top of page
  • Team Growth Navigate

What is Down Round? How Does it Impact Startups and Investors?

Raising a financing round from venture capitalists with a lower pre-money value than the post-money value of the prior round is known as a down round.

This means that the valuation of the company has decreased, which can raise several questions and concerns among investors, founders, and stakeholders. Down Rounds are not uncommon, and they can happen for various reasons, such as changes in market conditions or a company's financial performance.

According to PitchBook, the proportion of flat and down rounds as part of all completed rounds rose to 15.4% in Q1 2023, with down rounds making up 7.5%. This is up from 5.2% in Q1 2022.

Why do Down Rounds Happen?

Understanding the reasons behind a down round is essential. Several factors can lead to a company's valuation decreasing:

  • Market Fluctuations: Economic conditions and market trends can have a significant impact on a company's valuation. If there is a downturn in the market, it can lead to a decrease in a company's perceived value.

  • Performance Issues: If a company is not meeting its financial projections or experiencing operational challenges, it may result in a lower valuation during the next funding round.

  • Investor Sentiment: Sometimes, investor sentiment can play a role. If current investors are not confident in the company's prospects, they may be reluctant to invest at the same or higher valuation.

What is Down Round

How does a Down Round work?

Private enterprises often do their capital-raising in "rounds" which are discrete segments of fundraising. If the necessary funds can be raised in the first round, further rounds may be unnecessary. Sometimes a startup's burn rate is significantly greater than expected, forcing the business to seek more funding.

As a firm matures, it is customary to raise capital in a series of "sequential funding rounds" at ever-increasing valuations. A firm's actual value may be lower than its historical high for a variety of reasons (for example, if the company fails to fulfill standards or new competitors enter the market, or if the company receives less venture capital investment). If the price of the shares or convertible bonds is lower than it was in the last financing round, then an investor may consider taking part. A "downround" describes such an event.

Even if a firm does everything perfectly, it may nevertheless have a down round. Lower valuations, board seats, and other forms of involvement in decision-making are common concessions venture capital companies make in exchange for taking on risk. The founders of a business may see a considerable reduction in their stake and a loss of control in such a scenario, but the engagement of a venture capitalist firm may be just what it needs to realize its core goals.

Importance of Understanding Down Round

When a firm has a down round, it may be devastating to its value and ownership structure. The consequence of issuing ordinary stock at a price lower than what those shares had originally been sold for is to dilute the holdings of current shareholders in the company during a financing round of this sort.

Down rounds often entail the issuing of preferred stock, which may come with enhanced voting privileges, liquidation preferences, anti-dilution security, or other features that eventually dilute regular shareholders even more.

For founders with substantial holdings in their firms and investors who have contributed funds over numerous investment rounds, this may be an issue when windfall profits are on the horizon. Because of the stakes involved, this sort of fundraising round has to be managed carefully to keep everyone invested in the company's future.

Impacts of Down Round

Significant and potentially fatal consequences await the firm, shareholders, and the company's founders in the event of a down round. Due to the lower price at which the new common stock is issued, existing investors often suffer dilution throughout these rounds. The following are the most common implications of down rounds.

  • Investors who have participated in many rounds may notice a considerable decline in the value of their holdings as a result.

  • In addition, preferred stock is sometimes issued during down rounds, further diluting common equity holders because of the preferred stock's potential for enhanced voting rights or liquidation priority.

  • Furthermore, this sort of round may have far-reaching effects on corporate culture and morale.

  • Many founders may experience irritation and confusion when the value of their investments in their companies declines.

  • If not addressed, downrounds may harm team morale by making workers doubtful that their efforts will contribute to the company's success.

Let’s understand their implications for the firm and equity holders further in this section.

Down Round Effect on Equity Holders

When a company raises capital in a down round, it affects investors who bought or were given shares at a higher price. When a corporation issues extra shares, the ownership stake of current equity holders is reduced. All parties involved in a downround worry about dilution, or the reduction in the value of their shares as a result of the lower share price.

You should also look at the conditions of prior fund-raising rounds if you're thinking about doing one. Preferential shareholders' contractual protections against dilution may date back to earlier funding rounds.

If your company's value drops in a future round, an anti-dilution clause will allow the investor to acquire additional shares at the reduced price, preserving their original ownership percentage.

Without anti-dilution provisions, an investor's ownership stake and investment value might be considerably diluted. To enhance the result for existing investors in the event of a departure or closure, you may negotiate conditions with them as part of your down round.

Down Round Effect on Startups

Because they often have fewer resources to fall back on during tough financial times, entrepreneurs might find the consequences of down rounds to be especially onerous. If a startup's stock structure and value are drastically changed, it may have trouble obtaining future funding.

When the value of a founder's interest in their company drops, it's natural for them to feel frustrated and unsure about the future. In addition, common shareholders are likely to experience more dilution over time as a result of the issue of preferred stock in down rounds.

In light of these threats, entrepreneurs must be prepared for potential down rounds. They should formally establish a down-round plan with their present investors and clarify the rights and responsibilities of all parties involved in the event of additional external investment.

Additionally, businesses may negotiate other types of remuneration for founders, such as cash incentives or options, to reduce dilution for current equity holders.

Finally, a down cycle might be an opportunity for a firm to take stock of its strengths and identify areas for growth to position itself for long-term success. A down round may be managed responsibly, keeping all investors interested and dedicated to the startup's future, with proper preparation and management.

Down Round Effect on Employees

Shares of common stock are greatly diluted in the event of a down round. This is the most common kind of stock granted to employees. Stock options that have previously been exercised by employees may have been purchased at a price that is greater than the current price.

This might leave employees "out of the money" or "underwater" if they have not yet exercised their options. If the share price doesn't recover, the stock may be worthless. Employees may be dissuaded from exercising their options if the FMV remains low, allowing the underlying equity to revert toward the option pool.

How to Avoid a Down Round?

For both businesses and investors, down rounds may be a harsh but often inevitable reality. Down rounds may be problematic because of their ability to lower valuations and dilute existing shareholders' stakes, but fortunately, some options might assist.

  • Debt financing - The process of taking a loan from a financial institution and repaying the lender with interest and any security they may have required. Startups that need to seek capital but don't want to give up ownership or management control may find debt financing to be a good option.

  • Convertible debt - Another option for companies to explore is issuing warrants, which allow investors to convert their loans into stock at a future date and price that is based on specified benchmarks. If the company's value rises in subsequent fundraising rounds, the investors will benefit from the predetermined purchase price of their shares.

  • Alternate forms of Compensation - Businesses should negotiate alternate types of remuneration, including cash incentives or options, for founders to limit dilution for current equity holders. Avoiding this sort of round and keeping all participants invested in the company's future is generally possible with these preventative measures.

  • Due Diligence - Investors should constantly conduct the necessary due diligence to verify the firm they're betting on has a good business strategy and is making efforts to reduce risks down the road, since down rounds, including a fall in the worth of funds and dilution, are a regular reality for many businesses.

Frequently Asked Questions

1. How does a down round affect company valuation?

A down round significantly diminishes a company's valuation, a consequence of selling shares at a lower price per share than in previous funding rounds. This reduced valuation has a ripple effect, leading to dilution of ownership for existing shareholders, reduced investor confidence, lowered employee morale, and heightened difficulties in securing future funding. In essence, a down round poses considerable challenges for the company, necessitating strategic measures to rebound and regain its financial strength.

2. Are Down Rounds always a bad sign for a company?

Down rounds are not always a bad sign for a company. While they do indicate a decrease in the company's valuation, they can also be a strategic move to raise capital to support the company's operations or growth, especially in challenging times. Down rounds can provide an opportunity for the company to secure necessary funds and reset expectations. It's important to assess the reasons behind the down round, the company's overall financial health, and its potential for recovery. With the right strategy and execution, a company can navigate a down round and position itself for future success.

3. How can a company attract investors after a Down Round?

To attract investors after a down round, a company should focus on transparent and open communication regarding the reasons behind the down round and the steps taken to address them. Developing a strong, realistic business plan that outlines how the new funding will be utilized and the path to profitability is crucial. Demonstrating measurable performance improvements, showcasing market potential, and building trust with potential investors through ethical practices and regulatory compliance are also essential. Leveraging existing relationships, tailoring pitches to address investor concerns, and offering incentives can help rebuild investor confidence and interest in the company.

bottom of page