May 31, 2020  
 
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Equity Dilution in Funding Rounds

 

Avoid Allegation of Impropriety in Dilutive Funding Rounds

Dilutive funding rounds (or down rounds) are a source of frustration for a company's existing investors. In many cases, their frustration boils over into a lawsuit. Before it gets to that point, there are a few ways to mitigate the risks of legal challenges surrounding investor equity dilution.

No one likes losing money.
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Yet when a company experiences financial difficulties, it affects everyone–including investors who often bear the brunt of negative business trends. Venture capitalists and others who have invested in the early stages of a company experience balance sheet losses as the value of their investment goes down.

But investors are hit with a double whammy during "down round" investment scenarios in which new shares of stock are sold at a price per share that is lower than the price paid in previous investment rounds. Down round funding has the net effect of diluting ownership shares in the company. When this happens, stockholders usually look for someone to blame–and their litigious anger most always lands on the company's board of directors.

From a legal standpoint, decisions made by a company's board of directors are protected by the "business judgment rule". This rule makes the assumption that the Board of Directors is acting in the best interest of the company and its shareholders when it engages in decision-making activities. The business judgment rule is an effective legal safeguard – provided its decisions (including the decisions that involve additional rounds of funding) are informed and made in good faith.

Here's what your company can do to avoid allegations of impropriety in dilutive funding rounds:

  • Stay informed. Company directors should go above and beyond in making sure they are informed about the details of the down round as well as the company's strategic plan. The business judgment rule is only effective if board members can support the claim that decision-making was informed.
  • Document the process. When down round or dilutive funding is an option, assume that every aspect of the decision-making process will be subject to legal scrutiny. With that in mind, it's important to not only document your decisions, but the decision-making process itself.
  • Consider alternatives. Down round financing might not be your company's best funding alternative. Borrowing from a commercial lender should also be examined to demonstrate that the board considered all its options.
  • Consult experts. Legally speaking, your case will carry more weight if the board consulted one or more financial experts during the decision-making process. If the experts agree that down round funding is the best option then it will be easier to prove that the board acted in the best interest of shareholders.

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