What is a down round?
Have you ever wondered - what is down round financing? And more importantly, how can it be avoided?
A down round is essentially raising money at a lower value. During a down round, investors purchase equity in the business at a lower price in comparison to previous rounds. Down rounds happen fundamentally because your investors have an altered perception of what they believe the value of your business is. This can be for a variety of reasons including, increased competition, lack of execution of goals set in previous rounds, a shift in your market or general economic conditions. Or because you raised funds at unrealistic valuations in previous rounds.
In a down round, you’re simply selling your shares for a lower price than in previous rounds. The requirement for capital will not have reduced (and likely increased as you won’t have hit your targets) so the result will be that you will need to grant more shares for the same cash and suffer more dilution than initially intended.
However, when a down round is needed, it can have a knock-on effect of being quite demoralising for your team as it can signal that you haven’t delivered on what would have been expected and intended previously. Generally, it’s a negative indicator to the market and investors and can lead to a loss of confidence in the company, founders and management. A down round can also indicate to your team that the business is not in a solid position making things look unstable.
What you need to know about a down round
While not ideal, a down round can happen and often isn’t the end of the world. flinder CFO Dave Eaton says,
“If you can secure the capital needed to execute the milestones you need, albeit at a lower valuation which gets your company evolution and funding journey back on track, then it’s a valid solution and keeps the show on the road.”
It’s widely accepted that there were some fairly lofty valuations in 2021 and that a degree of normalisation of those valuations is taking place at the moment in the tech funding world. Add to that a generally gloomy economic outlook and down rounds are likely to become much more common in the medium-term.
How to avoid a down round
Can you avoid a down round? Is there a way to insulate against it? In some cases, yes, you can. Dave offers, “Don’t get lured into false valuations. You should be planning your funding journey so think through what the next round will be, at what stage you will be at by then and on that basis, what valuation is achievable for that next round. Set today’s valuation with an eye on the next round or two and how the enterprise value will evolve.”
It’s a case of prevention is better than having to find a cure so think ahead to avoid a down round.
Equally, cutting costs to have a leaner operating model helps protract and protect your runway and can see you through until you reach your milestones and your valuation can continue going up. It’s about being smarter with your revenue.
Other steps you can take to avoid a down round:
- Seek bridge financing: if you know that your cashflow problem is only temporary, a bridge under the form of a convertible note can be a workable solution to keep things going.
- Renegotiate with investors: try renegotiating the terms of a round. Removing the anti-dilution protection from investor terms by exchanging these rights for other investor perks, investors who believe in what you do want to see you succeed. Note: Anti-dilution protection is how investors protect themselves in a down round and is triggered when the conversion price for a round is less than the conversion price from the previous round.
- Changing approach to slower, more sustainable growth is a tactic when markets are depressed. This is about shifting the business model from one of grow at all costs, to one focused on profitable growth.
Also, know that down rounds are often listed on down round trackers for VCs to see as well so that’s something to bear in mind.
What you should consider
Knowing what a down round can signal to investors and the market as well as your employees, you should consider your entire investment journey before agreeing any funding. With careful review of your investment steps ahead and being realistic about valuations and your operating model, you can make sound decisions and avoid any demoralising decreases in business value.
How are you planning your strategy to avoid the need for a down round?