What deal terms appear in down round and highly dilutive financings?
Takeaway: In a down round, investors have immense leverage and will demand a set of harsh, non-standard terms—like senior liquidation preferences, full-ratchet anti-dilution, and pay-to-play provisions—to protect their new capital and recapitalize the company.
A "down round" financing is a moment of crisis for a startup. It means the company is raising capital at a lower valuation than its previous round, and it signals that the company has failed to meet its milestones or is facing significant market headwinds. In this environment, the power dynamic shifts dramatically. The new investors are not just participating in a growing business; they are "rescuing" a struggling one. In exchange for this high-risk rescue capital, they will demand a series of aggressive, non-standard terms designed to provide them with maximum protection and control.
Understanding these "down round" terms is critical for any founder navigating a difficult fundraising process.
1. Stacked (or "Senior") Liquidation Preference
The Term: Unlike in a standard "up round" where all preferred stock is pari passu (on equal footing), a down round investor will demand a senior liquidation preference. This means that in a future sale of the company, they have the right to get all of their money back before any of the previous investors (Series A, Series Seed, etc.) receive a single dollar. They are jumping to the front of the line.
2. "Full Ratchet" Anti-Dilution
The Term: While standard anti-dilution is a "weighted-average" formula, a down round investor may demand a "full ratchet." This is a much more punitive calculation that adjusts the conversion price of the previous round's investors all the way down to the new, lower price of the down round. This is massively dilutive to the founders and earlier investors and is a clear sign of a distressed financing.
3. Pay-to-Play Provisions
The Term: The new investors will want to see that the existing investors still have conviction in the company. They will often insist on a "pay-to-play" provision, which requires all existing preferred stockholders to invest their pro-rata share in the new down round. If an existing investor fails to participate, their preferred stock is automatically converted into common stock, wiping out their liquidation preference and other special rights.
4. A "Re-Vesting" of Founder Stock
The Term: To ensure the founding team is fully re-incentivized and committed to turning the company around, the new investors will often require the founders to subject a portion of their already-vested stock to a new vesting schedule. This "founder re-vest" is a powerful tool for locking in the management team for the next phase of the company's life.
A down round is a painful "recapitalization" of the company. It is a necessary, but difficult, process that re-aligns the company's valuation with its current reality and gives it the capital it needs to survive and fight another day.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.