In an ideal world, every startup would experience positive, linear growth, valuation growing steadily at each round of perfectly planned financing. Unfortunately, nothing in the startup realm is so clean or easy. Revenue targets aren’t always hit, valuations don’t always grow, and financing may not go as planned. When startups aren’t able to reach that next foothold, it can result in down round financing. While down rounds aren’t the end of the world, they do present a challenge for startup teams.
In this post, we will discuss what down rounds are, how and why they happen, and best practices for mitigating the chances of having one.
What is a Down Round?
A down round of funding occurs when a company’s pre-money valuation is less than the post-money valuation of the prior round of funding. Conversely, if the company’s pre-money valuation for the current round is greater than the post-money valuation of the previous round, that is considered an up round.
Down Rounds vs. Up Rounds
Of course, an up round is viewed positively by investors. They signal growth, which in turn, can bolster market confidence in a company. On the opposite end, we have down rounds. Down rounds may signal trouble and shake investor confidence. Investors want their investment to grow in value, and a down round represents just the opposite.
Public vs. Private Market
While down rounds can happen for both private and public companies, they are more troubling for private companies, especially those that are still early stage. Stock prices for public companies fluctuate all the time, and not always for reasons unique to the company. General economic conditions can play a major factor in stock performance; therefore, dips in stock prices may not be reflective of the value of the company itself.
What Causes a Down Round?
Aside from market conditions, there is a myriad of different internal and external factors that might cause a down round. Failing to meet certain milestones or benchmarks (like revenue), new competition within the market and general market cooling on private equity can all lead to a down round of funding.
More recently, another factor that has led to an increase in down rounds has been the trend towards over-valuations, particularly in the tech space. When companies fail to live up to the hype, the market eventually corrects, resulting in a down round.
Consequences of a Down Round
Down rounds can signify a loss of forward momentum, which understandably, rounds can have a significant impact on company morale. And while investors typically have protection from down rounds in the form of anti-dilution provisions, this means that founders will likely have to cede their own equity.
Minimizing the Chances of a Down Round
There is no sure-fire way to avoid a down round, but there are ways to minimize the risks of having one. Generally, it’s prudent to raise what you need to reach goals and keep a handle on your burn rate to avoid having to continually raise. And while it can be exciting to raise funds at a massive valuation, it can set startups up for trouble later down the road if they can’t live up to that overblown valuation. By taking a more conservative approach, startups can mitigate the likelihood of down round.
In the startup world, one certainty is that things will not always go according to plan. Down rounds are not ideal, but one positive to consider is that capital is still being raised, even if under imperfect conditions.
The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.