Financings

In more challenged private company financing environments, down rounds (i.e., an equity financing at a lower valuation than a prior equity financing) often go from a relatively uncommon occurrence to a more common aspect of many growth equity and venture capital financings. The interrelated impact of geopolitical and macroeconomic events such as valuation resets from post-pandemic highs, public and private market liquidity constraints, prolonged fundraising cycles, and shifts in bargaining power can have profound effects on growth equity and venture capital financing dynamics, making down rounds and valuation pressure more common. Down rounds have significant implications for all participants in the venture ecosystem: founders and management teams, investors, employees, and fund limited partners.

This article focuses on the basic mechanics of conversion price-based anti-dilution protections for convertible preferred stock. Anti-dilution protections need to be considered in the context of the impact on the pricing of the down round in question, and also on the potential impact of future adjustments.

Anti-Dilution Protections

In any equity financing, two types of dilution can occur when a company issues new shares: (1) percentage dilution occurs because the issuance increases the number of outstanding and fully-diluted shares, reducing an existing holder’s ownership percentage if that holder does not maintain their ownership percentage through additional investment, and (2) economic (or price) dilution occurs when a company issues shares at a price that is lower than the conversion price applicable to an investor’s shares, reducing the value of that investor’s position on an as-converted basis.

The conversion price-based anti-dilution protections discussed below are intended to mitigate economic (or price) dilution and the resulting percentage dilution on an as-converted basis. Investors may also help protect against percentage dilution through preemptive rights, which can permit pro rata participation in later financings, whether those are up rounds or down rounds.

Below is a simple illustration of how dilution can occur:

• Before a down round, if Investor A purchased 2,500,000 shares of convertible preferred stock at a price of US$5 per share, and after that financing there were 10,000,000 shares of the company outstanding, Investor A’s US$12,500,000 investment would represent a 25% ownership stake in the company.
• In the down round, the company sells 5,000,000 new shares to investors (other than Investor A) at a price of US$4 per share.
• Following the down round, Investor A continues to own 2,500,000 shares of convertible preferred stock, now out of 15,000,000 outstanding shares of the company, representing a decreased ownership stake in the company of 16.67%, valued at approximately US$10,000,000.

To help protect against the scenario above, Investor A would typically have negotiated for price-based anti-dilution protection when it originally purchased its convertible preferred shares. In a down round, these protections operate to adjust Investor A’s conversion price and therefore the rate at which those shares ultimately convert into common stock. There are two main types of conversion price-based anti-dilution protection: (i) full ratchet and (ii) weighted average.

Full Ratchet

While less common in practice, there has been an increased use of full-ratchet anti-dilution protections to bridge valuation gaps (sometimes, with a sunset date). When used, they can have a profound impact on down-round financing. With full ratchet anti-dilution protection, the conversion price applicable to Investor A’s convertible preferred shares is reset to the new lower price per share from the down round (which is US$4 in the example above), meaning each preferred share from then on would convert into 1.25 shares of common stock.

Now, as a result, if those preferred shares convert, Investor A would own 3,125,000 shares of common stock out of 15,625,000 outstanding shares, meaning Investor A would therefore have a 20% ownership stake (which is less than Investor A’s initial 25% stake, but greater than the 16.67% stake Investor A would have been left with without this full ratchet protection).

Full ratchet protection is not common, but when it does exist, the resulting impact in a down-round financing can be profound.

Weighted Average

Weighted-average anti-dilution protection is far more customary. With weighted-average anti-dilution protection, a formula is used to determine a new conversion price that will apply to existing preferred shares following a down round:

• New Conversion Price = Old Conversion Price * [(X + Y) / (X + Z)]
  • X = the number of shares outstanding on a fully-diluted basis before the down round.
    • Note that the nuances of the X variable are sometimes negotiated, with a company preferring a broader approach (often referred to as the “broad-based” weighted-average formula) that includes all shares on a fully diluted basis, and an investor preferring a narrower approach (often referred to as the “narrow-based” weighted-average formula) that excludes certain types of derivative shares such as options and warrants. The broad-based weighted-average formula is more commonly used.
  • Y = the number of shares that would have been issued to new investors in the down round had the full investment been made at the old price per share (which is US$5 in our example above).
  • Z = the number of shares issued to new investors in the down round at the new price per share (US$4 in our example).

In our example, the resulting math would be:

New Conversion Price = US$5.00 * [(10,000,000 + 4,000,000) / (10,000,000 + 5,000,000)]

• US$5.00 * [(14,000,000) / (15,000,000)]
• US$5.00 * [0.933]
• US$4.67

Under this approach, the adjusted conversion price applicable to Investor A’s convertible preferred shares is now US$4.67, meaning each of Investor A’s preferred shares is convertible into 1.07 shares of common stock.

Now, if those preferred shares convert, Investor A would own 2,675,000 common shares out of 15,175,000 outstanding shares, meaning Investor A would therefore have a 17.63% ownership stake (which is less than Investor A’s initial 25% stake, and less than the 20% stake Investor A would have had with full-ratchet protection, but more than the 16.67% stake that would have resulted without any protection).

Economic Dilution

As mentioned above, conversion price-based anti-dilution protections are designed to reduce the impact of percentage dilution, but they also mitigate economic dilution. Continuing with our example:

• Before the down round, the value of Investor A’s as-converted stake in the company was US$12,500,000.
  
  • Value = (Price Per Share * Number of As-Converted Shares)
    
    • (US$5.00 * 2,500,000)
    • US$12,500,000

• Without any anti-dilution protection, the value of Investor A’s as-converted stake in the company would drop to US$10,000,000.
  
  • Value = (Price Per Share * Number of As-Converted Shares)
    
    • (US$4.00 * 2,500,000)
    • US$10,000,000

• With full-ratchet anti-dilution protection, the value of Investor A’s as-converted stake in the company would remain US$12,500,000.
  
  • Value = (Price Per Share * Number of As-Converted Shares)
    
    • (US$4.00 * 3,125,000)
    • US$12,500,000

• With weighted-average anti-dilution protection, the value of Investor A’s as-converted stake in the company would drop to US$10,700,000 instead of US$10,000,000.
  
  • Value = (Price Per Share * Number of As-Converted Shares)
    
    • (US$4.00 * 2,675,000)
    • US$10,700,000

Down Round Pricing Must Be Modeled Holistically

These anti-dilution mechanics may be familiar to and understood by most management teams, investors, and advisors, but the practical implications are often not as straightforward. In practice, the negotiated enterprise value, or pre-money valuation, of a company is typically set at the outset of a negotiation, but the resulting per-share price often is not. The per-share price must generally be solved for after giving effect to anti-dilution adjustments, any option pool increase, and the resulting post-closing capitalization. When solving for this price per share, if anti-dilution adjustments would be triggered, the result is that the end-result number of as-converted shares outstanding will be higher than otherwise, which can prompt an iterative calculation. The end-result number of as-converted shares outstanding, and therefore the preferred price per share, must be solved for again.

Existing investors’ anti-dilution protections typically create a direct economic tension with the investors proposing to lead the down-round financing. This is because new investors typically bargain for a specified ownership percentage and expect their investment to buy it. Existing investors may seek to maximize the value of their anti-dilution adjustments. Common stockholders and other unprotected holders, including management and employee option holders, end up bearing much of the resulting dilution and often are most heavily “crammed down.” On the other hand, existing and new investors typically want to ensure that the management team is protected and appropriately motivated, so the option pool increases, the number of end-result fully diluted shares outstanding again changes, and the entire iterative calculation dance begins again. Add in the fact that many down rounds are led by some subset of existing investors, and the tension around the per-share price calculations increases further.

Because of these dynamics, down-round pricing should not be modeled by simply picking a per-share price. Instead, the agreed pre-money valuation, anti-dilution adjustments, option pool increase, and post-closing ownership targets should be modeled together and holistically to ensure that the intended transaction is delivered.

Discussions over a down-round transaction often expand well beyond pricing mechanics and can raise questions about participation, including the potential emergence of a pay-to-play dynamic, board fiduciary duties, voting power, minority equityholder protections, contingency planning for future financing, potential waivers of anti-dilution protections, control-investor risks, the consent process, and the consensus-building required to secure key approvals.

For private companies backed by venture capital investors, acquisition is frequently the most likely path to liquidity. Founders are often laser-focused on product development, market expansion, and fundraising, without devoting the same early-stage discipline to ensuring the company is well-positioned for a future exit via a merger or acquisition.

M&A preparedness is not a late-stage exercise, but an operational strategy to position your company as an attractive, high-value target to potential acquirors.

Corporate Governance

Some of the most common obstacles to efficient M&A processes stem from issues related to corporate governance. Complex capitalization tables, unclear chain of equity ownership, and unresolved governance issues can create transaction delay and, depending on the structure of the transaction, loss of leverage.

Companies should consider focusing on three key areas of corporate governance to be prepared for future M&A processes: capitalization table discipline, stockholder rights, and board and stockholder alignment.

Capitalization Table Discipline

Maintain clear documentation of all equity issuances with proper board and stockholder approvals; confirm board minutes are complete, approved by the board, and signed; verify that 83(b) elections have been timely filed with respect to restricted stock grants to founders and early employees; and ensure 409A valuations are updated following major events that may impact valuation (such as a financing) and, absent such events, at least annually.

Stockholder Rights

Ensure all stockholders have signed the relevant stockholder agreements and that the company’s management team understands the protective provisions embedded within such agreements; similarly, ensure that the company’s management team is familiar with relevant provisions of any investor side-letters (think drag-along mechanics, rights of first refusal, and co-sale rights).

Board and Stockholder Alignment

Understand what approvals are required to approve a sale or merger of the company and whether any investor has blocking rights.

Contracting Discipline

Material contracts, such as key vendor and customer agreements, collaboration agreements, and licensing arrangements, are some of the first diligence requests in an M&A process. These contracts often contain assignment or change-of-control provisions that can require third-party consent, accelerate payment obligations, or trigger termination rights or other contractual rights that could significantly impact the trajectory of a deal. Accordingly, it is important for companies to maintain clear records of all material contracts, ensuring that all contracts are fully executed and include all attachments, exhibits, amendments, and restatements. Companies should track whether any material contracts have upcoming renewals or expiration dates. Additionally, tracking key provisions in such material contracts that may be triggered by an M&A (such as third-party consent requirements) will help streamline the M&A diligence and consent process.

Intellectual property is another value-driver for life sciences companies and technology companies, making it vital for companies to have documentation that clearly delineates intellectual property ownership. Companies should verify that all employees and contractors have signed Proprietary Information and Inventions Assignment Agreements (PIIAAs), review consulting agreements to confirm that intellectual property created by consultants/contractors has been validly assigned to the company, and obtain confirmatory assignments from founders and early contributors, if needed, and at the appropriate time. For companies with affiliated entities, confirm that the company’s core intellectual property assets sit within the target entity and not within any affiliated entities.

Being proactive can save time and expense during the M&A diligence process.

Regulatory Compliance

Depending on industry and geography, regulatory risk can become a gating diligence issue. Companies should identify areas of risk and preemptively resolve any outstanding compliance risks (e.g., data integrity, marketing, industry-specific licensing, etc.). In particular, life sciences companies should consider pursuing regulatory planning with the assistance of healthcare and/or FDA counsel (as needed) to ensure, among other things, that regulatory filings, communications, and approvals are complete and accessible.

Deal Team Preparation

Once the company has decided to start a sale process, identify at the outset who will be part of the core deal team, which will typically consist of a select number of employees and outside advisors. Members of executive management and other key internal personnel with specialized knowledge about the company’s corporate governance, labor and employment practices, employee benefits structure, assets (IP, real estate, etc.), litigation exposure, and regulatory compliance are typically included within the core deal team. Further, at the appropriate time, companies should engage outside advisors, such as outside legal counsel, financial/tax advisors, and investment bankers, all of whom can help quarterback the transaction and efficiently drive the deal process.

After the deal team is in place, consider implementing deal confidentiality procedures to maintain the integrity of the sale process:

• assign code names to the project and company participants;
• limit working group size and access; and
• consider antitrust issues and the use of “clean team” agreements and data rooms.

Data Room Readiness

Prepared companies treat diligence readiness as an ongoing process and not an exercise triggered by a letter of intent or term sheet. First, select a virtual data room that provides strong security and activity tracking. Second, build the company’s data room with organizational discipline, using logical folder structures (corporate, IP, finance, regulatory, benefits, etc.) and uploading documents in a searchable, digital format with consistent document naming conventions. Lastly, in connection with building the data room, flag with the guidance of deal counsel any confidentiality concerns and access restrictions that need to be put in place. For example, are there any documents that need to be redacted or anonymized? Does the transaction present antitrust sensitivity requiring documents to be shared through a “clean room”?

In all, a well-maintained and categorically organized data room significantly accelerates a sale process and signals sophistication to potential acquirors.

The most successful exits rarely begin when a banker is engaged. Ideally, they begin years earlier with strategic and operational foresight. Companies that understand the value of M&A preparedness can preserve negotiation leverage and act more decisively when M&A opportunities arise. After all, engineering an exit is more than closing a deal — it is positioning the company so that the right deal finds you.

Ordinary Delaware law tells a board selling control to get the best price reasonably available; however, by statute, directors of a public benefit corporation must balance stockholders’ financial interests against the interests of other people affected by the business and the company’s stated public mission. In Drakes Landing Associates, L.P. v. Tilden Park Capital Management, L.P., the court held that the Revlon stockholder value maximization standard of conduct does not apply to these directors, though courts may still review their decision-making under an enhanced scrutiny standard. The case was dismissed on a separate ground: the directors were protected by a statutory safe harbor, given that their decision was found to be informed, disinterested, and not one that no sensible person would approve. Here, an independent special committee with its own lawyers and a banker ran a market check before approving emergency financing that heavily diluted existing holders.

With sweeping cuts to federal research funding driving academic scientists in the life sciences toward entrepreneurship, there are practical steps for navigating this transition: adopting an entrepreneurial mindset that embraces risk and redefines success; leveraging university incubators, tech transfer offices, and alumni networks; broadening professional networks through industry events and mentorship; validating ideas through market research and minimum viable products; understanding regulatory pathways and engaging FDA-specialized counsel early; learning intellectual property fundamentals and working with IP attorneys to build a competitive strategy; developing a comprehensive business plan with milestones and financial projections; securing a diverse mix of funding from grants, angel investors, and venture capital; assembling a multidisciplinary team with complementary expertise; and launching pilot projects to demonstrate feasibility and build credibility with investors and partners.

By the time a venture-backed company reaches its mid to late stages, its board is usually built out of overlapping interests. Directors are affiliated with the funds that led earlier rounds, a founder may hold a large voting block, and executives and investors alike see a steady stream of opportunities, some of which look a lot like the company’s own roadmap. Generally, Delaware corporate law treats these relationships not as misconduct but as a process question. Most recently, Delaware corporate law received meaningful codified updates to its conflicted transaction rules and the key in evaluating such transactions remains to ensure that process follows the most recent developments in the law.

Loyalty Sets the Baseline

Directors and officers of a Delaware corporation owe fiduciary duties of care and loyalty to the corporation. The duty of loyalty bars a fiduciary from using a position of trust to advance personal interests at the corporation’s expense, and it is the source of both bodies of law discussed here. A conflict of interest does not by itself make a transaction wrongful; what it changes is the standard of judicial review if the transaction is later challenged. A conflicted transaction that has not been properly cleansed risks review for entire fairness, the most demanding standard under Delaware law, while a transaction that satisfies the statutory safe harbors described below is insulated from fiduciary duty damages and equitable relief.

Conflicted Transactions Under Section 144

DGCL Section 144 gives boards a set of alternative cleansing paths. An act or transaction involving a conflicted director or officer qualifies for the safe harbor if any one of the following is true: the material facts of the interest and the transaction are disclosed or known to the board or a committee, and a majority of the disinterested directors approve it in good faith and without gross negligence; the transaction is approved or ratified by an informed, uncoerced, affirmative vote of a majority of the votes cast by the disinterested stockholders; or the transaction is fair to the corporation and its stockholders. However, if a majority of the board is conflicted, the director-approval route must run through a committee of at least two disinterested directors.

Controlling stockholder transactions have their own rules, and the statute defines who is a controller: a person who owns or controls a majority of the voting power, has the right to cause the election of a majority of the board, or holds at least one third of the voting power together with the power to exercise managerial authority over the corporation’s business and affairs. On a maturing cap table, that can describe a founder with high-vote stock or, in some circumstances, a lead investor, and stockholders acting together under an agreement or understanding can constitute a control group. A controlling stockholder transaction (other than a going private transaction) qualifies for the safe harbor if it is approved or recommended by a committee of at least two disinterested directors with express authority to negotiate and to reject the transaction, or if it is conditioned on and receives an informed, uncoerced majority-of-the-minority vote. Only a going private transaction requires both protections, a deliberate departure from prior case law, under which both were generally required for a controller transaction to earn business judgment review.

The statute also defines disinterestedness. A disinterested director is one who is not a party to the transaction and has no material interest in it or material relationship with a person who does, with materiality keyed to whether the director’s objectivity would reasonably be expected to be impaired. Directors of exchange-listed companies also receive a heightened presumption of disinterestedness if the board has determined they are independent under exchange rules, a provision that becomes relevant after an IPO.

The Corporate Opportunity Doctrine

The corporate opportunity doctrine answers a different loyalty question: when a business opportunity belongs to the corporation rather than to the fiduciary who learned of it. A director or officer of a Delaware corporation may not take an opportunity for personal benefit if the corporation is financially able to undertake it, the opportunity falls within the corporation’s line of business and would be of practical advantage to it, the corporation has an interest or reasonable expectancy in it, and taking it would place the fiduciary’s self-interest in conflict with the fiduciary’s duties. The Delaware Supreme Court has emphasized that the factors are weighed together and that no single factor is dispositive.

In the venture ecosystem, fund-affiliated directors see deal flow across an entire portfolio, and founders and executives routinely encounter ideas adjacent to the corporation’s business. A fiduciary who takes an opportunity that a court later decides belonged to the corporation faces disgorgement of the opportunity or its proceeds. However, a fiduciary who presents the opportunity to the board and obtains a rejection from disinterested directors gains the benefit of a safe harbor, mitigating the risk of an after-the-fact judicial determination that the opportunity was usurped. Presentation is not legally required, but it creates a clean contemporaneous record, and the rejection should be clearly documented in the minutes.

Advance Waivers Under Section 122(17)

Delaware also permits much of this to be resolved in advance. Section 122(17) of the DGCL authorizes a corporation to renounce, in its certificate of incorporation or by action of its board, any interest or expectancy in specified business opportunities or specified classes or categories of business opportunities, whether presented to the corporation or to one or more of its officers, directors, or stockholders. Waivers of this kind are common in venture capital investments, where a firm and its designees may hold positions and board seats across a sector, and it is recommended to build them into the certificate of incorporation at the time of investment (which is consistent with the NVCA model certificate of incorporation). Note that such a waiver addresses only the corporate opportunity doctrine, not confidentiality. Accordingly, funds holding positions in competing companies should maintain information screens and avoid seating the same designee on the boards of competitors.

That said, advance waivers may not be an absolute shield to all issues arising out of potential corporate opportunities. Although details are scant as of the time of writing, and we expect to publish more detailed analysis once information becomes available, in August of 2026 the U.S. Department of Justice has been investigating certain venture capital firms with partners serving on boards of competing companies, potentially raising antitrust concerns, separate from the corporate law concepts of corporate opportunity.

DO’S & DON’TS:

Board Process for Conflicted Transactions

DO: Surface conflicts early and choose the cleansing path before approval. Disclose all material facts about the fiduciary’s interest and involvement, obtain approval from a majority of the disinterested directors acting in good faith and without gross negligence, and use a committee of at least two board-determined disinterested directors whenever a majority of the board is conflicted.

DON’T: Treat a conflicted deal as either automatically prohibited or automatically safe because the terms feel like market. Without disinterested director approval, a qualifying disinterested stockholder vote, or provable fairness, the transaction and the fiduciaries remain exposed.

Controlling Stockholders and Investor Directors

DO: Test whether a founder, investor, or group acting together is a controlling stockholder or control group under Section 144(e) before structuring any related party transaction. For controller transactions, use a fully empowered committee of at least two disinterested directors or a conditioned majority-of-the-minority vote, and use both for a going private transaction.

DON’T: Assume control requires majority ownership; one third of the voting power plus managerial authority can suffice. And do not rely on a stockholder vote to cleanse a controller transaction unless the deal was conditioned on disinterested stockholder approval by its terms when submitted for the vote.

Corporate Opportunities

DO: Adopt a simple protocol: fiduciaries promptly disclose opportunities arguably within the corporation’s line of business, the board or its disinterested members decide whether the corporation will pursue them, and any rejection is documented in the minutes before the fiduciary proceeds.

DON’T: Let a director or officer pursue such an opportunity quietly, or with the corporation’s resources, personnel, or information. Informal assurances from management are not a substitute for board-level disclosure and a documented rejection.

Waivers and Information Hygiene

DO: Consider a Section 122(17) waiver in the certificate of incorporation tailored to fund-affiliated directors and stockholders, revisit its scope at each financing, and pair it with confidentiality screens where investors hold competing positions.

DON’T: Seat the same designee on the boards of competing portfolio companies or treat a waiver as permission to share the corporation’s confidential information.