Bearish turns have generally been viewed in a negative light, but a recent Pro rata Axios article raises an interesting point. If everyone raises a down round, does anyone really notice? Do they always have the same negative implications if they occur at all levels? With current conditions making downward rounds more necessary for many startups, it’s time to take a closer look at the downward round and the alternatives.
What is a down round?
Private companies raise funds through a series of investments called rounds. In a perfect world, each cycle should have higher prices as the company’s valuation increases. However, not everything goes to plan, and companies will often pivot, and investors give them a second chance, albeit at a lower price.
Several factors can affect a company’s valuation, including hiring, growth, revenue, emergence of a competitor in the market, and obsolescence, not to mention the overall funding environment. When new investors look at these and other factors, they may determine that the company’s valuation is not as high as it was in the previous cycle.
When this valuation falls below the level of previous cycles and the company still needs additional investment to move forward, it could be looking at a down cycle. During a down cycle, the company will sell shares to new investors at a lower price than in its previous cycle(s).
What are the implications of a turn down?
As stated earlier, down rounds can have a negative perception. They can lead to greater dilution, loss of trust in the company, and lower employee morale. But for some companies, a drop may be the only way to survive, and under current conditions, the need for funding could outweigh these negative factors.
In any investment cycle, founders and previous investors will see a dilution and a reduction in their ownership percentage. As new investors arrive, their share of the pie is reduced. The difference is that in an upside turn, this dilution is somewhat combated by the higher price of the new shares. In a down cycle, this does not happen and the impact of dilution for founders and previous investors is greater.
A down cycle can also trigger anti-dilution protections for investors. These protections are built in for investors because they have a different class of shares than the founders and employees of the company. If the anti-dilution protections were triggered in a bearish turn, their action would be less diluted than that of the founders or the employees.
There are two different dilute protections that can be used in a turn down.
Weighted Average Adjustment: This is the most commonly used protection. In this case, the adjustment is based on the size and price of the lower round compared to the previous round.
Full Ratchet Adjustment: This option provides greater protection for existing investors as it essentially adjusts the price of investors’ previous rounds to the lower price. This means that the shares of founders and employees would bear the brunt of the dilution resulting from the decline.
Regardless of the anti-dilution protection used, there will be accounting implications as these come with reporting requirements. It can also lead to lower employee morale as they see their property disproportionately impacted on investors.
Let’s not forget the impact of a down-round on existing investors. Often, new investors will make their new investment conditional on existing investors waiving their anti-dilution protections. Especially for newsworthy down-rounds, there is a negative impact on reputation. Look no further than the hit taken by SoftBank’s Vision Fund, which invested in Swedish giant “buy now pay later” Klarna in June 2021 at a valuation of $45.6 billion, to see his investment reduced to a seventh of what it was valued in a July 2022 round of decline resulting in a valuation of $6.7 billion, or just 1/7e. Following the announcement, SoftBank CEO Masayoshi Son publicly expressed a shift in strategy, favoring smaller note sizes, lower equity holdings and more numbers.
Are there alternatives to a down round?
There are of course alternatives to a down round, but they don’t always make sense or work in all situations. The obvious solution is for businesses to spend less and operate more efficiently, but if that wasn’t the issue that led to the need for additional funding, it’s not an option.
Startups may also seek to bring in cash through different avenues such as short-term bridge funding, accelerated multi-year revenue agreements with upfront cash payments, government incentives, or revenue-sharing agreements. There is also the possibility of renegotiating with their original investors and, depending on the circumstances, the company could consider closing completely.
Startup CEOs and investors may seek to avoid declines by offering other investor-friendly terms beyond the base price. For example, they may offer liquidation preferences at a price higher than what was paid, accrue dividends, participating preferred dividends, warrant hedging, or issuing additional shares of another security. Startup CEOs can attempt to negate the impact of these incentives on the current management team by pairing them with a new management exclusion plan that guarantees a minimum percentage or amount of the liquidation stack for the direction. It is important to note that vesting conditions could be negotiated immediately or left to be determined at a later date. Buckle up, these are dizzyingly complex negotiations, and consider setting aside a room for an offer of “rights” to existing holders of the common.
“Pay to play” or “pull up” financing mechanisms may attempt to force existing investors to invest more money for fear of being converted into common stock at an embarrassing conversion price. These mechanisms require a new lead investor to invest a portion and some cooperation with existing investors who wish to participate. Put on your helmet, these are very tough discussions.
The valuation of public companies has a direct impact on the valuations of startups and their ability to raise funds. With the markets in turmoil right now, founders need to make the most prudent decisions for their business and look for all the ways to save where they can. But even startups operating at the highest level of efficiency may need to raise additional capital, and under current conditions that could easily be at a lower valuation than they expected.
As we have asked from the beginning, if startups start raising rounds at a higher rate, will they face the same negative impact that we have seen in the past? That remains to be seen. But for the moment, the conditions do not seem to change. This means it’s essential that founders fully understand the potential implications of a funding round and how best to navigate the process to secure the funding they need, while mitigating the negatives that can accompany the funding round. table.