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Legal Risks: Raising Capital in a Down Economy

Chris Williams, Chair of the Corporate Transactional Group at FBFK, weighs in on why business owners should be particularly sensitive to important legal issues that often arise during troubled economic times.
By D Partner Studio |
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Rising interest rates, tightening credit markets, and high inflation rates have led to challenging market conditions for companies looking to raise capital. And yet, during an economic downturn, businesses may be in even greater need of raising capital. Recognizing this reality, business owners should be particularly sensitive to important legal issues that often arise – or are overlooked – during troubled economic times.

Inadequate Securities Disclosures

Whenever a company seeks to raise capital, whether through a debt offering or an equity offering, securities laws generally require it to disclose detailed information regarding the issuer, its business and operations, financial condition, and risk factors. A failure to provide adequate disclosures can lead to lawsuits and regulatory penalties and potential rescission rights for investors.

To minimize legal risks associated with inadequate securities disclosures, companies should ensure they provide potential investors with all relevant information about their business. This includes financial statements, risk factors, and any material contracts. Companies should also ensure that they provide updated information to investors as necessary, especially if there are any material changes in their business operations.

During an economic downturn, an issuer may attempt to cut corners with respect to offering documentation; this could be a serious mistake and lead to future issues with investors and regulators.

Negotiating Terms for Down Rounds

A “down round” occurs when a company issues new equity at a lower price than in previous rounds.  Particularly for growth or emerging companies, a down round can be a matter of necessity – survival of the company can outweigh the negative impacts of a down round.  These situations often give the new investors significant leverage over not only the issuer but the existing investors as well.

When negotiating a down round, the liquidation preference for the new security (and the preference for any existing security) is a key consideration. A liquidation preference describes what a particular class of equity will be entitled to receive on the liquidation, dissolution or winding up of a company and in what priority it will be entitled to receive the preference. In many cases, the liquidation preference is set at the original purchase price an investor paid for the equity. In a down round, however, the liquidation preference may be a multiple of the original purchase price and it is required to be paid prior to other preferences, or to common equity (including founders). Investors in a down round may also be able to negotiate a “participating” preference, which allows the investor to receive its preference and participate with junior classes of equity in any capital remaining for distribution.

In addition to liquidation preferences, anti-dilution rights are a common feature of preferred equity offerings. Typically, anti-dilution rights provide investors with the ability to maintain their ownership percentage in a company by adjusting the conversion ratio or purchase price of their preferred equity in the event of a subsequent financing round or other equity-related transaction. In other words, if the company issues additional equity at a lower price than the preferred equity, anti-dilution provisions ensure that investors in the preferred equity offering are not unfairly diluted.

There are two main types of anti-dilution provisions: Full ratchet and weighted average. Full ratchet anti-dilution provisions are not common but provide the most protection to investors by adjusting the conversion ratio of the preferred equity to the new price of the common equity on a dollar-for-dollar basis. This means that if the company issues new equity at a price lower than the original preferred stock, the conversion ratio of the preferred equity will be adjusted downward to reflect the new, lower price. Weighted average anti-dilution provisions, on the other hand, take into account both the new price and the amount of equity issued in the new financing round. This results in a more nuanced adjustment to the conversion ratio of the preferred equity that reflects the overall impact of the new financing round on the company’s valuation.

In addition to protecting investors from dilution, anti-dilution provisions can also have other important implications for the company and its future financing rounds. For example, anti-dilution provisions may make it more difficult for the company to attract new investors in subsequent rounds of financing, as these investors may be reluctant to invest at a higher valuation than existing investors who have the benefit of anti-dilution protection. As a result, companies and their investors need to carefully consider the potential benefits and drawbacks of anti-dilution provisions when negotiating the terms of a preferred equity in a down round and to balance the interests of both existing and future investors.

Finally, a company should be aware of the impact of cumulative dividend provisions associated with preferred equity.  With a cumulative dividend, if the specified amount is not paid when due, the outstanding amount accumulates until the next time the issuer pays dividends. A cumulative dividend provision can have a significant impact on a down fundraising round, as it can increase the cost of capital and can create a substantial burden on the company’s financial resources and further exacerbate possible cash flow difficulties.

Potential Conflicts of Interest

Another factor a company looking to raise capital in a down economy should consider is the potential conflicts of interest a down round may create for its existing investors as well as its board of directors (or equivalent). In many cases, members of the board, or even majority owners, may be deemed to be “interested” in a particular transaction – particularly if such party will be investing in the down round. If a governing person or owner may derive a personal benefit that other owners will not receive, the issuer should be particularly sensitive to conflict issues. These conflicts can potentially be overcome through the use of mechanisms, such as approval by the disinterested directors or shareholders, or offering all existing owners the ability to participate in the down round on the same terms and conditions as the interested parties. In addition to these mechanisms, an issuer should carefully document its consideration of the potential conflicts through minutes of its governing body to demonstrate the fairness of its process.

Conclusion

Raising capital during a difficult economic environment is challenging and companies need to navigate significant legal considerations. The considerations described above are just a few risks that companies may face. Therefore, it is crucial to seek legal advice when raising capital, particularly in a difficult economic environment, to ensure that risks are minimized, and investors are protected.

To learn more about how FBFK can partner with you, visit https://www.fbfk.law/our-firm.

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