortable seeing non-participating investors stay on the sidelines but nevertheless enjoy the protection. In that context, there is a feature known as a “pay to play” provision, that is as often sought by venture capital investors as by the issuer, that requires that a holder of preferred stock must actually participate, to a pro-rata extent, in a later down-round as a condition to the availability of the anti-dilution protection, with the consequence of not investing in such later down-round resulting in the conversion of such preferred into another series of preferred that does not enjoy price protection (effectively freezing the conversion rate for such non-participating holders of existing preferred stock at the pre-down-round rate). The “pay-to-play” provision is intended to incentivize prior investors to participate in, rather than pass upon, future down-rounds, or risk losing one of the key downside protections of convertible preferred stock. OTHER CONSIDERATIONS Down-round financings are often euphemistically referred to as “recapitalizations.” In essence, the down-round financing, with its attendant dilutive effect on the capitalization of the issuer, may well have an impact more commonly associated with a formal recapitalization transaction (for example, in a redemption or repurchase transaction, when the equity of one or more major stockholders of a company is being bought back by the company, or in a secondary sale transaction, in which existing stockholders are selling their equity interests to current or new investors, and in each instance a material change in the composition of the equity ownership in the company is occurring). The impact of a down-round may well be to effect a change-in-control transaction, and consideration must be given to determine whether any agreements or instruments to which the company is a party have covenants or consent requirements that may be triggered. Indeed, the “deemed liquidation” provisions highlighted earlier may define a sale of the company as a change-in-control (rather than a sale of 100 percent of the outstanding equity of the company), in which case the company, and the investors participating in the down-round, may be faced with an unintended consequence of the company being legally compelled to effect a liquidating distribution to existing preferred stockholders. As in most instances, the participating investors can condition the closing of the financing upon the amendment of such deemed liquidation provision so as not to apply to such financing. Potential conflict of interest concerns will be raised with directors who represent investors participating in down-round financings, particularly where such investors have meaningful existing ownership positions in preferred stock with anti-dilution protection, and who approve such financing as a board member or who are otherwise actively involved in the negotiation of such financing on behalf of a participating investor. Such directors will, as with all other directors, need to be able to defend the valuation, and the terms of such investor’s participation in the down-round, as being fair and in the best interests of all stockholders, as such directors are susceptible to claims from minority stockholders, especially those being heavily diluted by such down-round, of, by way of example, conflict of interest, breach of fiduciary duties, self-dealing and corporate waste (as in authorizing the sale of stock at below fair value). In view of these conflict of interest concerns, directors in such position may be advised to recuse themselves from the formal board vote approving the financing and the deliberations leading up to such vote, and, in an effort to better enable such director to discharge his or her fiduciary duties as a board member may also be advised to have another principal or employee of the investor conduct all negotiations relating to the terms and conditions of such investor’s participation in the down-round. The Board of Directors will, of course, need to carefully analyze the terms and conditions of a financing proposal, and particularly a down-round financing proposal led by current investors. The board should ascertain that all meaningful efforts have been made by the company to secure financing, and that after diligent efforts have been made, the proposal to be approved is in the best interests of all stockholders of the company. This is critical in that it provides support for the valuation and financing terms as reflective of the prevailing market for the company’s equity. To that end, to the extent possible and practicable, it would be advantageous for the company, and for the participating investors, to attract a lead investor that is new to the company, so as to provide further support for the adequacy of the price and terms of the financing and to provide an all-important “arms-length” character to the transaction. A valuation opinion from a reputable investment banking firm or valuation expert will provide further support for the valuation, although in most instances the cost and timing involved is often a deterrent to the company seeking financing. In the context of down-round financings, companies are often advised to offer all existing stockholders an opportunity to participate on a pro-rata basis in such financing, by way of a “rights offering,” thereby insuring that each stockholder is both aware, in advance, of the price and material terms of the financing and has a chance to purchase equity on the same terms as the investor group. Of course, a rights offering does not insulate the board or the company from claims by minority stockholders as to the inadequacy of the deal pricing or the aggressiveness of deal terms and conditions, but, at a minimum, it provides existing stockholders with the opportunity to be involved in the process and certainly enhances the optics of the transaction. Finally, as mentioned below, stockholder approval will likely be required to consummate a preferred stock financing, including a down-round financing. The board should consider the appropriateness of submitting the terms of the financing to the stockholders for their formal approval at a stockholder meeting, with appropriate advance notice and an opportunity to discuss the terms with management, even if the transaction could be approved by written consent with simple notice after the closing to the non-consenting stockholders. Certainly, a formal stockholder vote provides meaningful added support for the board; nonetheless, there are strict time requirements for notice that must be complied with, and the company may simply not be in a position to wait until the requisite time period has run before closing the financing (in which case written consent in lieu of a meeting must be obtained). As mentioned earlier, consideration will necessarily need to be given by the company and investors participating in a down-round to assure that, after giving effect to the financing, an adequate equity pool is reserved for management and employees, both to insure sufficient incentives for the management team to stay with the company and help drive the business to success, and also in recognition of the reality that their compensation is a balance of cash and equity, and often heavily weighted toward equity. Accordingly, concurrent with a down-round financing, the stock option plan will often be amended to increase the number of shares of common stock available for grant; there may be grants of additional options to key personnel to offset some of the dilutive impact on such persons in particular as a result of the down-round; and out-of-the-money existing employee stock options may be re-priced or terminated and replaced with new, substituted options at an appropriate discount to the down-round price. However, there are significant accounting and tax consequences to repricing options and to terminating and reissuing substitute options, a discussion of which is beyond the scope of this article. Suffice it to note here that repricing of options may result in negative accounting consequences to the company, and such consequences generally make repricing unattractive. The company would be best advised to seek experienced compensation and benefits counsel to understand any such impact and structure appropriate arrangements under the circumstances. Stockholder approval of a down-round financing will be required under most circumstances and is recommended as indicated above. The protective provisions granted to the holders of the existing preferred stock play a critical role in the structuring of a down-round financing. Such protective provisions typically provide that the company must obtain the approval of a certain percentage of each class or series of preferred stock before it may take certain enumerated actions, including the amendment of its certificate of incorporation in a manner adverse to the holders of preferred stock, and the creation of any series of pari-passu, and often senior, preferred stock. Accordingly, existing preferred stock likely will have the ability (as a class and/or by individual series) to block the proposed down-round financing and any terms disadvantageous to such series of preferred stock. It is possible that those investors participating in the down-round hold enough shares of existing preferred stock such that their favorable vote will carry the day. If not, the company and the investor group sponsoring the down-round will need to gain the support of existing investors in order for the financing to go forward, and terms may need to be revised or modified as necessary to gain such support. The realities of the market downturn have, in many instances, resulted in a profusion of down-round financings to the extent that early stage and emerging companies are able to attract equity capital at all in the face of a retreating market. In such transactions, the parties must consider and balance a range of concerns with a shared objective in each instance to better position the company for success, be it as an independent company, as a merger partner or as a target for acquisition, and to enhance shareholder value. Martin H. Levenglick is a partner in the corporate and technology group of Orrick, Herrington & Sutcliffe, resident in its New York office. Mark A. Danzi and Rahul Maitra, associates in the office, assisted in the preparation of this article.

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