What is a down round in startup financing?

Startup round inflation skyrocketed in 2021 when the median for a Series A reached $ 13 million (a 30% increase from 2020), and venture capital investments saw a 92% year-over-year increase. Things are shaping up somewhat differently now, though.

Many founders, employees, and investors who profited from inflated startup valuations in 2021 may be forced to endure down rounds in today's market. We've already seen some significant declines in 2022, as valuations of prominent companies like Stripe, Klarna, or Canva dropped by a few dozen percentile.

Interest rate rises, geopolitical tensions, and public market downturns are among the factors that had the most impact on private market valuations in 2022. This year, the situation continues, as the recession fears keep investors relatively frugal. The final quarter of 2022 saw a staggering 63% decrease in startup investments.

How can founders prepare themselves for the imminent economic turbulence ahead and find ways to avoid a down round? Let's start by analyzing what a down round is, studying its implications on the startup financing process, and examining alternative courses of action for founders.

• When a startup conducts a "down round," it sells new shares at a lower price than it did during the prior round of financing.
• Down rounds are prevalent when a company fails to meet its business goals. The milestones may include product-market fit, shipping a product or service, revenue generation and reaching profitability, production output,etc.
• A down round can result in stock dilution (lowering the percentage of ownership) for investors, and have a detrimental effect on employee morale and how it's perceived in on the market.

A down round happens when a company raises capital at a valuation that is lower than its previous round of funding.

This can occur when a company is struggling to meet performance milestones or when market conditions have changed.

Down rounds can be challenging for private companies because they can lead to dilution of existing shareholders’ equity and can signal to potential investors that the company may be in financial trouble.

Down rounds occur for a number of reasons, but here are the most common ones.

• Failure to meet business goals. When a startup struggles to reach product market fit, get clients, and ship products on time, it will inevitably fail existing investors’ revenue and growth expectations. This will result in lowered growth projections and a corresponding reduction in the company's value.
• Overvaluation. Company valuations may have initially been overestimated during its previous round of funding, and as the market and industry conditions change, the company’s true value becomes clear.
• Unfavorable macroeconomic environment. Increased interest rates, inflation, recession, and decrease in spending are all important economic factors that can cause a decreased appetite among investors.
• Challenging competitive environment. When a particular niche or industry gets saturated with other competitive solutions, it can lower a startup's ability to properly establish a sufficient market share, which influences the valuation of the company.

One of the main implications of a down round is that existing stockholders will see their equity diluted. When a company raises capital at a lower valuation, it is issuing more shares to investors, which can lead to existing shareholders owning a smaller percentage of the company. This can be difficult for early investors and employees who may have invested significant time and resources in the company.

Another challenge of a down round is that it can signal to potential investors that the company may be in financial trouble. If a company struggles to maintain or increase its valuation, it may be a red flag for potential investors. It can make it more difficult for the company to raise capital in the future and make it more challenging to attract new investors or partners.

Finally, down rounds can take a toll on employees, as startups often promise equity grants and stock option plans to provide extra incentives. Employee morale can be diminished when they hear that their company needs to raise money at a lower price.

Anti-dilution provisions are clauses built into preferred stocks that protect investors whenever a down round happens. These clauses help investors mitigate the risk of financing high-growth and high-risk companies.

Anti-dilution provisions kick in when a round's conversion price is lower than the initial round's. When a company raises money, an anti-dilution clause will increase the number of common shares to which each preferred share converts.

Why is this important?

Because investors have two options for cashing out if there is a liquidity event, they either convert their preferred stock to common stock and share proportionally or retain their preferred shares and get their liquidation preference before the common stock holders receive their profits.

There are two types of anti-dilution provisions:

• Full Ratchet. Full-ratchet anti-dilution is the approach that is both the simplest to compute and the one that is used the least. For owners of preferred shares, the conversion price will be set at the level of the preferred share price that is the lowest. For example, if the original conversion price was $10 and it would decrease to $5 in the following round, the original conversion price for the investor would change to $5.
• Weighted Average. This anti-dilution provision is by far more common, and it uses the weighted average price of what all investors have paid, to determine the new conversion price. The formula is following:

Where:

C2 = new conversion price

C1 = previous conversion price

A = total amount of outstanding shares before the new financing round

B = total consideration received by the company for the new issue

C = total amount of new shares issued

Startups unable to raise money sustaining previous valuations have more than one alternative available to them besides down rounds that result in anti-dilution adjustments. Here are some of them:

1. Bridge Financing. It's not uncommon for startups to struggle in the early stages of their growth. Sometimes all that is required to bring a company out of a rough patch is a short-term financial injection. Convertible note financing is a straightforward answer to this problem; when the notes are converted into the next round of funding, they often do so at a discount to the price of the following round. In many instances, this solution is a good one to pursue, despite the possibility that it may just serve to postpone rather than resolve the issue of value.
2. Reduce your burn rate. This alternative may not always be applicable, as you could potentially hurt the company's growth if you seek savings in the wrong places. However, if you have enough cash in the bank, reducing unjustified spending could give you enough leeway to reach your revenue targets or wait out the macroeconomic turmoil.
3. Renegotiate. Founders often engage in negotiation with investors to lessen or eliminate anti-dilution measures. The degree to which management—often the company's primary common stockholders—will be properly motivated to continue devoting their time and energy to the firm's operation due to their post-financing equity ownership is an important consideration.

In conclusion, a down round can be a challenging event for a startup company, but there are situations when it may make sense.

A company may need more capital to continue operating, make a significant investment to stay competitive, be looking to bring on a strategic investor, or be looking to restructure its business model or operations.

In these situations, a down round may be necessary to provide the company with the capital it needs to move forward.