Phantom Down Rounds and Their Impacts on Venture Valuations

Mark Marcus, Director of Valuation Services at TMF Group

Mark Marcus, Director of Valuation Services at TMF Group

Regardless of the market environment, venture-backed companies are loath to accept financings in the form of “down rounds”, where the most recently issued security is priced below the prior one. To do so often triggers anti-dilution provisions for previously issued securities and would appear to be a public admission that the company’s management was unable to enhance value with the cash that earlier investors provided. VCs are engaging in what I would call “phantom down rounds” to avoid the specter of a down round. What do I mean by this? We are increasingly seeing new financing rounds at the same price as the prior round but come with various sweeteners that make the new securities superior to the old ones. These sweeteners come in many forms that can include warrant coverage, seniority, enhanced liquidation preferences, or participation, to name a few. Depending on the company's state, new rounds can include more than one of these features, further enhancing their value relative to prior rounds while appearing not to show a decline in the company’s overall post-money valuation. Hence, it is a down round in substance, even if not in name.

When a VC’s portfolio company engages in a phantom down round, the question becomes how that impacts the valuation of the fund’s investment in prior rounds. For example, let’s assume a portfolio company previously did a Series B round at $5 per share. Total shares outstanding are now 10 million, for a post-money value of $50 million. The company now sells 2 million Series C shares at $5 per share. On its face, the company is now worth $60 million because it now has 12 million shares outstanding worth $5 apiece, rather than the 10 million shares at $5 before. However, let's assume the Series C round came with 10% warrant coverage. New investors did not buy 2 million Series C shares worth $5, they bought 2 million Series C shares, and 200,000 Series C warrants for $10 million. While the stated price of the Series C shares was $5, we know that the warrants hold value (otherwise, why would investors care about getting them, and why would the company bother to offer them?). A portion of the $5 share price is clearly for 0.1 warrants.

What does this mean? It means that even if one used a post-money approach to value the company, it would not be worth $60 million because the recently issued shares are not worth $5 apiece. Rather, the post-money value and all other equity securities should be calculated based on the standalone value of the Series C share after stripping out the value allocable to the 0.1 warrants that came with it.

A similar logic applies when no additional securities are issued but rather other sweeteners that enhance the value of a security relative to others. Let’s modify the example above slightly. Instead of 10% warrant coverage, the Series C shares carry a 2x liquidation preference, while the Series B shares have 1x. This feature shows that Series C shares are more valuable than Series B shares. The question, of course, is how much more valuable. The answer will depend on the valuation framework used.

When citing valuations on a post-money basis, it assumes that all shares will convert to common upon an exit. In this case, all preferred shares give up their rights and preferences for the upside associated with common stock. The probability of a fully-diluted exit is much lower for companies engaging in phantom-down rounds rather than new financings at a significant step-up. Using a post-money framework is appealing because it is easy and shows no decline in value, but doing so exclusively is likely to invite scrutiny. It is common to use an option pricing model to value a company and the different equity securities it comprises in a sale scenario where the preferences matter. The option pricing model will consider the varying features of a company’s equity securities and can be used to solve for the implied company value that results in the value of the recently issued security equalling the price paid. In this example, one would solve for the equity value that results in a Series C price of $5. In doing so, the option pricing model would also provide values for the other equity securities and necessarily result in a lower value for Series B. It would also result in a lower value for the company than the post-money approach, which would seemingly be more realistic given the premise that only the Series C shares are worth $5, and everything else must be worth less.

There are more nuances and approaches to dealing with phantom-down rounds than can be covered in this article. The key takeaway is that in the current market environment, it is essential to be aware of phantom-down rounds to treat them appropriately for valuation purposes. Simply seeing a new financing round at the same price as the prior round is not necessarily a validation that valuations have not changed. Instead, it will be key to evaluate the new round's terms relative to the last one, not simply the price, to determine whether the new round is truly flat and conclude on the appropriate framework for an updated valuation.