What Is A Down Round?

Seeking capital funding when running a private company is a run-of-the-mill task for founders. Businesses tend to receive negotiated amounts of cash injection based on their valuation and growth prospect. However, as conditions change, your company might no longer elicit additional financing at the previous valuation, but rather at a lower price. This is called a down round.?

What is a down round??

A down round is when a private company offers new shares at a lower price compared to the previous round of financing. In other words, at the time of raising capital, the company has a lower valuation than the previous funding round, forcing the executive team to sell the business’s equity ownership at a discounted price per share.?

Operating a startup company is undoubtedly challenging, but you can expect to receive a higher valuation provided the business continues to have a promising trajectory. However, there are scores of cumbersome nuances associated with running a startup that valuation, more often than not, fluctuates owing to different developments.

For example, failure to achieve revenue goals can hamper the enthusiasm of investors, new competition entering the playing field could mean an uncertain growth prospect, and gloomy economic conditions can lower valuation across the board. Under these not-so-desirable circumstances, financiers may only provide funding on the requirement that the sale of shares, or the offering of convertible bonds, happens at a lower price than in the previous funding phase. ?

Furthermore, early investors usually get to enjoy the lowest price when they invest in a startup since the company has yet to prove its business model. But participants who provide subsequent funding phases have the benefit of assessing the startup based on its past performance – whether it succeeded in developing a viable product, securing key personnel, or having reliable revenue. However, as soon as the company shows any sign of struggles – incompetent management, overpromising and under-delivering, or concerns about the soundness of the business plan – investors will demand a lower price from the company.

While one wrong decision from the management team can lead to a less valuable business, an overall precarious economy can force a down round to ensue regardless of the startup’s performance. Throughout the course of 2022, rising interest rates and raging inflation have caused activities and deals in the private market to dry out. Private companies’ valuations slumped while startups had to accept down rounds in other to stay afloat. ?

Implications of a down round

No company relishes the possibility of a down round as it results in some adverse effects. It is first worth noting that a shift in private companies’ valuation differs from that of public firms. Companies that are listed on stock exchanges experience fickle price movements on a daily basis, which is not necessarily indicative of business performance. Startups’ valuation, on the hand, reflects some fundamental changes at the company.?

As a result, a down round can scare off future venture capital. VC entities have to deal with inexperienced businesses, risky endeavors, and illiquid equity ownerships, all the while having to meet limited partners’ expectations and payments. Therefore, venture capitalists hunt for startups with high growth potential and profitable business, and they are particularly concerned about companies willing to raise capital at a discounted share price, which could mean something is failing with the business intrinsically.??

Another consequence of a down round is ownership stake dilution. While offering new shares to new investors will naturally dilute the existing shareholders’ positions, the dilution is more pronounced in a down round. For instance, suppose your fintech startup needs to raise $1 million to sustain the current burn rate. Under normal conditions, you can raise $100 per share for a total of 10,000 shares. However, as the financial industry is having a rough time due to rising interest rates, VC firms only agree to a $50-per-share investment. Meaning, you need to offer 20,000 shares to meet the $1 million capital need. So, instead of introducing 10,000 shares to the pool of the company’s ownership, the number is doubled, making the dilution more severe.

Additionally, investors would not be the only ones worrying about down rounds as lower valuations also affect employees. Personnel in startup companies often receive stakes in the business as compensation. For such reason, every time a down round occurs due to a downgrade in valuation could make the employees’ ownership less valuable. This can lead to the departures of important employees, affecting the team morale and undermining its motivation to continue growing the business.

?Alternatives of a down round

Due to some disadvantageous ramifications of down rounds, you might want to seek other avenues for raising capital, depending on the circumstance.?

The most straightforward measure is to reduce the business’s burn rate. The primary reason why companies require more funding is that their cash outlay outpaces the income stream, or their runway is expected to exhaust soon. Perform a sweeping analysis of the company structure to identify any avoidable expense, streamlining the business operation to save on the precious cash trove. However, too much cutback can curtail the startup’s growth potential.

Management can also resort to short-term bridge financing. Bridge financing is a type of near-term loan that conveniently provides quick cash without demanding equity stakes in exchange. This can be a great option for companies looking for immediate capital to weather short-term struggles while waiting for more favorable long-term deals in the future. Nonetheless, bridge financing typically requires high-interest expenses and demands collateral before approving the loan.?

Conclusion

A down round happens when a private company offers sales of shares at a lower price than the previous financing round. This can be due to different reasons, such as failure to meet benchmarks, the emergence of competition, or challenging economic environments. Down rounds can deter interest from the market because of the lower valuation and affect employees’ morale. However, often the company doesn’t have a choice but to accept a discounted price, otherwise risks going out of business.