Extending For Success: The Rising Trend Of Extension Rounds And The Importance Of Due Diligence – Financial Services

Venture capital investment in United States startups is
projected to decline in 2022 by over one-third from 2021 levels
¹. And while down rounds remain infrequent relative
to historical trends, there has been a notable upward tick in their
occurrence, particularly in the fourth quarter of 2022
². In light of this slowing market, companies that
have already secured venture capital funding are increasingly
resorting to extension rounds as a means of obtaining additional
capital in an attempt to avoid a down round financing and extend
their runway until the fundraising environment improves. Extension
rounds involve the infusion of additional funding from existing or
new investors under the same terms as the previous financing round.
In some cases, extension rounds are being used to keep funding open
on rounds that were closed more than a year ago
³.

Extension rounds can provide several strategic benefits for
startups, including:

• Provision of additional capital: In a market
  where fundraising is challenging, extension rounds offer startups
  the opportunity to raise additional capital to support their
  operations and growth initiatives.




• Preservation of valuation: Extension rounds
  can protect the startup’s valuation by pricing shares at the
  same rate as the previous round and allow them to extend their
  runway until the funding environment improves.




• Streamlined process: Extension rounds
  generally involve similar terms as the initial round, thus
  simplifying and expediting the administrative process of
  fundraising. This can also result in significant cost savings in
  documenting the new financing.




• Credibility enhancement: Extension rounds can
  be viewed as a positive endorsement by outside investors, which can
  increase the startup’s credibility and lend validation to the
  company.

While the potential benefits of extension rounds for startup
companies are relatively straightforward-investors must necessarily
take a more circumspect approach. It is critically important that
investors carefully consider whether existing terms remain
favorable under evolving market conditions, warranting their
extension for another round. Some of the most important contract
provisions for investors to pay particular attention to
include:

• Voting thresholds: Investors should carefully
  evaluate the implications of extension rounds on existing voting
  thresholds, specifically in regards to any provision that may grant
  a single investor the ability to make unilateral decisions. If an
  existing or new investor obtains sufficient ownership such that
  they can unilaterally approve significant transactions such as
  additional financings or a sale transaction, existing investors
  should evaluate the thresholds and make appropriate changes. This
  evaluation is crucial in ensuring the preservation of the
  investors’ rights and interests in the company.




• Blocking rights: Similarly, investors should
  also carefully evaluate the potential impact of the extension round
  on investor’s blocking rights. An existing investor who had
  determined that their vote would be required to approve certain
  transactions under the terms of the existing round prior to the
  extension may find that their ownership is no longer sufficient to
  prevent an unfavorable transaction from happening and other
  investors may be able to proceed without that investor’s
  approval..




• Amendment provisions: It is imperative for
  investors to carefully review and consider the impact of the
  extension round on the amendment provisions in the existing
  financing documentation. This includes assessing whether these
  provisions continue to effectively protect their rights and
  interests, and determining whether the extension round would alter
  any of these protections. Additionally, it is important for
  investors to also consider whether current amendment provisions
  should be modified to provide additional safeguards and
  protections.

While extension rounds may seem straightforward on the surface,
it is important to note that they involve a number of critical
considerations. Given the complexity of the matter, it is strongly
recommended that investors consult with legal counsel to ensure
that their rights and interests are adequately protected.

Footnotes

1. CB Insights, State of Venture Q4 2022 Report
(January 11, 2023)

2. Pitchbook, Flurry of Down Rounds Hints at Valuation
Resets Ahead (December 14, 2022)

3. WSJ, Risks from Falling Valuations Prompt More Startups
to Extend Funding Rounds (August 08, 2022)

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.