Find out what a startup down round means, how it works, and whether founders should be concerned about going through one
Raising a round of funding can be an exhilarating time for startups. Startup valuations have been rising, seed rounds today can run into millions of dollars, and the funding slowdown has not stopped some companies such as MiningLamp or DiDi Chuxing from raising massive rounds.
But sometimes, things may not look as bright and sunny. For various reasons, startups in need of more capital may raise a ‘down round,’ often seen as a blow to the company’s reputation and stability.
Simply put, startups raise funds against a valuation of their company. The valuation of a company before a round of funding is called pre-money valuation, and its valuation after the round is called post-money valuation.
Ideally, a round of funding bumps up the startup’s post-money valuation since the company is thought to be worth more because of the incoming dollars. This is called an up round.
In a down round, the pre-money valuation of a company drops to lower than the post-money valuation from the immediate preceding round. This means that investors are buying shares at a lower price than before, and the company is not worth as much as it was before.
For instance, a company with a pre-money valuation of $100 million that raises a $20 million round should be worth $120 post-money. The company would experience a down round if it was valued at $110 million pre-money for a subsequent round. Price per share will drop because its current pre-money valuation is worth less than its previous post-money valuation.
Why Down Rounds Happen
The pre- or post- money valuations of a startup is not an actual realized amount, but rather what the startup is estimated to be worth. This is based on several factors, such as the kind of technology it uses, the problem it solves, competition, and market size.
Startups have been raising incredible amounts of money in recent years, and this wave of funding can lead to a startup valuation bubble, where investors estimate startups’ worth to be much more than probable. At this point, the startup is over-valued , which happens when the numbers are crunched incorrectly, or too optimistically.
Eventually, someone is bound to notice that the numbers do not add up. This is more likely to happen as the company nears its initial public offering (IPO), and it needs to find out what it is actually worth in order to list at a stock exchange.
Even before discussions have reached the IPO stage, what can sometimes happen is that investors may not feel confident about the company’s future performance. This could be because the company has missed benchmarks, has internal governance issues, or is being outperformed by heavy competition.
In such a situation, investors may not be willing to bet as much money on the company’s existing valuation, and will negotiate to buy shares at a lower prices to insulate themselves from the perceived risk potential.
There are also times when a company may have done everything right, and still have to raise a down round. This takes place when the industry as a whole needs to be corrected in terms of valuation, as with tech industry valuations, or the pull factor that makes companies popular become redundant due to black swans such as Covid-19, as can be seen in the cases of travel and hospitality startups.
How Down Rounds Affect Stakeholders
When a startup’s valuation drops, its reputation usually takes the worst hit. The drop in its valuation corresponds to a drop in investor confidence, employee morale, and often, founder motivation.
Another substantial impact of a down round is that it triggers anti-dilution protection measures, meant to protect investors from a drop in share price. When new shares are issued at a lower price than what was offered to previous investors, anti-dilution protection helps these existing investors maintain their share percentage.
This happens in two ways. Under the full ratchet method, investors are either compensated with additional shares to account for the difference in share price, or their shares are converted at the new price for convertible shares. This is bad news for founders, whose stock will absorb the brunt of the dilution.
The broad based weighted average method is seen as a fairer alternative. It uses a weighted average price to adjust dilution for existing investors and founders relative to their ownership, based on factors such as the number of shares to be issued and their price, outstanding shares prior to the raise, and conversion price prior to the raise.
This method distributes dilution a little more evenly and based on startup metrics, so that founders are not put at an extreme disadvantage in the event of a down round. This is important because if founders give up too much equity, raising further funding can become a challenge.
Recent Notable Down Rounds
Venture capital activity was at a 10-year peak in 2018, with a cumulative deal value of $86 billion. The next year, deal value was down to less than half this number. The funding pipeline slowed down significantly.
Now, funding has been reduced to a mere trickle because of the impact of the Covid-19 pandemic, and this has affected cash-strapped startups.
British neobank Monzo announced that it was raising between GBP 70-80 million (around US$88-100 million) in May earlier this year, with shares going at a discount of 40%. The deal would lead to a drop in the company’s valuation from GBP 2 million (around US$2.5 million) in June last year, to GBP 1.2 million (around US$1.5 million) as of May 2020, attributed to the Covid-19 pandemic.
San Francisco-based startup Airbnb, often in the news for disrupting the hospitality industry, also had a down round in April this year, when it announced a raise of $1 million via debt and equity financing via a company statement.
At $26 billion, the startup’s post-money valuation dropped by 16%, from its 2017 valuation of $31 billion. Some reports, however, suggest that its valuation dropped by as much as 50%. The company also had to cut a quarter of its workforce because of the pandemic’s impact on business.
WeWork and Luckin Coffee, two startups that have become case studies for poor governance, have also had a staggering decline in their valuations after reports of severe mismanagement of company funds and inflated valuations surfaced.
Mitigating the Impact of a Down Round
Down rounds are a bitter pill to swallow, but they bode well for the overall health of the startup in the long term. Lean operations and effective management can help founders get their startup back into the valuations race.
It does, however, spell out bad news for investors without anti-dilution protection, founder ownership, and employee stock options. Here are some ways a company can circumvent a down round without having to shut shop (though these are likely to pinch the company the same way as lowered valuations):
1. The main reason a company might raise additional rounds is because it cannot keep up with its burn rate. Cutting down on spending can free some money for business use, but this means taking tough steps such as laying off staff and closing underperforming units.
2. The company can look into alternate funding options such as bridge financing for short term capital requirements, or venture debt, which has been gaining traction in the Asia Pacific region.
3. A softer approach would be to renegotiate terms with existing and new investors to find wiggle room for compromise. Founders will want to be careful, as this could lead to further ownership dilution.
Down rounds do not mean that the company is out of luck. Rather, it is a symptom of the overall health of the company that needs to be addressed for the company to sustain itself.
The bottom line of surviving a down round is to assert ethical governance and address responsibilities to company employees and other stakeholders, making sure that startup management does not repeat the planning and execution mistakes that overhyped their valuations in the first place.
Like most other challenges in the startup journey, think of down rounds as a speed bump, and not the end of the line.