Down Round

What is a down round? 

A down round is a funding round in which a company raises capital by selling shares at a price lower than the shares sold in previous rounds. For example, suppose a company sold 1M shares (10% of the company) at $10 per share in its series a. The company then decides to sell another 1M shares for its series b (10% of the company), but at a price of $5 per share. The company has experienced a down round, because the valuation has dropped from $10M to $5M.

What causes a down round to occur?

A down round can be caused by a number of factors, including but not limited to:

• Poor company performance: If a company is not performing well (e.g. lagging revenue, significantly more expenses, a slowed growth rate…etc.) it may be forced to raise money at a lower valuation. 
• Poor market conditions: If the macro market or the specific vertical that the company is competing in is doing poorly, it will be more difficult for them to raise money at a high valuation because investors are skittish.
• Changes in investor sentiment: Investor sentiment can change quickly, and when it does, it can lead to down rounds. For example, in a rising rate environment, investors become more risk-averse, so they are less willing to invest in startups that have high valuations but also carry a lot of risk.
• Overvaluation: In periods of market expansion, company valuations become stretched or “overvalued”. When the market corrects during a period of contraction, the valuations come back “down to earth”, which often results in a down round. 

What are the implications of a down round?

There are a number of implications that may occur from raising capital via a down round.

• It can signal to investors that the company is not performing well and thus, might make it more difficult for them to raise money in the future.
• It might trigger anti-dilution protection covenants, which would result in the conversion of investors' preferred stock into common stock.
• It might trigger redemption rights, which would result in investors requesting their investment back at the original price or the fair market value of the stock at the time of the triggering.
• It can signal to competitors that the company is vulnerable for attack, which may result in “marketing warfare” e.g. takedown campaigns, PR/Comm blitzes, and more.

Is having a down round a bad thing?

Generally speaking, down rounds are seen as a negative event because they can signal that the company is in trouble. However, some people believe that down rounds are a necessary evil and can be a healthy part of a company's lifecycle. Regardless of which stance is taken, there have been a handful of companies who have raised capital in a down round and went on to have successful exits. Ultimately, it’s up to the company (and its board of directors) to decide whether or not a down round is right for them.

How does a down round affect prior stakeholders?

A down round can have a number of effects on prior stakeholders, depending on the terms of the new round and the provisions included in the prior rounds. One of the major events that may occur is the triggering of anti-dilution protection. See our guide on anti-dilution protection for a more in depth breakdown of how this works and how it affects prior stakeholders.

What happens if you take a down round and your investors have full-ratchet or weighted average anti-dilution protection?

At a high level, if your company takes a down round and your previous investors have some form of anti-dilution protection, their shares will be converted and their strike share will be retroactively adjusted. See our guide on anti-dilution protection for a more in depth breakdown on the specific implications of raising a down round.

How to prevent a down round from occurring?

There is no surefire way to prevent a down round from occurring. However, there are a few things that you can do to minimize the risk:

• Avoid taking more money than you need: Rather than raising as much money as possible, consider taking only the amount of money that you need to reasonably hit your growth targets. This will limit the amount of dilution you experience and limit the number of investors that have anti-dilution protection—ultimately minimizing the impact of taking a down round.
• Be realistic about your valuation & growth targets: When the macro environment is in a period of expansion, it may be easy to overestimate revenue projections to raise capital at a higher valuation. However, when the market corrects and you are no longer able to hit the growth targets you set, and you are in need of capital, you’ll likely be forced to take a down round.
• Consider alternative forms of financing: Rather than raising capital from equity investors and taking a down round, consider pursuing debt financing, or if you generate revenue, seek out a revenue based financing provider to meet your capital needs. 

How to handle a down round if it cannot be prevented?

The most important thing to do if you find yourself in a down round is to be transparent with your investors. Be upfront about the situation and explain why you are raising money at a lower valuation, and how you plan to deploy the additional funding. It is possible that some of your current investors may step in to help by offering bridge financing, or an introduction to a debt or revenue based financing provider. 

How to help your employees following a down round? 

Typically, the perception is that the investors of a company are the “only” ones affected by a down round, but that’s just not the case. The employees of a company can also be affected, especially if their options are underwater (e.g. the current strike price is lower than their strike price). Employee morale is also typically affected by a down round, which can result in attrition. To ensure that your employees are taken care of, you can:

• Issue additional grants: This helps minimize the loss that your employees incurred from the down round and helps with retention (since they come with a new vesting schedule).
• Cash payout for options: You can repurchase the stock options from your employees to provide liquidity.
• Option repricing: You can lower the strike price of your employees options to match the new down-round strike price without impacting the vesting schedule.

Regardless of which path you choose, ensure that you have approval from your board of directors prior to announcing or kicking off your plan.