Down Round Disputes: When Fundraising Leads to Shareholder Conflict and Litigation

A down round can bring in the funding a company urgently needs, but it can also expose tensions between founders, investors, directors and minority shareholders. Where valuation, dilution, approvals or conflicts are mishandled, the financing can quickly become a shareholder dispute.

Founders may see the round as necessary to keep the business alive. Existing investors may view it as a way to protect further capital. New investors may require stronger rights before committing funds. Minority shareholders may see the same transaction very differently, particularly where the valuation is low, information is limited, ownership is reduced and control shifts towards those able to participate.

Down round disputes rarely arise from the lower valuation alone. They usually arise from the process around the round: how the valuation was reached, who approved the transaction, who benefited from it, whether conflicts were managed and whether the company’s documents were followed.

Where a down round gives rise to concerns about unfair dilution, minority shareholder treatment or conflicted decision-making by founder or investor-appointed directors, the issue can quickly become a director and shareholder dispute rather than simply a financing matter.

This article focuses on the disputes that can arise from a down round. For the wider legal and commercial context, see our main guide to down round funding for founders, investors and directors in the UK.

Why down rounds lead to disputes

Down rounds create pressure because the economic pain is not shared equally.

A company may need urgent funding, but not every shareholder will be able to participate. Some investors may have anti-dilution protection. Some may hold board seats. Some may have access to detailed financial information. Others may be asked to approve a transaction that substantially dilutes them, without the same ability to protect their position.

Disputes often arise where shareholders believe:

• the valuation was artificially low;
• the round favoured existing institutional investors;
• minority shareholders were not given enough information;
• investor directors were conflicted;
• pre-emption rights or consent rights were mishandled;
• the company failed to consider alternative funding;
• founders or management received unfair incentives;
• the new investment shifted control away from existing shareholders.

In England and Wales, the legal issues may involve company law, contract, directors’ duties, unfair prejudice, breach of articles, breach of shareholders’ agreement or defects in the share allotment process.

The valuation dispute: was the company really worth that little?

Valuation is often the emotional centre of a down round dispute.

A company that previously raised at a high valuation may later need money at a much lower price. That does not automatically mean the valuation is improper. Market conditions may have changed. Revenue growth may have slowed. The company may have limited runway. Investors may be unwilling to fund the business at the previous valuation.

However, disputes arise where the valuation appears to benefit one group of shareholders at the expense of another.

For example, an existing venture capital investor may lead the down round at a low valuation while also participating heavily in the new investment. Minority shareholders who cannot invest may be diluted substantially. If the same investor has board representation or access to information, non-participating shareholders may question whether the process was fair.

The company should be able to explain the commercial basis for the valuation. Relevant evidence may include funding alternatives explored, financial forecasts, cash runway, investor feedback, revenue performance, customer losses, debt position and the company’s negotiating position.

A defensible valuation process is often more important than trying to prove that one number was objectively “correct”.

Minority shareholder claims and unfair prejudice

Minority shareholders may consider a claim if they believe a down round has unfairly harmed their interests.

The most obvious route is an unfair prejudice petition under section 994 of the Companies Act 2006. This allows a member of a company to apply to the court where the company’s affairs are being, or have been, conducted in a manner that is unfairly prejudicial to the interests of members generally or of some part of them. The court has wide powers under section 996, including orders regulating the company’s affairs or requiring shares to be purchased.

In a down round context, allegations may include:

• issuing shares at an unfairly low valuation;
• excluding minority shareholders from information;
• allotting shares for an improper purpose;
• favouring a connected investor;
• ignoring pre-emption rights;
• diluting minority shareholders without a proper process;
• giving management or founders new incentives on unfair terms.

An unfair prejudice claim is highly fact-sensitive, and the courts apply the test narrowly. A down round will not be unfair simply because it dilutes minority shareholders, and ordinary commercial pressure between shareholders is not usually enough. The question is more likely to be whether the process, purpose and consequences of the transaction were unfair in the circumstances.

Where a claim succeeds, a common remedy is a share purchase order, under which the court may require the majority, or in some cases the company, to buy the petitioning shareholder’s shares at a value determined by the court. Depending on the facts, the court may also consider whether the valuation should take account of, or disregard, the dilution being complained about.

This is why an unfair prejudice claim can be a serious risk in a down round. A founder or investor group that pushes through an aggressive round may later face a costly dispute over process, valuation and shareholder treatment. The cost and disruption of that dispute may be far greater than the time it would have taken to run the round properly.

Breach of the articles or shareholders’ agreement

Many down round disputes begin with the documents.

The company’s articles of association and shareholders’ agreement may contain rights that affect the down round, including investor consent rights, reserved matters, class rights, pre-emption rights, information rights, anti-dilution provisions and board appointment rights.

If those rights are not followed, shareholders may argue that the round was invalid, improperly approved or completed in breach of contract.

Common problems include:

• issuing shares without the required investor consent;
• failing to waive or disapply pre-emption rights correctly;
• varying class rights without class consent;
• misapplying anti-dilution provisions;
• approving new investor rights without the required majority;
• using outdated documents that no longer reflect the cap table.

These issues can have substantive commercial consequences. They may affect ownership, voting rights, economic returns and future investment.

An experienced corporate solicitor can review the company’s existing documents before completion and identify which approvals, consents and waivers are required.

Conflicted investor directors

Investor directors can be particularly exposed in a down round. A director appointed by a venture capital fund or other investor owes their duties to the company, not to the investor who appointed them. Those statutory duties, set out in sections 171 to 177 of the Companies Act 2006, include acting within powers, promoting the success of the company, exercising independent judgment, avoiding conflicts of interest and declaring any interest in a proposed transaction.

A conflict commonly arises where an investor director takes part in a board decision approving a down round in which their own fund is participating or receiving enhanced rights. This does not necessarily prevent the transaction from proceeding, but the conflict should be identified and managed properly. The board may need to decide whether the investor director should take part in the discussion, vote on the transaction or receive certain information. The company’s articles and shareholders’ agreement may also contain specific conflict provisions.

Depending on the facts, it may not be sufficient for the interested investor simply to rely on its voting power to approve the transaction, particularly where the alleged breach benefits that investor. The company should therefore consider carefully how any conflict is authorised, approved and documented.

A poorly managed conflict can remain open to challenge long after completion. This is precisely the kind of issue that is easy to miss in a fast-moving round and difficult to unwind once a dispute has begun.

Founder conflicts and management incentives

Conflicts are not limited to investor directors.

Founders may also be conflicted. A founder director may be negotiating the round while being personally affected by dilution, leaver provisions, revised vesting or a new incentive package. Management may support a transaction that gives them fresh equity while diluting non-participating shareholders.

This can create a perception problem even where the commercial rationale is legitimate.

For example, a company may need to refresh management incentives after a down round because existing options are underwater. That may be sensible. However, if the incentive package is agreed without transparency or proper approval, minority shareholders may argue that value has been diverted back to insiders after they were diluted.

The board should ensure that any founder or management incentive arrangements are properly justified, approved and documented. Where appropriate, the company should consider separate approvals or independent advice.

Improper use of share issue powers

Directors must exercise their powers for proper purposes.

A down round may be vulnerable to challenge if shareholders argue that the board used the power to issue shares primarily to alter control of the company, entrench particular investors or dilute dissenting shareholders, rather than to raise capital for the company’s genuine needs.

The existence of a funding need will usually be important, but it is not always the end of the analysis. The board should be able to show why the terms were appropriate, what alternatives were considered and why the transaction was in the company’s interests.

The stronger the evidence of genuine funding need and proper process, the easier it will usually be to defend the decision.

Pre-emption rights and rushed allotments

Urgency is common in down round funding. It is also where mistakes happen.

Pre-emption rights are a frequent source of dispute. Existing shareholders may have statutory rights, contractual rights or both. These rights may need to be waived or disapplied before new shares are issued.

In a pressured situation, companies sometimes proceed on the basis that “everyone knows the company needs the money”. That is not enough.

If the correct process is not followed, a shareholder may challenge the allotment or argue that they were deprived of the opportunity to participate. This can cause serious problems, especially if the defect is discovered during due diligence for a later funding round or sale.

The company should check the articles, shareholders’ agreement, Companies Act requirements and board authorities before issuing shares.

Information rights and shareholder communications

Down round disputes are often made worse by poor communication.

Minority shareholders do not necessarily have a right to every piece of commercial information. However, where shareholders are being asked to approve a dilutive transaction, the company should consider carefully what information they need in order to make an informed decision.

Problems arise where communications are incomplete, overly optimistic, inconsistent or sent too late for shareholders to respond meaningfully.

The company should avoid presenting the down round as a foregone conclusion if approvals are still required. It should also avoid making statements about valuation, runway or investor demand that cannot be supported.

Well-managed communication will not prevent all objections, but it can reduce the risk of shareholders alleging that they were misled, excluded or unfairly pressured.

Litigation risk after completion

A down round dispute may not emerge immediately.

Shareholders may only challenge the transaction later, after they receive the updated cap table, see new investor rights, learn that insiders participated or discover that the company is preparing for a future sale or fundraising round.

By that point, the legal and commercial position may be more difficult to unwind. The company may have issued shares, amended articles, granted options, appointed directors and entered into further contracts in reliance on the round.

Litigation or threatened litigation can:

• distract management;
• create uncertainty over ownership;
• delay future venture capital investment;
• concern potential buyers;
• require disclosure of sensitive documents;
• damage relationships with investors and employees;
• increase transaction costs.

For investors, unresolved disputes may also reduce confidence in the cap table and governance structure.

Practical scenario: the insider-led down round

A growth company needs urgent funding. Its previous round was completed at a £25 million valuation, but performance has weakened and runway is short.

An existing institutional investor offers £3 million at a £7 million valuation. The investor already has a board seat and is able to participate fully. Several angels and minority shareholders cannot. The round includes senior liquidation preferences, enhanced consent rights and a pre-completion option pool increase.

The transaction may be commercially justifiable. The company may genuinely need the money and the valuation may reflect market conditions. However, the litigation risk increases if the board does not manage the investor director’s conflict, obtain the correct consents, explain the valuation basis, deal properly with pre-emption rights and document why the round is in the company’s interests.

The fact that the company needed funding will be important, but the process still needs to withstand scrutiny.

How to reduce down round dispute risk

Companies cannot remove all dispute risk, particularly where shareholders suffer substantial dilution. They can, however, reduce avoidable risk by managing the process properly.

Before completing a down round, the board should consider:

• whether the company’s financial position and funding need are properly documented;
• whether alternatives have been considered;
• whether the proposed valuation has a defensible commercial basis;
• which shareholder and investor approvals are required;
• whether pre-emption rights apply;
• whether anti-dilution rights are triggered;
• whether any directors are conflicted;
• whether minority shareholders need further information;
• whether incentive arrangements require separate approval;
• whether the board minutes explain the decision-making process.

Proper process is a form of risk management. It helps the company explain and defend what it has done if the round is later challenged.

FAQs

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Related articles

• Down Round Funding: A Guide for Founders, Investors and Directors in the UK
• Is Your Start-Up Worth Less Than It Was Last Year? 10 Warning Signs a Down Round May Be Coming
• How Much Equity Could You Lose in a Down Round? A Founder’s Guide to Dilution, Control and Survival
• Down Round Funding in the UK: 13 Legal Mistakes Founders and Investors Must Avoid

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This article is intended for general information only, applies to the law at the time of publication, is not specific to the facts of your case and is not intended to be a replacement for legal advice. It is recommended that specific professional advice is sought before relying on any of the information given. © Jonathan Lea Limited.