Many public tech company valuations have fallen significantly this year – for example, Facebook’s share price was $223 in May, and was $99 on Friday. This has cascaded down into the startup market, especially Series B, whilst Series A and Seed are still adjusting. The goalposts have shifted: ventures with metrics strong enough for a Series A in 2021 are now only able to raise a Seed. No up cycle lasts forever. Down rounds are happening for this reason.
What is a Down round? A Down round refers to a company offering additional shares for investment at a lower price than had been sold for in the previous financing round. Simply put, more capital is needed, and the company discovers that its valuation at which investors are prepared to inject cash is lower than it was at the previous round of financing.
Everything has slowed down. There are fewer pitches, longer diligence cycles, stretched-out decision making timelines. Investors are sticking their focus on their portfolios or sitting out until they believe we’ve hit bottom. Indeed, it’s no longer cool to dabble in Web3. A risk for founders right now is taking a lot of meetings with investors that aren’t actually investing. Last week I got a view from a VC: You have to talk with 3x more VCs to raise 1/2 the round at 1/2 the valuation.
It’s finding growth funding amidst uncertainty. The consumer internet and frontier tech segments have delivered slower revenue growth amid declining consumer confidence slowing demand. Fintech and healthcare holding strong, though multiples for fintech have come down considerably at later stages. AI/ML? No longer acronyms, very real.
Tech is no longer a vertical category but horizontally integrated into every aspect of the economy. Since I’m glass half full person, I continue to remind folks during rocky times that some of the best tech companies were born out of adversity. Meanwhile, many late-stage startups, still flush with cash from the 2021 funding spree, may be putting off new raises until signs of market recovery emerge.
One of the key things to keep in mind is that we are scaling down from extremely giddy heights, as 2021 surpassed prior funding records by a long shot. We see it best in SaaS, the darling of the raging bull market. Multiples are close to 75% down from a year ago – that means each pound of ARR is valued at just a bit more than 25% of what it was last year. But while a 50% year-on-year funding decline makes an alarming headline, given the dry powder in the coffers of venture investors, it’s likely they’ll begin spending once consensus emerges around valuations and exit conditions improve.
The impact is playing out before us. We’re seeing promising startups who spent their seed round to generate early traction, not have enough traction to set them up for a Series A currently given the higher bar. These companies face a virtuous spiral of despair: they are running low on cash; prospective new investors want more proof, particularly given the previously high seed valuation; existing investors want to stay diversified and not go again. These companies’ futures are rapidly being called into question.
All things being equal, if your startup valuation doubled in the past year, it’s now worth half of what it was. You’re back where you started. Are you sure you’re worth what you were in the last round? Just ask your existing investors. They’ll know, or at least have an informed opinion. So many early-stage ventures are now facing a Hobson’s choice between trying to maintain the high-flying valuation they established – no matter the contortions necessary to do it – or conducting a Down round based on a lower valuation.
Removing the emotion, frustration, and optics of a Down round – previously regarded as a ‘funding of last resort’ scenario – I suggest this makes more sense where a company needs capital than trying to rabidly cut costs to extend the runway. A founder and her board need to bite the bullet and adjust the company’s valuation downward. Founders and their investors are hesitant to reset valuations because no one yet knows how long current conditions will last, but it’s just doing a clean resetting at whatever the valuation so that everybody is aligned and dealing with reality today.
It’s a much better option restructuring your cap table rather than trying to maintain an artificially inflated price and stress the cash runway. That’s a recipe for disaster. Instead, give yourself the chance to raise additional capital in the future when conditions have improved, and don’t forget, the people who are working for the business today maybe disappointed with their option being under water, but going forward they are the ones that are accruing the value. Given the alternative to a Down round today may be no round at all, it’s like the old Brazilian saying: If it fell into the net, it’s fish. Weather the storm and live to fight another day.
In the months since the winds shifted, the messaging to startups has been to reduce burn and do it quickly by laying off employees, shelving projects, freezing R&D and slashing other expenses to become more self-sustaining. But from chasing growth, many startups won’t be able to shift gears fast enough. They’ll need to raise more capital, and start over from a valuation standpoint, that’s simply damage limitation compared to a Down round taken with a growth mindset.
Whilst Down rounds are no one’s preference, they do give original investors the opportunity to lower their average cost of investment. If it’s poor company performance that is forcing the Down round, then you reap what you sow from failing to deliver to previous investor promises. However, if the business has performed well and the fundamentals remain intact, and your valuation is a victim of the macro-economic situation, then take the cash and go again. It’s an opportunity to execute your strategy and gain completive advantage.
Moving quickly is best, too, especially if a startup is executing the business plan but not outperforming it and has maybe six months of cash runway. Assume that things will get worse from here, and that it’s going to take you twice as long to raise half as much money as you’re looking for. Founders never want to be in a position where you’re three months out, trying to raise money. People will smell blood in the water.
The Down round conversations reflect the end of the ‘denial’ phase and the beginning of the ‘acceptance’ phase’, referring to the initial disbelief many founders had about the sudden change in the fundraising environment. Down rounds are accompanied by many unique features in addition to lowered valuations that can adversely affect the stakes of founders, employees and early-round investors alike, so let’s look at the key features and consider how they could apply to you.
Tranched Financings To de-risk their investments and capture more upside from future growth, investors will often tranche their funding by limiting their initial financial commitments and tying additional cash injections to hitting financial performance milestones. Ensure you’ve got a good handle on your numbers in this scenario.
Enhanced Liquidation Preferences To secure their returns, many investors insist on enhanced liquidation preference positions, set at multiples of their investment amount. These liquidation preferences represent the entitlement of the company’s equity in the event of a change of control. Again, ensure you understand the triggers for this, as they can be severe for founders.
Full Ratchets Down rounds are commonly accompanied by full ratchet anti-dilution protection which has the effect of re-pricing the prior round at the lower price at which future financing rounds are consummated. This has the effect for holders of ordinary shares that do not benefit from such protection to bear all the dilution burden caused by the new financing.
Cumulative Dividends The typical dividend is non-cumulative if it is payable at all. In contrast, dividend provisions in Down rounds are commonly cumulative dividends which represent a fixed dividend entitlement that continues to accrue during periods where it is not paid. Again, investors are taking risk, but seek higher returns to compensate ahead of existing investors.
Protective Provisions To address the increased risk of a Down round, investors will negotiate for enhanced protective provisions that give them consent rights, not only with respect to fundamental matters such as a change of control, but also operational items, such as staff hiring and approval of budgets. Investors may demand more than pro-rata representation on the board too.
Director’s duties Under a Down round scenario, greater scrutiny is often placed on the decisions of the directors in negotiating and approving the terms of the round. Directors should pay particular care to their fiduciary duties and implement a thorough process and clearly document its reasons for approving the financing despite the negative effect on existing shareholders, and that ultimately the transaction at hand is deemed to be the best source of funding available to the company.
Companies which accelerate to lofty valuations should be realistic and expect a correction is inevitable at some stage without delivering stellar underlying consistent growth. But how worried should investors and founders be at the prospect of a falling valuation? Investors will be left wondering whether the original valuation was over inflated, whether there were holes in the business strategy or whether the founder simply over-promised and couldn’t deliver.
Sometimes none of these factors are to blame. The tech sector has gone from boom to bust and back again over the last twenty years, and a certain proportion of the valuation of any tech business will reflect the stage of the cycle and the external environment. As all boats rise with the tide, so shall they fall. Investors need to understand the reasons for the reduction in the valuation and founders need to be able to tell the story openly and honestly.
Down rounds are also more likely to occur when founders have pushed for high valuations in their early rounds of funding. The valuation of early-stage is not an exact science and often with new tech innovation it can be difficult to forecast growth. However, in some instances, founders may push for a high valuation early based on overconfidence in their ability to achieve aspirational milestones in unrealistic timeframes.
This often results in the founder losing out, pushed into a Down round leading to a lack confidence among investors. None of these situations mean the business is doomed. It may just indicate there were unforeseen challenges that have since been overcome, although not without implications for the value of the startup. After all, the value of a business is an estimate until there is a liquidity event.
The biggest fear for most investors at the prospect of a Down round is the dilution of equity for founders and employees and being squeezed too tightly, largely because early-stage investors often have anti-dilution clauses which see founders bearing the brunt of the declining valuation when the cap table is reset. Investors will, therefore, be looking to see that founders and employees have enough equity to stay motivated.
A Down round can be a platform for future success when the founder shows a confident, clear path forward. Don’t let it hang over you like a shadow. As Warren Buffet said, it’s only when the tide goes out that you learn who has been swimming naked. Things may look good and rosy up to a certain point, but if a company is leveraged too much expecting a wave to come, but instead the tide goes out, everything will be exposed. If you’ve just been caught by the market sentiment, then simply ride the wave out.
Experienced investors who take the time to understand the founder and the business will be supportive. If handled well, a Down round can be completed with the support of existing shareholders like any other funding round if investors see the value of the investment opportunity. It’s not dissimilar to investing in property when the market has taken a fall. Investors will look for signs that a property will increase in value in the future, and if the fundamentals are right, they will not be put off by a decreased valuation, rather see it as a good opportunity to get in at a healthy discount.