What Are Down Rounds?

What are down rounds? In a nutshell, a down round occurs when a company raises funding at a lower valuation than the preceding round. Startup down rounds typically have negative connotations; most companies want to avoid this situation.

However, when executed strategically, a down round can have several advantages. Investors may appreciate the initiative; such rounds help keep the cap table organized and uncluttered. Read ahead for some detailed information about this funding strategy.

The Facebook Down Round Case Study

In 2007, Facebook raised a much-hyped funding round worth $240M from Microsoft at a valuation of $15B. Two years later, the company raised a down round of $200M at a valuation of $10B. A Russian investment group, Digital Sky Technologies, funded this round.

Because of changing market conditions, FB’s valuation ranged from $4B to $6B in 2009. Facebook accepted the funding exchange for preferred shares valued at $200M but did not cede any board seats. Reports stated that the social media giant turned down a $8B valuation funding round.

Their reasons? Mark Zuckerberg preferred not to award investors a board seat for higher valuations. The capital injection provided Facebook with a much-needed cash cushion along with the flexibility for strategic growth options, including acquisitions.

Despite the negative implications, down rounds can be advantageous for a company. Founders must also research alternatives and develop an understanding of leveraging this funding strategy for growth and stability.

What are Down Rounds?

A down round refers to a situation where a private company offers additional shares to investors. But at lower prices than the shares sold during the preceding funding round. The company may need a fresh capital infusion, but the valuation is less than the previous round.

As a result, it may resort to the down round option. This happens when the company’s pre-funding valuation of the current round is less than the post-funding valuation of the preceding round. Note that if the pre-funding and post-funding valuations are equal, the round is a “flat round.”

During a down round, investors purchase equity in the company at a lower price than the price offered to previous investors. This reduced pricing can occur for many reasons, such as changing conditions within the vertical or macroeconomic instability.

The company’s inability to meet its milestones can also trigger a lower valuation and down round.

Understanding How Down Rounds Work

Startups and private companies raise capital from the market and investors through funding rounds. They issue shares to investors and raise adequate capital to fund their growth through the next phase. Their pitch will reflect a business plan and benchmarks they intend to achieve.

As the company scales and is ready to expand its product portfolio or market reach, it needs more money. Typically, it should have a higher valuation with each successive funding round. Accordingly, it offers shares at progressively higher prices to match the stock value in the open market.

However, valuations depend on several variables, such as lower market share because of emerging competition. Or regulatory shifts that influence demand or product costs. Chances are that the company has a lower valuation before the next funding round.

If that happens, investors may offer capital but participate only if they get shares or convertible bonds at lower prices. Or prices lower than they were in the preceding funding round. Investors typically purchase shares at the lowest prices during the pre-see and seed stages.

But, during later stages, they evaluate the company’s performance and whether it has reached the desired milestones. For instance, achieving metrics like revenues, sales, customers, or product development. If the company has missed the milestones, investors may insist on a lower valuation.

Sometimes, even if the company has attained the desired benchmarks, investors may demand a down round. Their objective is to hedge their risks and ask for a board seat or decision-making rights. However, founders may be unwilling to accept the dilution or loss of control over the company.

In that case, they may opt to accept the down round instead. From the investor perspective, a down round could mean dilution since the company has to sell more shares to raise the desired capital.

Triggers for Down Rounds

When understanding what are down rounds, you’ll also explore the triggers that result in lower pricing. Internal, external, and macroeconomic conditions can result in lower valuations. Understand that the company’s valuation is mainly about the investor’s risk perceptions. Here’s what you need to know:

Internal Conditions

• Venture capitalists typically support startups with the potential for rapid growth. Not meeting the growth milestones consistently can result in lower valuations when the company needs a fresh capital infusion.
• Rapid growth milestones typically include developing the product or service on schedule and generating revenues and profits. Meeting production benchmarks such as a particular number of units or capturing a specific customer base can be another milestone. Growing the core team to a pre-determined number can also indicate growth.
• An expensive lawsuit that can cost the company a loss of money and reputation lowers prices.
• Emerging competitors with better products may result in the startup losing its edge and market share. If the company cannot demonstrate its ability to rise to the challenge, that is a trigger.
• Missed benchmarks may translate into a loss of investor confidence. They may cite reasons like inexperienced or incompetent management and the company’s inability to execute its business plan on schedule. The gap between hyped projections and results is also a trigger.

Companies can often rebound from internal issues and avoid down rounds if the investors believe in the founder’s resilience. They may accept a more reasonable valuation if they are confident the company can pull through the crisis. Capital infusion can help with recovery and stability.

External and Macroeconomic Conditions

• If the market is in recession, stock values are lower across the board. Every company is likely to face a lower valuation, which cannot be avoided.
• Higher interest rates can impact the entire economy. A good example is the hike in interest rates that the Federal Reserve executed in 2022 to manage inflation. As a result, risk asset valuations decreased significantly, including for startups venture capitalists had backed.
• The regulatory impact on a particular vertical can also cause a deep dive in valuations. In 2022, the crypto and fintech sectors experienced substantial drops in valuations. Companies like Stripe and Instacart also lowered their valuations.
• Upcoming and disruptive verticals with products that are as yet untested in the market also likely have lower valuations. Risk-averse investors hesitate to back a startup that has not demonstrated a Minimum Viable Product. Or the ability to capture a customer base. In that case, the company may have to settle for a lower valuation and accept the prices investors are willing to offer them.

Down rounds don’t necessarily indicate that the company’s performance is not optimal or it is falling short of expectations. It could instead mean that you must delay your funding round until market conditions have improved.

However, you may have to settle for a lower valuation during an economic downturn to stay afloat and operational. That is, at least until the market is on the uptick. Keep in mind that demanding a lower share price is also the investor’s strategy to hedge against the risks.

Regardless of the funding round you’re raising, you should know how to put together an investor outreach strategy. Check out this video in which I have explained how it’s done.

Implications of Down Rounds

For Existing Stakeholders and Investors

Before execution, make sure to understand what are down rounds, and their impact on future rounds that you’ll raise. Explore alternatives and other investor-friendly rights and preferences you can adopt. You’ll also send over term sheets to an expert funding consultant before accepting.

Each funding round dilutes the company’s ownership and equity. When you issue more shares, it lowers the ownership stake, and stakeholders will undoubtedly be concerned. Mainly since a lower share value means that you’ll issue more of them to get the capital you need.

Work with your fundraising consultant to examine the terms and conditions of previous funding rounds. Check for the anti-dilution provisions you may have included when issuing preferred shares. That’s because anti-dilution terms can impact existing investors and shareholders.

Anti-dilution terms allow investors to purchase more shares at the new low price. As a result, they can maintain their ownership percentage in the company before the valuation decreases. That’s their protection from the value of the investment dropping significantly.

When you disclose your intentions to run a down round, existing investors may negotiate their terms and update anti-dilution provisions. They will want this failsafe in case the company fails or closes down.

Down rounds may push investors to re-evaluate their total value to paid-in capital (TVPI). The TVPI is the sum total of the realized profits and unrealized future profits the investor has earned relative to their investment. Accordingly, they may choose whether or not to invest more money in the asset.

For Employees

Down rounds impact the option pools you may have given to your employees, which can have adverse effects on morale. Employees who have exercised their stock options may have purchased shares at a higher strike price than the current price. A down round results in lower asset value.

On the flip side, if they haven’t exercised their rights, the grant’s price per share may now be higher than the current price. If the stock price does not recover after the funding round, their shares could quickly become worthless.

Be prepared for the possibility that employees release the equity back to the option pool. They may choose not to exercise their options if the fair market value of the shares remains low. If that happens, you may have to evaluate their compensation packages and work out how to reprice wages.

For Founders

A drastic drop in valuation may also result in the founder’s ownership stake taking a huge hit. This situation can be even worse if investors with preferred shares exercise their anti-dilution provisions.

It’s not unusual for founders to lose their motivation and interest in continuing to run the company. So, take the time to explore in detail what are down rounds before you go ahead with the raise.

Keep in mind that a down round need not necessarily be detrimental to the company and investor confidence. If the valuation is a result of macroeconomic or sector-based conditions, investors may be less risk-averse.

If the company absolutely needs money, you could negotiate for other investment instruments that won’t result in drastic dilution. Also, scout around for other strategies to ride out the downturn. Always be aware of the future implications on the company’s valuation, reputation, and funding capability.

Keep in mind that storytelling is everything in fundraising. In this regard, for a winning pitch deck to help you here, take a look at the template created by Silicon Valley legend, Peter Thiel (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

Remember to unlock the pitch deck template that is being used by founders around the world to raise millions below.

Alternatives to Down Rounds

Even as you’re exploring what are down rounds, explore alternatives to bridge the gap in capital availability. Here are some possible solutions you can adopt:

• Deploy drastic cost-cutting measures to lower the burn rate and free up all possible cash. Consider downsizing your team and trimming peripheral expenses as temporary measures.
• Consider offering SAFEs and convertible notes to raise extra funding while the downturn lasts. You won’t need to value the company or lose investor confidence.
• Consider raising debt financing that won’t impact equity or ownership stakes.
• Offer investors perks and incentives to cover their risks and avoid a down round. Redemption rights, liquidation preferences, and other investor-friendly terms could work well.
• Negotiate with vendors, suppliers, and other partners for deferred payments.
• Explore the option of raising a small business loan with an extended payment period and other benefits.
• Sign up for a fundraising campaign on a crowdfunding platform and approach unaccredited investors. Offer payment terms like product samples or affordable interest rates.
• Renegotiate with the employees who have received stock options. Offer them a cash payout so they have instant liquidity. This strategy entices investors by giving them the opportunity to own a larger amount of stock.

During economic downturns and unfavorable macroeconomic conditions, the company may have to go for an unavoidable down round. Explore options that can help you delay the round until conditions improve. If you cannot delay it, work out the terms and conditions to minimize negative impact.

Make decisions after accounting for the possible implications on the company’s reputation and investor perception in future funding rounds.

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