What is a “down round” and why would a company settle for these financing terms?
To fully comprehend the circumstances that might lead to a down round, one first needs to grasp how private companies grow. Typically, they will raise capital through equity financing events (known as rounds), in which shares of the company are sold at a negotiated price. The cash infusion from investors helps support growth. If the business matures accordingly, every time the company needs to raise money, it should inherently be worth more, and therefore be accompanied by a higher valuation.
A down round refers to the process in which a company sells shares at a price that is lower than an earlier financing round. In other words, when the pre-money valuation of a given round is less than the post-money valuation of a previous round. A down round implies that the lead investor, or the entity negotiating the term sheet, does not consider the company as valuable as it was in the past.
For Example:
In January 2020 Acme Inc. raised $2M at a $5M pre-money valuation, making the post money valuation $7M. (The initial value of the company is $5M, but after receiving $2M in cash from investors, it’s now worth $7M).
Then in January 2022, Acme Inc. needed more cash to fund the business’ growth, so it returned to investors to raise another $1M. However, the $2M Acme raised previously didn’t create more than $2M of inherent value, so investors tried to negotiate a $6M pre-money valuation.
The 2020 $7M post-money vs. the 2022 $6M pre-money gives this round the distinctive “down round” label. The term sheet dictates that the company is not as valuable as it once was.
While there are many reasons why the dreaded “down round” might become a reality for burgeoning young companies, sometimes they can be seemingly impossible to avoid. It could be the market conditions, the valuation in a previous round was too high, or that the company has not hit key milestones since its last fundraise. In any event, a down round may signal that growth is slowing, which can seriously impact the company’s long-term viability.
Generally, the company and incumbent investors want to avoid a down round and view it as a last resort. It can trigger anti-dilution provisions and voting rights among preferred shareholders and as stated above, may imply that the business is not doing well.
So, while there are some instances in which a down round becomes inevitable, there are a few ways to avoid reaching this decision at the negotiation table.
- Tighten the Belt: If burn rate is the primary driver for raising capital, as opposed to strategic growth, lowering operating costs can help postpone the need for outside money. While it’s not necessarily a long-term solution, it can help stave off the need for an immediate cash infusion until the company is in a better negotiating position.
- Consider a “Bridge” Note: Early-stage investors are no stranger to a bridge note, or in other words, short term debt financing. Typically, this will come in the form of a “convertible note”, which will ultimately convert into discounted shares during the next equity raise. Of course, there are things to consider with the debt terms, like valuation cap, but it allows a company to kick the can down the road. Just make sure that this isn’t a “bridge to nowhere” and that the company remains on the path to success.
- Keep Valuations in Line: One common reason for a down-round is an already overvalued company. While founders and CEOs want the highest valuation possible during any given fundraise, if an early round is significantly overpriced, it will be challenging to come back later seeking an even higher valuation. Make sure valuations are in line with the market and based on comparable revenue multiples or other metrics.
- Observe the Cardinal Rule: a company should start fundraising before it even needs capital in the first place. Nothing weakens a negotiating position like desperation. With this in mind, calculate the burn rate and work backwards when determining the timing of a fundraise. It is always better to be too early than to come to the brink of collapse.
For more information about how we strategically partner with our clients, contact our team today.
Louisa Smith, Associate Vice President
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