Published by Stout
As the economic shutdown due to COVID-19 drags on and companies run out of financing alternatives, they may be forced to consider less appealing, and more dilutive, options. When the shutdown first occurred, many companies drew down on their revolver to its fullest, in order to hoard cash to weather the storm. Some companies had run out of cash provided through government lending initiatives, while other companies were either overleveraged already or otherwise didn’t qualify for emergency government funding programs. However, when the possibilities for raising capital from these methods run out, companies often consider “down round” financing options such as newly issued preferred securities or conversions of debt to equity. Down round financings are often fraught with complicated issues that have to be measured and balanced across numerous constituencies. A few of the key considerations that companies should be mindful of as they seek to enter into down round financing transactions include:
- Imperfect process – Most companies have an urgent need for liquidity in distressed situations, and there may be insufficient time to pursue a market check on the terms of the capital infusion.
- Uneven participation – Some shareholders may be unwilling or unable to participate in follow-on capital raises, resulting in dilution of the non-participating shareholders’ interests.
- Conflicts of interest – If the board of directors is controlled by the party injecting the capital (a private equity sponsor, for example), the board’s decisions and recommendations on the capital injection are likely not protected by the Business Judgment Rule due to the conflicts, and may be reviewed under the more demanding standard of Entire Fairness (which requires both fair price and fair process).
- Uncertainty regarding valuation – During a sudden and severe downturn, such as the current COVID-19 pandemic, many businesses can have a difficult time preparing a financial projection model given the lack of visibility on when the economy will return to normal. Viable projections are critical to ascertaining valuation for the subject company.
- Highly dilutive – Given the magnitude of the valuation impact due to the shutdown on most industries and companies, new capital can be extremely expensive, exacerbating the dilutive effect of the financing on non-participating shareholders.
Importantly, the terms of the capital infusion and the resulting pro forma ownership based on the valuation of the company (including the waterfall of future distributions to shareholders) need to be fair to the non-participating shareholders from a financial point of view. A fairness opinion from a qualified financial advisor can assist the board in meeting its fiduciary duty of care in considering a down round financing transaction, thereby helping to protect the directors in the case of any future litigation that may result.