Down Round Fundraising – Not At Any Valuation

A recent decision by the Economic Division of the Tel Aviv District Court emphasizes the requirement for a company’s officers and decision makers to undertake a stricter review standard when making decisions, especially in conflict of interest situations. Accordingly, companies must now increase their scrutiny on the decision making of directors in private companies. This marks an important ruling in light of the current economic climate.

The decision was given in the case of Unavoo Food Technologies Ltd., a company that was in desperate need of funding in order to survive. Following unsuccessful attempts at raising third-party financing, the company’s board of directors decided as a last resort to raise approximately USD 500,000 by way of an internal fundraising round, as is done in many struggling companies. Under the terms of the round, Unavoo proposed to raise funds at a company valuation of USD 700,000, representing a substantial down round from the previous fund raising valuation of USD 40 million.

One of the founders, Yuval Maimon, objected to the investment round and the company valuation, as the new issuance would have represented, following the financing round, approximately 42% of the company’s share capital. Maimon filed claim against Unavoo and the investing shareholders, claiming that they knew he would not invest and were therefore abusing their majority position to approve a transaction at an unrealistic valuation, in an effort to significantly and disproportionally diminish his shareholdings. 

In her ruling, Judge Ruth Ronen noted that financing decisions are subject to the business judgment rule of the company’s directors, and the courts will not interfere in such judgment if done in good faith. However, in contrast to past court decisions and common practice, Judge Ronen concluded that due to the consequences of the proposed financing round, and as the investing shareholders were due to personally profit from the low valuation, the burden of proof was on the approving shareholders to establish that the proposed valuation reflected the true value of the company.

Judge Ronen directed the company to either proceed with issuing equity at a valuation to be determined at a later stage by an expert opinion, or alternatively to pursue different financing routes. 

The ruling has raised several eyebrows in the startup sphere, especially in the current COVID‑19 landscape, where many companies like Unavoo are struggling and may be on the brink of bankruptcy. The reality of companies needing a down round, or to turn to their current shareholders for financing in order to navigate such difficult times, means that officers and shareholders must tread more carefully when making such tough fundraising decisions. Officers and shareholders must take into account additional considerations, as well as take extra care in conflict of interest situations, as such decisions may be questioned by shareholders who feel slighted, and further scrutinized by the courts.