Enforcing Unwritten Founder Sweat Equity Claims During Down Round Restructurings
Unwritten sweat equity claims convert to low-priority common claims during down rounds, facing total elimination beneath senior liquidation preferences.
wash out round
Meaning
Financing events at a lower valuation than previous rounds can result in the substantial reduction or elimination of existing ownership stakes. A wash out round typically occurs when a company is struggling and needs capital to survive but new investors are only willing to provide it at a very low price. This results in the issuance of a large number of new shares which dilutes the percentage held by founders and early employees.
In extreme cases the original shareholders are left with almost nothing.
Severe Dilution
The massive influx of new shares changes the ownership structure of the company. A wash out round often includes a recapitalization where old shares are converted or cancelled. This process is designed to clear the capital table of passive or uncooperative shareholders.
It allows the company to restart with a clean slate and new incentives for the remaining team.
Cramdown Pressure
Existing investors may be forced to participate in the round to avoid being wiped out. The wash out round often comes with pay-to-play provisions that penalize those who do not contribute additional capital. This creates a difficult choice for early backers who may not have the resources to keep up.
Operational Survival
Survival needs often dictate the terms of a distressed deal. A wash out round provides the necessary cash to continue operations even if it comes at a high cost to the original owners.