Down Round Funding in the UK: 13 Legal Mistakes Founders and Investors Must Avoid

Raising money at a lower valuation? These are the down round legal mistakes founders and investors must avoid, because the terms you agree under pressure can cost you control and equity long after the cash arrives.

Down round funding is often negotiated under pressure. The company may have limited cash runway, existing investors may be protecting their position and founders may be trying to preserve enough equity and control to keep building the business.

In that environment, legal issues are often treated as secondary to the commercial objective of getting the money in. That can be a costly mistake.

A down round investment can affect shareholder dilution, founder equity, investor rights, employee options, board control, liquidation priorities and minority shareholder relationships. If the transaction is not structured and approved properly, the company may secure short-term funding but create long-term legal, commercial and governance problems.

This article focuses on the practical errors that cause the most damage in a down round. For a full overview of how down rounds work, our guide to down round funding for founders, investors and directors is a good place to start.

For founders, boards, angel investors, venture capital funds and existing shareholders, the key is to identify these risks before terms are signed. Below are 13 common mistakes that can materially affect the outcome of a down round.

1. Treating the down round as “just another funding round”

A down round is not the same as an ordinary investment round at a higher valuation.

Where shares are issued at a lower price than in a previous round, the consequences are usually more sensitive. Earlier investors may have anti-dilution protection. Founders may suffer more significant dilution. Employee options may become less effective. Minority shareholders may question the fairness of the process.

The company should therefore approach the round as a restructuring of ownership and rights, rather than as a simple subscription for new shares. We explain the mechanics in our guide to how much equity you could lose in a down round.

A start-up funding lawyer or corporate solicitor with venture capital investment experience can help assess how the proposed investment affects the company’s existing legal and commercial position before negotiations become too advanced.

2. Signing a term sheet before understanding the legal consequences

A term sheet is often described as non-binding, but in practice it can become difficult to move away from once agreed.

Founders may focus on headline valuation, amount raised and completion timing. However, the most important points may be buried in the detail: liquidation preferences, board rights, investor consent rights, option pool increases, warranties, anti-dilution waivers and founder vesting.

Once investors have agreed terms internally, they may resist changes. The company may then find itself trying to correct legal or economic problems after the negotiating position has weakened.

Before signing a term sheet for down round funding, the company should understand the likely dilution impact, approval requirements, investor protections and future fundraising implications.

3. Failing to check existing investor rights

Most venture-backed companies have existing investor rights contained in their articles of association, shareholders’ agreement, investment agreement or previous subscription documents.

These rights may affect whether the down round can proceed, who must approve it and whether certain shareholders have special protections.

Common issues include:

• investor consent rights;
• reserved matters;
• pre-emption rights;
• class consent rights;
• anti-dilution provisions;
• information rights;
• board appointment rights;
• restrictions on issuing new shares.

A down round investment may trigger several of these rights at once. If they are missed, the validity of the share issue or related amendments may be questioned later.

This is a key area where experienced corporate solicitors can add value by reviewing the company’s existing documents before the round is agreed.

4. Misunderstanding anti-dilution protection

One of the most common errors is accepting an investor’s anti-dilution calculation at face value, without checking whether it is actually correct.

Where an investor claims anti-dilution protection, founders often take the resulting share adjustment at face value. In practice, whether the protection applies at all, and how severely, turns on the precise wording of the company’s documents: whether an exclusion (such as shares issued under an option pool or to existing investors) removes the issue from the calculation, whether a waiver or consent is required, and whether the formula has been applied correctly to the actual numbers.

A small error here has an outsized effect. An adjustment calculated as though it were a full ratchet, when the documents in fact provide for a weighted average, can transfer a materially larger slice of the company away from founders and unprotected shareholders for no good reason. The priority is to check the document, the exclusions and the arithmetic before the adjustment is agreed.

5. Ignoring pre-emption rights

Pre-emption rights give existing shareholders the right to be offered new shares before they are issued to others, unless those rights are waived, disapplied or do not apply.

In urgent down round funding, companies sometimes treat pre-emption rights as a procedural inconvenience. That is dangerous.

If shares are issued without properly dealing with pre-emption rights, shareholders may argue that the allotment was invalid or unfair. Even if the company urgently needed funding, failure to follow the correct process can create avoidable legal risk.

The company should check both statutory pre-emption rights and any contractual rights in its articles or shareholders’ agreement. The correct waivers, resolutions or disapplications should be obtained before completion.

6. Underestimating how differently the round affects each shareholder

The mistake is assuming that all shareholders will view the down round in the same way simply because the company needs the funding.

In practice, a down round rarely affects shareholders evenly. An existing venture capital fund may be able to participate and protect its position, while angel investors or minority shareholders may not. Incoming investors may also require preferential rights that affect the economic position of existing shareholders.

Those who cannot participate are often the shareholders who suffer the greatest dilution. If they believe the valuation, approval process or allocation of rights was unfair, they may later question whether the round was properly approved or whether their interests were unfairly prejudiced within the meaning of section 994 of the Companies Act 2006.

These issues should be identified before completion. Clear communication, proper approvals and careful documentation can reduce the risk of a funding round becoming a shareholder dispute. We examine how these arise in our article on down round disputes and shareholder litigation.

7. Mishandling director conflicts and the board process

The mistake is failing to identify directors’ conflicts and record the board’s reasoning properly.

Down rounds frequently involve conflicts of interest. A founder director is personally affected by dilution. An investor director may be connected with a fund that is participating in the round. A shareholder may also be a lender. Management may be offered revised incentives shortly after completion.

The existence of a conflict does not necessarily prevent the transaction from proceeding, but it should be identified, declared and managed in accordance with the company’s articles, shareholders’ agreement and applicable law. Directors should also consider whether any conflicted director should take part in the relevant discussion or vote.

Board minutes should not be generic. They should record the company’s financial position, the funding options considered, the key terms of the proposed round, the conflicts identified, the approvals required and the reasons the board concluded that the round was in the company’s interests.

Where the company is in serious financial difficulty, the board may also need to consider creditor interests. The more severe the company’s financial position, the more important it is to take advice and keep a clear written record.

A good process will not remove every risk. However, if the round is later questioned by shareholders, creditors or future investors, it makes the board’s position far more defensible.

8. Agreeing liquidation preferences without modelling the exit outcome

The mistake is agreeing a new preference on the strength of the headline valuation, without modelling what shareholders would actually receive on an exit.

In a down round, new investors often seek a senior or participating preference to compensate for the risk, and existing investors may already hold preference rights. Founders tend to focus on the valuation and their resulting percentage, assuming that percentage reflects value. It frequently does not. Once a layered preference stack sits ahead of the ordinary shares, the order and size of those payouts, not the cap table percentages, determine who is paid and how much.

The consequence only becomes visible on a sale, when it is too late. A company might sell for what looks like a good number, yet founders and employees receive little or nothing because preferences absorb the proceeds first. Before agreeing any new preference, the board should model the exit waterfall at several sale values, so it can see exactly where the ordinary shareholders sit at each one.

9. Increasing the option pool without understanding who bears the cost

Investors may require the company to increase its employee option pool as part of the round. This can be commercially sensible if the company needs to retain or recruit key employees after a valuation reset.

However, the timing and calculation of the option pool increase can materially affect dilution.

If the pool is increased before the investment, existing shareholders may bear more of the cost. If it is increased after the investment, the new investor may share in the dilution. This distinction is often overlooked.

Option arrangements also raise legal, tax and employee communication issues, particularly where EMI options are involved or existing options are underwater.

The option pool should be considered as part of the overall economics of the down round, not as a separate administrative point.

10. Failing to address underwater options

Employee share options may become much less valuable after a down round.

If options were granted when the company had a higher valuation, the exercise price may exceed the current value of the shares. Employees may then view the options as having little practical value.

This can damage retention and morale at precisely the time when the company needs stability.

Possible responses include repricing, cancelling and regranting options, issuing additional options or creating new management incentive arrangements. Each approach has legal, tax and shareholder approval implications.

A company should avoid making informal promises to employees before the legal and tax position has been reviewed.

11. Letting emergency funding terms create future fundraising problems

Down round funding may be urgent, but the company still needs to remain capable of raising further investment.

New investor rights that appear acceptable during a cash crisis may become problematic later. Excessive veto rights, complex preference stacks, aggressive anti-dilution provisions or unclear share rights can make the company less attractive to future investors.

A future venture capital investment round will involve due diligence. If the down round documents are unclear, inconsistent or heavily investor-weighted, the company may face difficult questions before the next round can proceed.

The objective should be to secure funding without making the cap table or governance structure unnecessarily difficult for future investors to accept.

12. Using AI, templates or old investment documents without proper review

AI tools, templates and previous investment documents can help explain concepts or provide a starting point, but they cannot determine whether a particular down round works for the company’s circumstances.

A down round depends on the company’s existing documents, shareholder base, investor protections, option arrangements, board composition, financial position and proposed investment terms. A document used successfully in a previous funding round may not work when the company is issuing shares at a lower valuation and existing rights may be triggered.

For example, reusing documents from an earlier round may miss a consent threshold, anti-dilution adjustment or pre-emption issue that did not apply last time. The round may appear to complete, but the problem can later emerge during due diligence for a future venture capital investment or sale process.

Advice from an experienced corporate solicitor with venture capital and growth company fundraising experience can help identify these issues before completion, ensure the documents reflect the agreed economics and reduce the risk of avoidable dilution, governance problems or shareholder disputes.

13. Waiting until a dispute has already emerged

Many down round disputes are predictable.

They often arise from low valuations, rushed processes, limited shareholder communication, insider participation, unmanaged conflicts, missed approvals or unclear documentation.

The best time to manage those risks is before completion.

Once shareholders feel unfairly treated, or once a transaction has completed on defective documents, the company may face a more difficult and expensive problem. Litigation or threatened litigation can distract management, concern investors and complicate future fundraising or exit discussions.

Early legal input can help the company identify where objections may arise and take steps to reduce the likelihood of a dispute. 

FAQs

How The Jonathan Lea Network can help

For founders, boards, investors and shareholders, the legal support needed on a down round is practical, strategic and transaction-focused. The Jonathan Lea Network can help identify the legal and commercial pressure points early, structure the investment properly and ensure that the documentation reflects the agreed economics, control rights and approval requirements.

We can help with:

• reviewing existing articles, shareholders’ agreements and investment documents;
• identifying consent rights, pre-emption issues and investor approval requirements;
• advising on anti-dilution protection, liquidation preferences and investor rights;
• modelling shareholder dilution and founder equity impact;
• advising directors on duties, conflicts and board process;
• preparing and negotiating transaction documents, resolutions and completion documents;
• addressing employee option and management incentive issues;
• managing minority shareholder and dispute risk; and
• coordinating with investors, accountants, tax advisers and other professional advisers.

Our experienced corporate solicitors, venture capital solicitors and shareholder dispute solicitors advise founders, growth companies, investors and shareholders on down round funding, venture capital investment, shareholder dilution and growth company fundraising.

Contact us

If your company is considering down round funding, or if you are a founder, investor, director or shareholder concerned about the impact of a proposed financing, speak to an experienced corporate solicitor before terms are agreed.

The Jonathan Lea Network can help you understand the legal risks, assess the proposed terms and structure the investment in a way that protects the company’s position and reduces avoidable shareholder risk.

We provide most enquiries with an indicative scope of work and fee estimate, based on the information you share. We aim to respond within one working day.

In the same email you will be invited to arrange a 20-minute complimentary, no-obligation video consultation, should the proposed scope of work and fee estimate be of interest. This initial discussion is designed to better understand your requirements, refine the scope and ensure our approach is fully aligned with your objectives, at the end of which we will email you a definitive formal fee estimate to consider and approve.

Where you would prefer to receive initial advice and guidance from the outset, or where a short introductory call would not be the most appropriate starting point, we may instead recommend a 2.5-hour fixed-fee appointment, starting from £750 + VAT. This enables us to review the information you provide, discuss your situation with you and provide considered, tailored advice at an early stage.

To make an enquiry, please email us at wewillhelp@jonathanlea.net, complete our contact form, or call us on 01444 708640.

Related Articles

• • • 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 Disputes: When Fundraising Leads to Shareholder Conflict and Litigation
    • Down Round Funding: A Guide for Founders, Investors and Directors in the UK

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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.