What’s Up with Down Rounds🤔
Down rounds aren't as bad as they seem
Written by Daniel Szekely with the parts that are actually useful (see excel template below) prepared by Britt Bloom
A “down round” is simply a funding round at a valuation that is lower than a prior round. If you raise capital at a price of $100 per share and you previously raised capital at any price above $100 per share, then, you got it, you're raising a down round. This used to be a lot more common. The reason they became less common was because the fundraising market was so absurdly overheated that a business could raise money at a full valuation, fail to deliver anywhere near its plan and still raise more money at the same price if not more.
Those days are over. Not only will companies need to deliver results in order to continue to raise capital at high prices but the bar for delivery is that much higher if the price of a business’ last round was set during the market peak.
But it really isn’t as bad as it sounds.
Since the recent market collapse, I have witnessed an enormous number of founders facing down rounds. I have seen these both within and outside of our own portfolio. Unfortunately, I have also witnessed some of the most talented founders I know express fear and sometimes shame in the face of a down round, but there’s no shame in a down round. The exceptional circumstances of the period leading up to 2022 has left founders ill-equipped to deal with the emotional and technical burden of a down round and I hope this article goes a small way to arming them.
To be clear, down rounds are not a good thing. They are more dilutive than up rounds (duh),can have negative flow-on effects and you should avoid them if you can. My intention is not to advocate for down rounds. Rather, it is to clarify misunderstandings around down rounds, firstly in relation to why down rounds aren’t as bad as you might think and secondly, to provide some basic suggestions when it comes to navigating down rounds.
As aptly put by Dan Primack:
“There's strength in making a hard decision, even if it highlights past hubris. Own it and live to fight another day”
WHY DOWN ROUNDS AREN’T THAT BAD
1. Down rounds are very common, you just don’t know it
No one goes to the AFR to announce a down round. Short of the round being high profile enough that it makes its way into the hands of the media, founders and their boards don’t announce them. They are much more common than they appear. If you’re facing a down round, trust me, you aren’t alone, not by a long shot.
Some of the most successful technology companies in history have had down rounds, CB Insights lists some hundreds of them here from many hugely successful companies here and trust me, that’s not all of them. Many of these businesses are SUCCESS STORIES. Private markets are irrationally fearful of down rounds, sometimes leading to poor decision making. After all, no one throws shade at large listed companies when they do placements at a lower price than it has in the past – ostensibly a down round.
2. A down round has many causes
One of the reasons a business might face a down round is a failure to deliver on growth expectations, but there are many other factors that influence why down rounds occur. In fact, you can deliver perfectly and still face a down round.
You do not control market conditions. If the market has fallen and with it your valuation, this is entirely out of your control. Energy would be better spent focusing on what you can control, such as negotiating fair terms with investors so that down rounds aren’t overly dilutive. Of course, you might try to use market conditions to your advantage but this isn’t always possible.
3. A down round might still be a full and fair valuation
Founders are often warned not to raise capital at a valuation that is ‘too high’. It isn’t impossible to find investors that will pay way over the odds in some cases. This alone isn’t an issue. The issue arises when you can’t beat that price again in future. I have written about this in the past.
Truth be told, if your last round was “overpriced” - whatever that means - a down round might actually represent a decent outcome. If you were once valued at 15x revenue and now you’re valued at 9x revenue, you’re doing a hell of a lot better than most of the market and probably delivering an excellent outcome at a great price even if 9x represents a down round.
4. Your investor knows the risks
Early-stage investing is inherently risky. If an informed investor made a decision to invest in your business at a certain valuation and they are now facing a price write down, this doesn’t alone mean you’ve failed or that you’ve wronged anyone. In fact, you are doing right by your investors if you are accessing capital at the best price that you can to drive the most value that you can for them. Down rounds dilute founders as much as anyone else, if not more after considering anti-dilution. IF you’ve managed your capital effectively and performed along the lines of what was promised but your investor still hauls you over hot coals for a down round, they should know better - you’re all in it together.
5. It’s a long game
The majority of VC funds have 10-12 year time lines. The startup journey is a long one and you still have plenty of time to drive value for your stakeholders after a down round. It is not the end of the road – in most cases, it is just the beginning.
6. A small piece of a big pie is usually more valuable than a big piece of a small pie
When considering a down round, you should consider the future value of your equity after dilution, not just the dilution itself.
Founders worry about dilution. They should. But they should look at what they think their equity can be worth with the down round capital. For example, you might hold 20% less of the company after a down round but if you think you can increase the company’s value by 2 or 3x with that capital, it may be the best outcome for you and your investors.
7. Today, anti-dilution rights are usually inconsequential in a small down round
Anti-dilution rights most frequently take 2 forms, full ratchet anti-dilution and weighted average anti-dilution.
The former has seldom been used for several years and is considered highly aggressive. In effect, it gives an investor the number of shares they would have received if their share price was the same as the price of the down round. The impact of this can be catastrophic in the event that you raise a small amount at a low price. For example, if you previously raised $10m at a pre-money valuation of $90m, your dilution is 10%. If you then have to do a small down round of say $1m at a tough pre-money valuation of $20m, the entire $10m raise would be priced the same as the $1m round, meaning the dilution from the $10m originally raised could be 33%, plus the additional dilution from the $1m raised.
Weighted average antidilution weights the additional shares an investor received based on the size of the down round such that a small raise at a lower price has a limited impact. This is explained further below.
8. The effect of weighted average anti-dilution
Weighted average anti-dilution is hard to understand. In essence, it gives investors facing a down round additional shares based on:
· the number of shares with anti-dilution rights attached
· the price of shares with anti-dilution rights attached
· the number of shares issued in the down round
· the price of shares issued in the down round
A typical formula for calculating how many shares an investor with anti-dilution rights is entitled to looks like this:
CP2 = CP1 x (A + B) ÷ (A + C)
But this isn’t very helpful to you.
I have attached a sheet that you can use to calculate how many shares your investor would receive in a down round. You can play with the cells in blue:
If you’re facing a down round, you’re not alone and it’s probably not as bad as it seems.
TIPS FOR NAVIGATING A DOWN ROUND
1. Investors can elect to waive anti-dilution rights
This is only possible by mutual agreement but I have seen it occur many times (including in the case of EVP) where it is in the best interests of the company.
One way to navigate this is by having an investor fund the down round on the condition that all shareholders waive anti-dilution rights. It wouldn’t be unreasonable for an investor to make their investment conditional on all shareholders waiving anti-dilution rights on the basis that they don’t want founders to be diluted unnecessarily. The incoming investor has material influence and if all shareholders want the capital, and it is in the best interest of the company, there is a good chance your existing investors will concede.
2. You can structure terms that increase your share price
There are a number of terms that you can offer your investor in exchange for increasing the price of a round. One of the most common and most valuable rights you can offer an investor is a liquidation preference which may come in many forms. Terms you may offer to increase the valuation include:
participating or non-participating preferences;
1, 1.5x, 2x and other preference multiples;
warrants and options; and
preferential dividends and coupons.
Explaining these rights in detail is beyond the scope of this article but if you’re facing a dilutive down round, you might explore giving these rights away to increase your valuation and potentially avoid triggering anti-dilution rights. Giving these rights away should be compared to the alternative of increased dilution.
In the current market, rights like this, typically considered downside protection, are becoming more common but they are not to be taken lightly.
3. Don’t forget your thresholds for appointment rights
Startups often have ownership thresholds that shareholders are required to meet in order to retain board appointment rights.
If you engage in a dilutive cap-raising, don’t forget to check the impact on your board appointments.
4. Make decisions based on math rather than emotion
If you own 20% of a business, the difference between raising $5m on $25M and $5M on $30M is, on a very simple analysis, the difference between you diluting to 17.14% or 16.67%. That’s a difference in ultimate holding of 0.48%.
In this example, a difference in valuation of $5M (20%) might sound huge but it doesn’t translate to a massive difference in dilution.
In my experience, people often irrationally obsess over percentages. I have met numerous founders that believe that if they dilute below 50% they will lose control of their business. In private companies, control is generally governed by a shareholders agreement. You can technically hold 0.1% of a company and still control it if you contract appropriately. Dilution itself will not cause you to lose control.
I am not suggesting that you ignore dilution, you shouldn’t, but you should understand it for what it is without making decisions based on emotion and headline numbers. What matters here above all the value of your shareholding. If a down round is an enabler to materially increase this value, even if the percentage holding decreases, it may be the right decision.
6. Don’t sell your soul for a dollar
Aggressive deal terms (other than valuation) can be more detrimental to business interests than the valuation itself and you’re often better off taking a more modest valuation with vanilla terms than you are taking a higher price with an aggressive legal structure.
Make sure you know what you’re getting yourself into before you sell your soul for a nominal valuation increase and last but certainly not least…
7. Examining your cost base should be the first place you look to avoid dilution.
As always, thanks for reading.
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