By Paul Jones

[Part 1 of this 2 part column can be accessed here]

If the Ordinary Course down round is generally a dry, weary affair, when a down market and a depleted cash stockpile coincide with disappointing performance and team turmoil, down rounds can become much more … stimulating.

For our purposes we’ll assume that our startup, Newco, has had some serious mishaps, both in terms of real business/technical issues and perceived management issues. Current investors are mostly tapped out but variously open to considering a modest new investment with the right players, and on the right terms. A potential new investor, CEO candidate in-hand, is interested.

Welcome to the Hard Times down round scenario. It’s the bookend to the Ordinary Course down round, which I described in the first part of this series. This is the down round from the lower reaches.

In our generic example, the players fall into four categories. First, there is the new investor (the “New Money”). Next, the prior investors who, as noted, are not looking to double-down on their bet but might be tempted to pony up enough to call at the right price (the “Old Money”). Then the prior managers who are no longer considered essential going forward (the “Forsaken”). And, finally, the prior and new managers (mostly the new CEO) who are considered essential going forward (the “Blessed”).

In evaluating who “wins” the Hard Times down round, the key is appreciating that the legal rights of the various parties are secondary to the practical realities of the deal. The legal issues are better thought of as considerations than constraints.

In our Hard Times setup, the New Money and the Blessed have no legal rights whatsoever. At the same time, together (and that dynamic itself is a critical variable) they are sitting at the head of the table. On the other hand, the Old Money likely have the law on their side in the form protective provisions and possibly voting control at the board and/or shareholder level. Their practical negotiating power is sharply limited by their lack of appetite for either funding the company themselves or writing off the investment.

Finally, the Forsaken; cursed with little in the way of either legal or practical leverage.

How all this plays out is, of course, a function of how each of the parties plays its hand. That said, those hands come with certain intrinsic merits that almost always shape the outcome.

Clearly, the New Money holds high cards, across many suits. The Golden Rule, and all that. The New Money’s practical leverage more than compensates for its dearth of legal leverage.

Ditto the Blessed. The new CEO-in-waiting arguably has the most leverage of all. That’s because the New Money’s interest in the deal is most often contingent, at least in the first order, on the new CEO playing ball. In that sense, the New CEO is a bit of a wild card from the perspective of the New Money.

The third party with real leverage – albeit limited, as we shall see – is the Old Money. They have the legal right to block any deal. And, in fact, they sometimes will. But when they do, it’s at a high cost: they either consign the deal to the dustbin of history, so to speak, or have to pony up more money than they’d like to put the company on life support while they look for another well-capitalized new investor to step up.

That leaves the Forsaken. Any practical leverage they have is moral … as, say, Belgium in 1918 and 1940, but without even a treaty to make a stand on.

Put all of this together and the “solution” to the various competing interests is in outline, if not in every detail, clear. Valuation takes a serious hit, but at least the Old Money gets to average down its price and thus get some of that dilution back. The new CEO gets a big chunk of new equity, and anyone else considered valuable going forward gets an equity boost of some sort. The considerable dilution from all of this is born by the Forsaken. While everyone else will fill the chill of a down round, the Forsaken will feel something more like the deep freeze of a washout.

It’s been awhile since down rounds made up any significant portion of venture investment rounds. Those were the days, and they were heady days, indeed. And, for now at least, they are over. While there will still be up rounds now and again to keep everyone interested, look for down rounds to take more than their fair share of the harvest. And get used to thinking about how your next round comes together in the dynamics of a down market.

Jones is a veteran venture-backed entrepreneur and investor. He is of counsel to the law firm of Michael Best. His previous columns can be read here.