Many private companies, especially early-stage startups, are struggling to find funding, and often, those that do are experiencing “down rounds.” In a down round, a company typically sells larger stakes to new investors at the same cost or less than what earlier investors paid, driving down the company’s valuation and diluting shareholder values in the process. Down rounds pose multiple risks, from reduced capital support, to shrinking confidence among investors and employees, as well as greater exposure to Directors and Officers (D&O) liability.
After a record year for global venture capital funding in 2021, which saw $681 billion invested, venture capital firms have scaled back their investment activity. In 2022, global venture funding fell by 35%, to $445 billion.1 Reasons behind the reduction in funding include volatility in the stock market coupled with economic inflation, which has increased the cost of capital and led many investors to conserve cash. Not surprisingly, in these conditions, investors pulled back in 2022 across all funding stages, from seed to late-stage.
RED FLAGS FOR D&O UNDERWRITERS
Down rounds pop up as red flags for D&O underwriters because valuation changes can lead to lawsuits. Litigation may not be automatic following a down round, but anytime investors’ holdings lose value, the company tends to attract more scrutiny, sometimes along with questions about the effectiveness of its governance.
Employee morale also may suffer, leading employees to wonder whether the company will survive. Unhappy employees tend to be less productive, and some choose to leave, which can be detrimental to a company’s present and future operations. Lack of cash due to a down round may force companies to curtail benefits or alter the workplace culture, which can also lead to employment practices liability claims. Unlike public company D&O policies, employment practices are included under private company D&O coverage.
Therefore, private companies have good reason to fear down rounds, and some companies attempt to avoid announcing reduced valuations.2 Tactics used to avoid down rounds include enticing investors with confidential promises of discounted shares in an eventual public offering, seeking debt financing rather than equity, or issuing notes that can later be converted to stock. In some cases, existing backers that are less concerned about valuations might be persuaded to make additional investments if they believe in the company’s growth prospects.
In early 2023, valuations of publicly traded tech companies are almost universally down, while private tech companies' valuations look like they're up 20%-30%. The use of debt financing rather than raising equity may be why, and it also might not last long. However, following the collapse of Silicon Valley Bank, the reduced availability of venture debt is likely to mean that propped-up valuations will start falling faster, as they have in the public markets. For startups, there are fewer venture deals and dollars being doled out. Venture capital firms are taking longer to make decisions, so the amount of time between rounds is lengthening. The cheap debt many have used in the past to extend runway and avoid valuation realities won’t be as available moving forward. This will mean more down rounds, which typically equals greater D&O risks for companies seeking funding.5
D&O liability rates increased significantly for private companies in 2020 and 2021, before easing somewhat during the first half of 2022.3 With single-digit increases still occurring for private company D&O programs in the fourth quarter of 2022, growth in down rounds could tighten the marketplace further. Underwriters remain uncertain about the impact of delayed employment practices claims from the pandemic, which are just beginning to emerge. Several new markets have begun writing primary D&O limits, which may alleviate some of the pressure on private company rates.4
HOW AGENTS CAN HELP
Retail agents can assist insureds anticipating down rounds in funding by taking the following steps:
- Get the full story. Underwriters need and value information that helps them assess the risks presented, and D&O markets in general are seeking more financial information than ever. Retailers should work with clients to gather as much information as possible about a down round, including their interim financials, future funding plans, and operating strategies.
- Review/discuss relevant coverage points. During the renewal process, it’s wise to review coverage, including (but not limited to) the definition of securities claims, security holder exclusions, creditor exclusions, and notice of claim provisions. It’s also a good time to review overall D&O limits and consider adding additional risk transfer policies such as DIC side A, employment practices liability, and fiduciary liability insurance.
- Communicate the facts early. Starting the renewal process earlier is usually a good idea, and it may be critical when D&O underwriters are already cautious about submissions involving down rounds. Communicating the client’s risk story early to an incumbent carrier and alternate markets, if necessary, can make for a smoother renewal for all concerned.
- Set appropriate expectations. Private company founders may have unrealistic expectations and dashed hopes after securing high valuations in early funding and then experiencing a down round. Risk advisors can help prepare clients for more complicated renewal discussions by setting appropriate expectations.
BOTTOM LINE
A down round in funding does not necessarily mean a private company is doomed or cannot obtain adequate D&O liability coverage. But it does mean renewals, on average, will take longer and require more financial information for underwriters to consider. Working with an experienced wholesale specialist can enable retail agents to help clients obtain the broadest and most appropriate protection available. Reach out to your local CRC Group producer today for more information.
CONTRIBUTORS
- Kevin Ware is an Associate Broker with CRC Group’s San Francisco office where he specializes in private D&O and coverage for financial institutions, venture capital/private equity, real estate asset management, and broker-dealers.
END NOTES
- “Global Funding Slide Sets Stage for Another Tough Year,” CrunchBase, January 5, 2023; https://news.crunchbase.com/venture/global-vc-funding-slide-q4-2022/
- “How Cash-Needy Private Companies Are Avoiding Dreaded Down Rounds,” Bloomberg Businessweek, January 25, 2023; https://www.bloomberg.com/news/articles/2023-01-25/high-interest-rates-force-startups-into-creative-deals-to-avoid-down-rounds
- “State of the Market: D&O Liability,” CRC Group; www.crcgroup.com/Tools-Intel/post/state-of-the-market-d-o-liability
- “Private D&O REDY Index,” January 2023; https://www.crcgroup.com/Tools-Intel/post/private-d-o-redy-index-january-2023
- SVB’s Challenges Will Accelerate Valuation Down Rounds, Startup Mortality, and Layoffs, CBInsights, March 15, 2023. https://www.cbinsights.com/research/startup-valuations-mortality-layoffs/
- Dreaded 'down rounds' Shave Billions Off Startup Valuations, Reuters, August 9, 2022. https://www.reuters.com/business/dreaded-down-rounds-shave-billions-off-startup-valuations-2022-08-09/