An Ed Zimmerman Breakfast Briefing: What seed and early-stage VCs, founders, family offices, angel investors and LPs need to know when the price per share dips below previous rounds
At Ada Ventures, we believe in making investment decisions objective, transparent and fair — throughout the whole process. It’s part of ensuring our capital is invested responsibly and for the good of society, without compromising on returns.
Often the world of VC can seem opaque and confusing: decisions are reached without explanation and buzzwords used to deflect thorny issues.
Ada Ventures invests in pre-seed startups but we look for a life-long relationship with founders in the portfolio, participating in multiple rounds in many of our companies.
We also want to have an impact on VC firms and their attitude more generally; this article is targeted at them.
That’s why Ed Zimmerman, one of our LPs and member of Ada’s advisory board since 2019, gave a talk about the pitfalls of later-stage rounds. Ed cofounded and (since the 1990s has served as chair of) the Emerging Companies / Venture Capital group at US law firm Lowenstein Sandler LLP. He has been an adjunct professor of venture capital at Columbia Business School and is a cofounder of First Close Partners, a venture capital fund of funds. Ed and his wife Betsy Zimmerman (who also participated in the session and is a founding GP of First Close Partners) have also separately invested in over 100 VC funds and, as angels, have invested in more than 170 start-ups. Ed also cofounded (in March 2000) and leads VentureCrush, an event series for start-ups and venture investors. He certainly knows what he’s talking about.
This session was also an opportunity for a round table discussion with friends of Ada including founding partners at venture funds, general counsels of venture funds, and LPs in those funds. Guests included Reece Chowdhry, Founding Partner at UK-based pre-seed fund Concept Ventures; Mads Jensen, a Managing Partner at AI and SaaS-focused VC firm SuperSeed; and Carmen Alfonso Rico, founder of Cocoa.
Let’s begin by defining a “down-round”. It’s not simply whether the company’s total enterprise value is lower than in the last round. A “down-round” is a financing in which the price per share is lower than it had been in the prior financing … do the maths![1] As part of these “down-rounds”, the start-up’s capitalisation table will be reconfigured (a “recap” or “recapitalisation”) to create an incentive for (and therefore benefit) the new investors. Without it, the start-up may not be able to raise the necessary new money. But that “recap” can often hurt the existing investors, particularly if they do not invest new money. The same applies to founders and early employees, even more if they are not working at the start-up after the recap round.
Here are four critical considerations for seed and early-stage VCs, family offices, angel investors and LPs facing recapitalisations and down-rounds:
1. “Down-rounds can happen to good companies”
It’s worth remembering that lots of financially successful companies have had down-rounds. To name a few: Meta, Klarna, and Stripe. But even so, down-rounds and recapitalisations can be a significant blow to founder, employee, and investor morale.
As he so often does, Ed brought data and research to the conversation, reminding us that the median venture deal size in 2024 dropped to the lowest level since 2016 (NVCA). It’s not just you, right? It’s broader. Gloomy economic forecasts don’t help. Remember that the start-up’s share price is a function of its performance, but also the performance of the broader venture markets for start-ups (and your own company’s sector). That means that your start-up can make progress (for instance, improving revenue and reducing burn or even attaining profitability) and still experience a lower price per share simply because of a material downturn in the broader market or in your start-up’s sector.
A down-round isn’t necessarily the end of the world. Ed spoke of an early-stage down-round recap he did 20 years ago which worked out well for the continuing founders/management and investors because that company ultimately went public. But down-rounds can get complicated as different parties are misaligned and have different incentives and expectations: an investor who wants to invest more money will feel very differently compared to an investor who’s been there all along but no longer has funds to invest (even if they’ve been adding real value on top of their invested cash). Ed explained that this can be exacerbated by the fact many venture investors spend “more time on active investments at the cost of new deals”. (Preqin, 2024). And conversely, some deals can get ‘orphaned’ as the ‘originating’ investment professional in the seed fund may have moved on. Ed shared data on the recent (and likely forthcoming) high turnover at venture firms (Journal of Finance, J. Thelander). Read Ed’s article in the Wall Street Journal.
Take away tip: A down-round isn’t necessarily the end of the world but it can get complicated — make sure you understand the key terms and how they create misalignment and affect you.
2. Venture litigation continues to rise.
There’s a rise in actual and threatened disputes in venture land. Ed cited hair-raising statistics, press release and filed lawsuits to underscore the increasing rate at which lawsuits and governmental proceedings have impacted venture and start-ups (Tilburg University research, SEC and DOJ releases). This sharply contrasts the less litigious venture world of 20 and even 10 years ago, though Ed warned us in 2018 in the Wall Street Journal that more disputes were coming because of some of the shortcuts that were being used more frequently in venture deals.
More complex deals, lower valuations, and lower legal costs relative to outcomes are contributing to an increase in litigation. In addition, litigation funders have entered the venture/start-up market. The Department of Justice is also getting involved. Enforcement officials understand that when they go into private practice, tech and venture enforcement will burnish their resume and that the topics arising in tech and venture are super interesting, also resulting in enhanced enforcement.
And you will end up being affected even if you are a UK-based fund, founder, family office, angel investor, or LP. America has historically comprised two thirds of all venture money. UK funds (and other European VCs) probably will end up reaching into America, whether to raise funds for themselves or for their portfolio companies (especially their best companies): in many growth rounds, you’re going to end up having American investors and LPs, especially as the most ambitious start-ups target markets beyond their borders. Of course, the US remains an enormous and important market for customers and acquirers for so many start-ups and growth companies. While the risk of litigation might be lower in the UK than in the US, when doing business in the States, there is increased exposure to the US legal system.
Take away tip: familiarise yourself with governance standards; if you’re uncomfortable with someone as a business partner at the outset, consider leaning into that feeling and don’t partner with them (or do further checking); ensure your access to experienced advisors (and counsel) who understand the risks of litigation and what happens when things go wrong…very wrong (bonus points for advisors/counsel who understand this because they have been through it before).
3. Do the rights thing: “Do a ‘Rights Offering’ to cleanse the deal by offering the other stockholders the right to invest.”
In light of the increased likelihood for disputes and to ensure more equitable (and perhaps tranquil) outcomes in troubled companies, start-ups doing down-rounds — especially but not only if those financings are led by the start-up’s existing investors — should do a “rights offering” in which the existing stockholders have a right to invest on the same terms. The rights offering need not delay the closing because, in numerous situations, you can do it after the initial closing, as long as you provide for it by, for instance, reserving shares for those stockholders who come in during the post-closing rights offering period and bake it into the deal documents. Often, the term sheet for the down-round will include a provision specifying that there will be a rights offering (sometimes even saying that it will happen after the closing). Ed has previously published on this topic in the Wall Street Journal, Forbes (2017, this one from 2015 does a deep dive into rights offerings and “interested board members”), and in a case study he published and has been teaching for years at Columbia Business School.
In these rights offerings, start-ups want to ensure that they are providing an actual opportunity for their existing holders to invest. Providing that actual opportunity requires disclosure so that the stockholders understand the opportunity, as well as time to receive, absorb and then react to that information. There are, of course, market customs that people follow for timing and disclosure, as well as legal requirements, so you ought to ensure that when your start-up is planning a rights offering, you seek guidance from professionals who can help with both the legal and the judgment aspects of these deals. And, of course, reaching out to stockholders to make this offer means that you have to know who your start-up’s stockholders are and how to reach them. That’s why it’s vital to ensure the start-up’s cap table is accurate and up to date for any eventuality. It’s of course, even better, if those stockholders have been hearing from the company more regularly — as a long-term lack of communication can lead to friction.
Take away tip: plan and prepare for the Rights Offering to be part of the deal at the term sheet stage! Ensure your advisors and counsel understand how to execute on a rights offering well in advance of needing them to do so.
4. What’s not on the table: “Cap tables tell us percentage ownership but not total liquidation preference, which you simply must know to decide whether to re-invest”
A cap table, or capitalisation table, lays out a company’s equity ownership. It details each owner’s percentage of ownership, including the type of shares (common or preferred and, if preferred, what “series” of preferred) and even the percentage ownership of each class or series of preferred stock, with and without the exercise of the outstanding stock options. What a cap table does not provide, however, is how much “liquidation preference” the start-up has. The total amount of liquidation preference (referred to as the “Liquidation Preference Stack” or “Liq Pref Stack”) is, however, critically important.
Liquidation Preference is a term specified in the organising documents of a corporation (a start-up, for instance) that dictates the amount of money a stockholder is entitled to receive and the order in which holders of stock get paid when the start-up “liquidates.” But “liquidates” can be a deceptive term because it is a term that is defined in the organizing document and almost always includes a sale of the business (the “M&A” exit). In fact, “preferred stock” (which is what VCs generally buy in a priced round) is called “preferred” in large part because it has a “preference” over “common stock” (what founders and employees typically receive), in that holders of preferred stock get paid before holders of common stock. To illustrate: in a typical venture deal, the liquidation preference would be “1x,” meaning that in an M&A deal or a wind down of the start-up, the holders of preferred stock receive one times the money they invested before holders of common stock receive anything or, if the holders of preferred stock would do better by taking their percentage ownership (their ‘pro rata’ amount of the total proceeds of the sale), then they do that — they receive whatever is best for them. That’s a big part of why venture investors “prefer” to buy preferred stock. And, a series of preferred stock can be senior, junior or in parity (lawyers use the Latin ‘pari passu’) with another series of preferred stock. Senior preferred gets paid before junior and all of them get paid ahead of common stock. So, if a venture investor has senior preferred and another investor has junior preferred, they might be misaligned, especially if the M&A sale price is too low for all of the investors to get that 1x (or one times their invested cash) — that’s because, if the sale proceeds are insufficient to pay all the preferred holders, the senior might get paid in full and the junior might get far less. This misalignment could mean that as between one M&A deal that repays the senior preferred in full (while the junior preferred and common stock lose out) and another that also repays the senior preferred plus the junior preferred, the senior preferred might be indifferent or might prefer the first offer if it can close faster or for other reasons — because the money they receive at closing would be the same. The junior preferred will feel very differently in that situation. The same goes for the holders of common stock (like founders and option holders).
The reason we focus on Liq Pref Stack is because a company that has raised $200 million but is now worth $50 million is going to have a hard time convincing new investors to invest and the needed management team members to stick around because it would be really hard to envision how new investors or go-forward management would make a return on their stock. That’s why recap down-rounds are so important: a venture investor would decide very differently knowing that the financing round will result in a total Liq Pref Stack of $20 million as compared to $220 million. It’s therefore really crucial to know (a) how much aggregate Liq Pref is on the company before the deal, (b) how much cash is going to come into the company, © how much liq pref will the company have after the closing, and (d) if you’re an existing investor, how much of your existing liquidation preference you will preserve or lose based on how much you invest in the recap down-round (and what happens if you do not invest anything). These deals are complicated and the many variables in these deal structures become interdependent. When structuring these deals, you must do the math and understand what happens if too many people preserve their liquidation preference because that could make the deal undesirable (as the Company’s stock could be “under water” at the end of the deal). Ed spoke about too frequently seeing investors not understand (and sometimes not even ask about) how much liquidation preference would remain outstanding after the deal. This is important information and you should ask the questions you need in order to understand what that Liq Pref Stack will look like post-deal because that is a big part of what is undergoing meaningful changes in a recap down-round.
Take away tip: make sure you’ve understood and modelled Liquidation Preference in your Recap round
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If you’d like to have a look at Ed’s slides or join one of Lowenstein’s VentureCrush events, please email venturecrushfg@lowenstein.com.
[1] For instance, a start-up can raise venture funding and subsequently issue more options, or warrants, or SAFEs or convertible notes, all resulting in way more shares outstanding than there were at the end of the last “priced” venture round. When that happens, the start-ups total enterprise value has to be meaningfully higher than it had been in the prior round just to get the start-up’s stock to the same per share price as the last round. In venture deals that are “priced rounds,” there are consequences to issuing new shares at a lower price per share than the last round of financing.
