Navigating Down Rounds: A Guide for Today’s Startups

Navigating Down Rounds

by Ben Bartlett and Matt Melville

Welcome to the second installment of “A Crash Course on Fundraising’s New Reality.” In this issue, we’ll dive deep into the phenomenon of down rounds, an increasingly common scenario where companies raise funds at a lower valuation than in previous rounds.

What Are Down Rounds?

A down round is an investment round where a company’s valuation is lower than the valuation set in the previous round. This can happen for various reasons, including changes in market conditions, company performance, or broader economic factors.

Why Are Down Rounds Happening More Often?

The current economic downturn has led to more conservative valuations and cautious investment behaviors. This climate has made down rounds more frequent, as investors seek to minimize risk.?In addition, as the valuation trend line decreases, new investors see underpriced assets and opportunities and jump into the market at lower valuations thereby decreasing the valuations more.

The Impact of Down Rounds

?????????????????????????????Founder Dilution: Founders may see their ownership stake reduced unless the down round is combined with a founder true up or similar.

?????????????????????????????Existing Investor Relations: Existing investors may face dilution or altered terms unless they invest additional capital. Down rounds are often accompanied by cram-downs, pull-ups, pay-to-plays and other transactions intended to right-size the company's valuation and restructure its cap table. This typically prioritizes new investors over existing investors.

?????????????????????????????Employee Equity/Morale: Down rounds can send employee equity underwater thereby diminishing employee optimism and confidence in the business.

?????????????????????????????Reputation: Perception of the company in the market may change, affecting future fundraising.

?????????????????????????????Silver Lining: If conducted properly and thoughtfully, a down round can save a company from liquidation, position a company for sustained growth and, sometimes, completely turn a company's prospects around.

Legal Considerations

Down rounds often involve complex legal negotiations that go beyond mere valuation adjustments. These negotiations require a delicate balancing of the interests of both old and new investors, the company, and other stakeholders. Careful consideration of anti-dilution provisions, ratchet clauses, and other contractual terms is crucial. Here’s a closer look at some of the key elements:

1. Anti-Dilution Provisions

Anti-dilution provisions are designed to protect existing investors from a reduction in the value of their shares during a down round. These provisions can take different forms, such as:

• Full Ratchet Anti-Dilution: This allows existing investors to convert their shares at the same price as the new down round, effectively preserving their percentage ownership.
• Weighted Average Anti-Dilution: This takes into account both the price and the number of new shares issued, reducing the existing shareholders’ conversion price but in a manner that’s generally less severe than a full ratchet provision.

2. Ratchet Clauses

Ratchet clauses can provide additional protection for investors during a down round, potentially allowing them to increase their shareholding percentage. However, they can also significantly dilute the founders and other early shareholders, making these clauses a sensitive and complex negotiating point.

3. Other Contractual Terms

Various other contractual terms can come into play in a down round, including:

• Price-Based Warrants: These might give existing investors the right to purchase additional shares at favorable prices in a down round, affecting the overall economics of the deal.
• Voting Rights Adjustments: Changes might be needed to existing voting rights agreements to accommodate new investors.
• Board Composition: New investors might require board seats or specific governance rights, requiring careful negotiation and alignment with existing agreements.

4. Strategic Considerations

Understanding the legal terms is just the start. Crafting an approach to a down round requires strategic thinking about the company’s future, the potential reaction of the market, and the likely dynamics among different shareholders. It often involves crafting unique solutions tailored to the specific situation.

The complexity of legal negotiations in down rounds underscores the importance of expert legal guidance. It’s not just about getting the deal done; it’s about doing it in a way that positions the company for success in the next stage of its journey, preserving essential relationships, and maintaining the necessary flexibility for future growth.

Every clause and provision must be carefully considered and negotiated, aligning not only with the immediate financial considerations but also with the broader strategic goals and dynamics of the business.

Strategies for Navigating Down Rounds

• Transparency with Stakeholders: Clear communication helps manage expectations.
• Expert Guidance: Consult with legal and financial experts to navigate the complexities.
• Align with Investors: Maintain strong relationships with current investors and align on mutual goals.
• Assess Alternatives: Consider other fundraising options, such as bridge financing or strategic partnerships.

Case Study: Navigating a Down Round

Background:

Company X, a promising tech startup, was poised for growth and had successfully completed a Series B round at a $100 million valuation. But as the economic downturn hit, their market faced unexpected challenges, and revenue projections were slashed. Faced with the need to raise additional capital, Company X found itself navigating a down round.

Challenges:

• Valuation Concerns: Investors were cautious, leading to a proposed Series C valuation of $75 million, significantly lower than the previous round.
• Existing Investor Relations: Older investors had rights that needed careful negotiation to avoid discord.
• Employee Equity/morale: Staff had been promised stock options at higher valuations, and morale was at risk.

Strategies and Solutions:

• Transparent Communication: Company X openly discussed the situation with existing investors, explaining the need for the down round and seeking their support.
• Legal Expertise: They engaged experienced legal counsel to navigate complex anti-dilution provisions and ratchet clauses, balancing new and old investors’ rights.
• Employee Engagement: Leadership communicated openly with employees, restructuring stock options and aligning them with the new reality.
• Strategic Partnerships: They leveraged existing business relationships to secure additional support and validation, which helped in the fundraising process.

Outcome:

Company X successfully closed the Series C round at the $75 million valuation. Although painful, the down round provided the necessary capital to continue operations and pivot strategies. With a renewed focus and aligned stakeholders, Company X moved forward, leveraging the down round as a learning experience and opportunity for growth.

This case study underscores that down rounds, while complex and challenging, can be managed with clear communication, expert guidance, and strategic thinking. Company X’s experience serves as an illustrative example for others facing similar challenges in the current investment landscape.

Conclusion:

Down Rounds, while challenging, are not the end of the world. With proper guidance, strategic thinking, and transparency, they can be managed and may even offer unique opportunities for growth and collaboration.

Whether you’re a founder bracing for a down round or an investor seeking to understand the landscape, understanding the dynamics of down rounds is key in today’s investment environment.

Stay tuned for our next issue, where we’ll explore “Pay-to-Plays” and other related topics. If you have questions or need personalized assistance, feel free to reach out.