What Is a Down Round?
A down round refers to a private company offering additional shares for sale 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 is lower than it was prior to the previous round of financing. This “discovery” forces them to sell their capital stock at a lower price per share.
Understanding Down Round
Private companies raise capital through a series of funding phases, referred to as rounds. Ideally, the initial round should raise the capital needed where subsequent rounds are not required. At times, the burn rate for startups is much higher than anticipated, leaving the company no other option than to go through another round of financing.
As a business develops, the expectation is that sequential funding rounds are executed at progressively higher prices to reflect the increasing valuation of the company. The reality is that the actual valuation of a company is subject to variables (failure to meet benchmarks, the emergence of competition, venture capital funding) which could cause it to be lower than it was in the past. In these situations, an investor would only consider participating if the shares, or convertible bonds, were being offered at a lower price than they were in the preceding funding phase. This is referred to as a down round.
While the earliest investors in startup companies tend to buy at the lowest prices, investors in subsequent rounds have the advantage of seeing whether companies have been able to meet stated benchmarks including product development, key hires, and revenues. When benchmarks are missed, subsequent investors may insist on lower company valuations for a variety of reasons including concerns over inexperienced management, early hype versus reality, and questions about a company’s ability to execute its business plan.
Businesses that have a clear advantage over their competition, especially if they are in a lucrative field, are often in a great position for raising capital from investors. However, if that edge disappears due to the emergence of competition, investors may seek to hedge their bets by demanding lower valuations on subsequent funding rounds.
Generally speaking, investors compare the product development stage, management capabilities, and a variety of other metrics of competing companies to determine a fair valuation for the next funding round.
Down rounds can occur even when a company has done everything right. To manage risk, venture capital firms often demand lower valuations along with measures such as seats on the board of directors and participation in decision-making processes. While these situations can result in significant dilution and loss of control by the founders of a company, the involvement of a venture capital firm may provide what the company requires to reach its primary objectives.
Implications and Alternatives
While each funding round typically results in the dilution of ownership percentages for existing investors, the need to sell a higher number of shares to meet financing requirements in a down round increases the dilutive effect.
A down round highlights the possibility that the company might have been over-hyped from a valuation standpoint initially and are now reduced to selling their stock at what amounts to a discount. This perception could negatively affect the market’s confidence in the company’s ability to be profitable and also deal a significant blow to employee morale.
The alternatives to a down round are:
- The company cuts its burn rate. This step would only be viable if there were operational inefficiencies else it would be self-defeating in that it could hamper company growth.
- Management could consider short-term, or bridge, financing.
- Renegotiate terms with current investors.
- Shut the company down.
Due to the potential for drastically lower ownership percentages, loss of market confidence, negative impact on company morale, and the less than appealing alternatives, raising capital via a down round is often viewed as a company’s last resort, but it may represent its only chance of staying in business.
- A down round refers to a private company offering additional shares for sale at a lower price than had been sold for in the previous financing round.
- Company valuation is subject to variables (failure to meet benchmarks, emergence of competition, venture capital funding) causing it to be lower than it was in the past.
- Down round could lead to lower ownership percentages, loss of market confidence, and negatively impact company morale.