As the economic shutdown due to COVID-19 drags on and companies run out of financing alternatives, they may be forced to consider less appealing, and more dilutive, options. When the shutdown first occurred, many companies drew down on their revolver to its fullest, in order to hoard cash to weather the storm. Some companies had run out of cash provided through government lending initiatives, while other companies were either overleveraged already or otherwise didn’t qualify for emergency government funding programs. However, when the possibilities for raising capital from these methods run out, companies often consider “down round” financing options such as newly issued preferred securities or conversions of debt to equity. Down round financings are often fraught with complicated issues that have to be measured and balanced across numerous constituencies. A few of the key considerations that companies should be mindful of as they seek to enter into down round financing transactions include:
Importantly, the terms of the capital infusion and the resulting pro forma ownership based on the valuation of the company (including the waterfall of future distributions to shareholders) need to be fair to the non-participating shareholders from a financial point of view. A fairness opinion from a qualified financial advisor can assist the board in meeting its fiduciary duty of care in considering a down round financing transaction, thereby helping to protect the directors in the case of any future litigation that may result.