The Down-Round Dilemma

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As the meeting drew to a close, Portelli looked around the conference table -- at Behlendorf and his other top managers, all of whom had fairly sizable stakes in the company. The value of their equity and the size of their stakes would drop if they took the financing. Then again, the additional money might allow them to keep the company on a growth track. It was time to make a choice.

The Decision

In January 2003, CollabNet finalized a $13 million third round of funding led by Norwest Ventures. Most shareholders, including Benchmark and Oracle, did reinvest; notably, Hewlett-Packard and Novell did not. In a statement, a Novell spokesperson says, "The primary reason we did not participate is that we are no longer making venture capital investments. Furthermore, we are a small investor and do not have a seat on their board; our participation was not critical."

Seed-round investor Tim O'Reilly, whose stake in CollabNet dropped to 5% from 25%, says: "It's a big enough opportunity that it's still going to be a big win for all of us." His sentiment seems to be shared throughout the organization and among shareholders. "Some people's shares might appear to be diluted, but if the company's stronger and healthier, then any shares you have are going to become more valuable," says Portelli. Both the CEO and Behlendorf consider the round to have been a great success.

The Experts Weigh In

WILLIAM M. KUSHNER, an associate at law firm Perkins Coie's Menlo Park, Calif., office who has completed a large number of venture capital financings.

This is one of those situations where lawyers are a necessary evil. If this company augments its war chest at the cost of significant dilution, it could result in potential liability. In a down round, it's extremely important to treat all investors fairly. You want to ensure that founders and early investors who were diluted can't claim they were coerced or defrauded in any way. A company without severe cash restraints, like CollabNet, should have a lawyer send out a detailed information statement and investor questionnaire to all shareholders, providing full disclosure of the reasons behind the deal and explaining their rights to participate. Those are the most pivotal tools to protect the company from future litigation.

ADAM DELL, managing general partner at Impact Venture Partners, a New York City firm that invests in early stage companies.

One thing to remember in a down round is that management needs incentive. If a company has raised $30 million and then raises an additional $10 million in fresh money, it should reevaluate liquidation preferences. These typically favor venture capitalists. Common shareholders in management won't have much of an incentive if they need to create $40 million in enterprise value before they ever see a dime. I recommend that a company like CollabNet work with its investors to wipe out the old liquidation preferences in exchange for new terms. Another approach is to create a special management carve-out, which allows management and investors to share equally in the proceeds from a sale of the company.

K. CYRUS HADAVI, CEO and founder of Adexa, a Los Angeles software firm that completed a $15 million down round in August 2002.

A lot of companies see a down round as a defeat, but really you just have to make a mental adjustment. Running a real company is not about what it's worth today, but about building value that will last through the good times and the bad. You shouldn't focus too much on your valuation because any company -- whether private or public -- has a share price that fluctuates. That said, we had a more negative experience than CollabNet did. We were about to have an IPO at a valuation of about $2 billion in 2000, but then we backed out. The following year, our revenue dropped 17%. We didn't know how long the storm would continue. We saw all of the dot-coms dropping like flies. And things weren't looking good for the enterprise software companies. Like Portelli, we wanted a cushion, plus some more cash so that we could take advantage of bargains and buy up some new technology. Though our valuation dropped a lot, we went ahead with a down round. The valuation we had in 2000 -- it was nothing more than a dream, a fallacy.

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