Navigating Down Rounds: Strategies for Startups and Investors

In the world of startups and early-stage investments, the term "down round" carries a weight of concern and hesitation. A down round occurs when a startup raises funds at a valuation lower than its previous financing round, signaling a decrease in the company's perceived value and, at times, distress.

In this entry on Navigating the Startup Apocalypse, we'll delve into the intricacies of down rounds, why they happen, and explore alternatives that startups can consider before exploring this route, and what to expect if you are going through one.

Why Do Down Rounds Happen?

You may have heard of the successful startup Ramp recently announced down round. Down rounds can be triggered by various factors, and understanding these reasons is crucial for both founders and investors. Amongst the few factors:

1. Failure to Meet Growth Targets: Many startups operate on the premise of rapid growth. Consistently missing growth milestones can erode investor confidence and lead to a lower valuation in the subsequent round.

2. Loss of Competitiveness: In competitive markets, falling behind dominant players can result in a reevaluation of a startup's worth. If competitors outperform or capture market share, it can affect the startup's valuation.

3. Macroeconomic Trends: Broader economic conditions, such as rising interest rates or a bear market, can significantly impact startup valuations. Economic downturns, like the one experienced in 2022, led to several down rounds in various industries.

Implications of Down Rounds

Down rounds come with several implications that affect both startups and investors:

1. Dilution of Ownership: Startups often need to issue more shares in a down round to raise the required capital. This increased share issuance results in a dilution of ownership for existing shareholders and founders.

2. Employee Morale: Employees of startups often receive compensation in the form of equity or stock options. A down round can lead to a decrease in the value of their equity, potentially affecting employee morale and retention.

3. Founder Motivation: Founders' equity stakes may become significantly diluted in a down round, potentially diminishing their motivation and commitment to the company.

4. Investor Confidence: Down rounds can create doubts among investors about a startup's prospects, making it challenging to secure future funding.

5. Company’s Runway: As most of the time down rounds are a reflection of distress, companies raising at lower valuations can potentially extend their runway during difficult macroeconomic conditions. This can be seen as a “lifeline” for the company’s operations.

As seen, there is a valuation event involved. It is of utmost importance for founders and investors alike to understand and perform a formal valuation assessment of the company to understand the implications of a down round, and expected dilution, among other factors discussed below.

Make sure to check out the journal entries on valuation methods such as the Venture Capital Method, the Scorecard Method, and the Berkus Method.

Alternatives to Down Round Funding

While down rounds may seem like an inevitable path, startups have several alternatives to consider:

1. Reducing Burn Rate: Startups can cut costs to extend their runway, delaying the need for a down round. This may involve difficult decisions such as layoffs and cost-cutting measures.

2. Bridge Rounds: Bridge financing, often in the form of convertible notes or SAFEs, can provide short-term capital to buy time for improved market conditions or hit growth milestones. A recent popular fundraising alternative is through equity crowdfunding via platforms like WeFunder.

3. Debt Financing: Instead of equity, startups can explore debt financing options like mezzanine loans, venture debt, or convertible notes. Debt financing does not require a formal valuation exercise.

4. Investor-Friendly Terms: Offer investors more favorable terms, such as higher liquidation preferences, dividends, or protective provisions, to mitigate their concerns about increased risk.

5. Explore Strategic Partnerships: Seek joint ventures or partnerships that can provide capital without necessitating a down round.

Key Considerations Before a Down Round

When contemplating a down round, a startup's board of directors and/or Chief Executive Officer must carefully evaluate several critical factors:

1. Exploring All Alternatives: Exhaust all viable capital-raising options before committing to a down round. Consider debt financing, strategic partnerships, or courting new investors at a flat or increased valuation.

2. Understanding Impact: Assess how the down round will impact the capitalization table, considering anti-dilution provisions and investor protections.

3. Negotiating Investor Cooperation: Engage in discussions with existing investors, especially those with anti-dilution protection, to seek cooperation or waiver of protections.

4. Governance and Approvals: Ensure the down round complies with corporate governance practices and gains the necessary approvals to protect the company's interests.

5. Market Conditions Documentation: Document market conditions and industry trends that justify the need for a down round, helping to establish valuation and protect against potential disputes.

6. Outside Investor Leadership: If possible, involve a new outside investor to lead the down round, set the terms, and provide objectivity.

Example of a Startup raising a down round

As an academic, I believe in the value of practical perspectives. Let's walk through a simplified mathematical example of a startup raising a down round. In this scenario, we'll consider a startup that has already completed one funding round and is now facing a downturn due to certain challenges.

Initial Funding Round (Seed Round):

• Startup valuation: $5 million

• Number of shares issued: 1 million

• Price per share: $5

The startup successfully raised $5 million in its initial funding round by selling 1 million shares at a price of $5 per share. After this round, the ownership distribution among the founders and investors looks like this:

• Founders' ownership (pre-investment): 100%

• Investor ownership (post-investment): 0%

• Total ownership post-investment: 100%

Down Round Scenario:

Now, let's fast forward to the down round. Due to various challenges, the startup's valuation has dropped, and it needs to raise additional capital to continue its operations. In this example, the startup's valuation in the down round is $3 million.

• Startup valuation (down round): $3 million

• Number of shares to be issued (to raise $2 million): Unknown

• Price per share in the down round: Unknown

Here, the startup needs to raise $2 million in the down round, but the price per share and the number of shares to be issued are unknown at this point.

Let's say the startup's founders and investors agree to a down round where they sell additional shares at a lower valuation:

• Number of shares issued in the down round (to raise $2 million): 1 million shares

• Price per share in the down round: $2

Now, let's calculate the ownership distribution after the down round:

• Founders' ownership (pre-investment): 100%

• Investor ownership (post-investment): Unknown (depends on the number of shares they purchase)

• Total ownership post-investment: 100%

In this down round scenario, the startup raised the required $2 million by issuing 1 million shares at $2 per share. The ownership distribution among the founders and investors would depend on how many shares each party purchased in the down round.

Please note that this is a simplified example. In real-world situations, the ownership distribution can be more complex due to factors like anti-dilution provisions and negotiations between founders and investors.

Dr’s Order #8:

A downround is a humbling experience, but it does not have to be a death sentence. It should be seen as a necessary step to strengthen operations and as a means to grow lean but steady.

The Wrap-up

Down rounds are generally seen as unfavorable events in the startup world, but they can sometimes be necessary to secure the capital needed for a company's survival and growth. Startups should explore alternatives and consider the implications before opting for a down round.

In a constantly evolving business landscape, adaptability and sound decision-making are essential, and understanding the intricacies of down rounds and their alternatives is a valuable tool for founders and investors alike.

Finally, subscribe to my journal as I look to address these other methodologies and help founders and investors with the required toolbox (or set) of techniques to properly and consciously navigate these difficult times.