Understanding Down Rounds

In the world of startup investments, the path to success is often filled with twists and turns, and investors must be prepared for the unexpected. One situation investors can face is the phenomenon known as “down rounds.” Unlike the excitement of funding rounds that boost a company’s valuation, down rounds could potentially be a cause for concern. In this blog, learn more about understanding down rounds.

What Is a Down Round?

In VC, a down round is a situation in which a startup raises funding at a lower valuation than in its previous financing rounds. It essentially means that the company’s value has decreased, which can be a cause for concern among investors. These scenarios often arise due to a variety of reasons, including market downturns, business challenges, or the failure to meet revenue targets.

Down rounds have become more common in 2023, with the percentage of down rounds reaching 21% of all deals during Q2 2023—the first time the percentage of down rounds has surpassed 20% since Q2 2016[1]. However, in a report from PitchBook, only 13% of companies who raised down rounds between 2008 and 2014 were unable to raise additional funding or sell their company[2].

Down rounds can have various implications for startups and their investors. Understanding these implications can be important for investors looking to navigate the complexities of startup investing successfully.

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.

Another factor that has led to an increase in down rounds in some years has been the trend toward 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.

Implications of Down Rounds

Dilution of Ownership

One implication of a down round is the dilution of ownership for existing investors. When a company raises capital at a lower valuation, it typically issues more shares to the new investors, which can reduce the ownership percentage of earlier investors. This means that your ownership stake in the startup could become smaller, and the potential returns from your investment likewise could be diminished.

For example, if you initially invested $100,000 for a 10% ownership stake in a startup valued at $1 million, a down round that reduces the valuation to $500,000 could lead to your ownership stake decreasing to 5%. This dilution can be a concern for investors, particularly if they had invested early in the company’s journey.

In some cases, companies may have anti-dilution mechanisms in place, such as full ratchet or weighted average anti-dilution protection. These mechanisms adjust the conversion price of preferred stock held by existing investors to compensate for the reduced valuation in a down round. They can mitigate the dilution effect by giving earlier investors additional shares, which can help maintain their ownership percentage.

Loss of Confidence

Down rounds can erode the confidence of both investors and stakeholders, including employees, customers, and partners. When a company’s valuation drops, it can signal challenges, mismanagement, or a lack of market interest, which may make it difficult for the company to attract top talent or secure new business deals. It can also trigger concerns among existing investors who may question their initial assessment of the startup’s potential.

Reassessment of Investment Strategy

Investors faced with a down round may consider reassessing their investment strategy for the startup in question. They should evaluate whether the decline in valuation is a temporary setback or a sign of more profound issues within the company. This assessment may involve additional due diligence and communication with the startup’s management team to understand the factors driving the down round.

Diversification may help mitigate the risks of startup investments. When a down round occurs, investors may need to adjust their portfolio strategy to balance the impact of the devalued investment.

Evaluation of Future Funding Needs

Down rounds often signal that a startup requires more capital to reach its goals or overcome challenges. Investors may want to evaluate whether they are willing and able to continue supporting the company through additional funding rounds. These decisions can be made in light of the company’s prospects for recovery and the potential for future growth.

Long-Term Perspective

Investors need to take a long-term perspective when dealing with down rounds. The startup ecosystem is inherently risky, and setbacks are common. While a down round may signal challenges, it’s not necessarily a death knell for a company. Investors may want to consider the potential for recovery, and the resilience of the startup’s business model, before making decisions to exit.

How are Down Rounds Used?

While down rounds can have negative implications, they can still be useful for startup companies. They provide a way for startups to raise capital, even when the company’s valuation has decreased. In some cases, down rounds can be used to provide the company with additional cash flow to help it get back on track. In other cases, they could be used to attract new investors who are looking for a lower risk investment opportunity.

During a down round, the existing investors and the new investors agree on a lower valuation for the company. This lower valuation is then used to determine the price of the new shares that are being sold. The new investors are able to purchase these shares at a lower price, which potentially could give them a better return on investment if the company is able to recover and achieve a higher valuation in the future.

How Are Down Rounds Structured?

The structure of a down round can vary depending on the circumstances of the company and the terms of the previous funding rounds. Some of the main components of down rounds include:

• Valuation Agreement: The first step in a down round is for the existing investors and new investors to agree on a lower valuation for the company. This lower valuation will be used to determine the price of the new shares being sold.
• Issuance of New Shares: Once the valuation has been agreed upon, the company will issue new shares to the new investors at the lower price. The number of new shares issued can depend on the amount of capital the company is seeking to raise.
• Dilution of Existing Investors: The issuance of new shares will result in dilution of the existing investors’ ownership in the company. This means that their ownership will be reduced as a percentage of the total number of outstanding shares.
• Conversion of Convertible Securities: If the company has outstanding convertible securities, such as convertible notes or convertible preferred stock, they may be converted into common stock at the lower valuation agreed upon in the down round.
• Investment Agreement: Once the new shares have been issued, the company and the new investors will enter into an investment agreement that outlines the terms of the investment, including the rights and obligations of the parties involved.

Final Thoughts

Investing in startups can be a risky endeavor, and down rounds are a common part of the journey. While they can be concerning, understanding the implications and taking a strategic approach can help investors navigate these situations. By reassessing their investment strategy, evaluating future funding needs, and leveraging negotiation skills and protective provisions, investors can help mitigate the impact of down rounds and position themselves for the long-term in the dynamic world of startup investments.

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Want to learn more about investing in startups? Check out the following MicroVentures blogs to learn more:

• Embracing the AI Revolution: Hysteria and Opportunity
• Beyond Stocks and Bonds: Exploring the World of Private Markets
• Objectivity Over Conformity: Embracing Trends in Venture Capital
• Demystifying Venture Capital Fund Investing: What Every Investor Should Know

 

[1] https://www.cooley.com/news/insight/2023/2023-08-02-deal-count-and-invested-capital-increase-along-with-down-rounds-and-recapitalizations#:~:text=Despite%20the%20aforementioned%20good%20news,surpassed%2020%25%20since%20Q2%202016

[2] https://www.inc.com/steven-i-weiss/down-rounds.html

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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.