When does a downround protection become dangerous for founders?

How can founders ensure a fair downround protection clause?

1. High Ownership Dilution: Firstly, founders must understand the details and implications of a downround protection clause. If the protection is triggered, it results in issuing more shares at a lower valuation, which can significantly reduce the founders' ownership stake and control in the startup.
2. Negotiate Triggers and Terms: Negotiate the terms that trigger the downround protection clause. It is possible to exclude certain events that lead to the issuance of shares. This could be, for example, the issue of shares to employees and consultants. Or consider whether it should apply only to significant valuation decreases or to any valuation decrease.
3. Cap the Protection: Consider negotiating a cap on the extent to which the protection can apply. This ensures that the impact on founder ownership is limited. Such restrictions have not yet been accepted by investors in Germany, but this does not mean that such a proposal cannot be made by founders.
4. Weighted-Average vs. Full Ratchet Protection: Evaluate the calculation formular of the downround protection. Full ratchet protection is more severe, as it adjusts the price per share to the new valuation, leading to more significant ownership dilution. Weighted-average protection considers the new valuation while also factoring in the number of existing shares. Please see below a summary of the fact re. the different calculation formulas.
5. Consider Time Limits: Include time limits on the applicability of the downround protection. After a certain period, the clause might no longer apply, allowing the startup to recover and improve its valuation.
6. Assess Likelihood of Triggering: Consider the likelihood of a downround occurring. If your startup has a strong growth trajectory and is well-capitalized, the chances of a downround might be lower.
7. Incentive Misalignment: Excessive downround protection can misalign incentives between founders and early investors. Founders may become more focused on maintaining high valuations rather than on building a sustainable business.

Founders should carefully evaluate the terms of downround protection and consider the potential long-term implications before accepting them in investment agreements. It's essential to strike a balance between protecting investor interests and ensuring that the startup's leadership has the flexibility to navigate changing market conditions and pursue the company's growth objectives. Consulting legal and financial experts is recommended when dealing with complex investment terms.

Calculation formulas:

Broad-Based Weighted-Average:

In a broad-based weighted-average anti-dilution provision, the formula takes into account all outstanding shares, including both common and preferred shares, when calculating the adjusted price per share in the event of a downround. This means that the conversion price of existing preferred shares is adjusted to reflect the new, lower valuation while considering the total number of shares outstanding, regardless of their class. The formula for broad-based weighted-average anti-dilution is more inclusive, as it considers all types of shares, which can result in a less severe adjustment to the conversion price. This is because common shares, which have a lower liquidation preference than preferred shares, are factored into the calculation.

Narrow-Based Weighted-Average:

In a narrow-based weighted-average anti-dilution provision, the formula only takes into account the number of preferred shares outstanding when calculating the adjusted price per share in the event of a downround. This means that only the preferred shares' conversion price is adjusted to reflect the new valuation while ignoring the common shares. The formula for narrow-based weighted-average anti-dilution is more restrictive, as it considers only the preferred shares. This can result in a more significant adjustment to the conversion price compared to the broad-based approach.

Full Ratchet

The Full Ratchet formula is considered more investor-friendly but can lead to significant dilution for founders and other existing shareholders. The Full Ratchet formula adjusts the issue price of existing preferred shares to the price at which the new shares are issued. The goal of the Full Ratchet formula is to fully protect investors from the decrease in valuation by ensuring that their ownership percentage remains the same.