Here’s Everything You Need To Know About Down Rounds

Here’s Everything You Need To Know About Down Rounds

A down round occurs when a startup raises new funding at a valuation lower than its previous round

What Is A Down Round?

A down round occurs when a startup raises a new funding round at a valuation that is lower than its previous funding round. This can happen due to various reasons such as the startup’s inability to meet its growth projections, market conditions or a lack of investor interest.

How Is A Down Round Different From An Up Round?

The answer lies in its name. While both up rounds and down rounds are types of funding rounds, they differ in terms of the company valuation involved. An up round occurs when the pre-money valuation of a startup increases, while a down round occurs when the pre-money valuation decreases.

For example, company X raised a $50 Mn Series B round at a post-money valuation of $200 Mn in 2021. The company closed its Series C round of $70 Mn at a $180 Mn valuation. This means the company has gone through a down round.

Why Do Companies Go For Down Rounds?

Down rounds can happen from a number of internal and external factors. In India, several startups have resorted to down rounds as a result of changing market conditions.

The frothy market of 2020-2021 led to a funding boom triggered by FOMO-driven funding. But as the pandemic receded and the macroeconomic situation worsened, the tides turned. The general investor sentiment became bearish, leaving many startups struggling to secure funding or raise capital at down rounds. 

For instance, In 2022, healthtech startup PharmEasy was in talks with investors to raise $200 Mn at a valuation that could be 15% to 25% lower than its 2021 valuation of $5.1 Bn.

What Are The Consequences Of A Down Round For A Company & Investors?

When a company experiences a down round, it can lead to a decline in investor confidence, which can be damaging in the long run. 

The dilution of ownership caused by such a round can be a major issue for existing shareholders, leading to a reduction of their stake in the company. For instance, if an investor initially invested $20 Mn at a valuation of $150 Mn, and a subsequent funding round resulted in a lower valuation, the investor’s return would be reduced.

This can make it more challenging for the company to attract new investors, raise additional funds and achieve its growth objectives.

How Does A Down Round Affect A Company’s Valuation?

Industry trends show that down rounds have become increasingly frequent among late stage startups that are looking to conserve cash flows. 

Indian unicorns have long been under scrutiny due to their valuation-to-revenue multiples. This ratio is determined by dividing a company’s valuation (either enterprise or equity value) by a specific financial metric such as revenue. 

While there are no strict rules, a high ratio often suggests that a company is potentially overvalued in the market, whereas a low ratio may indicate the opposite. 

What Are The Typical Terms Of Down Round Financing?

Down round financing typically involves a reduced company valuation, which can result in dilution for existing shareholders. Investors may also negotiate for higher liquidation preferences and the restructuring of debt may be required if the company has outstanding debt.

How Can A Company Avoid A Down Round?

Startups can protect themselves from down rounds by following practices such as:

  • Reducing Cash Burn: Startups should use their funds efficiently and effectively and avoid excessive cash burn. Investors are more likely to invest in a company that has a solid financial plan and a clear strategy for using funds.
  • Maintaining Good Communication With Investors: Startups should maintain open communication with their investors and keep them informed about the company’s progress and any potential challenges. 
  • Look At Bridge Financing: If the cash flow problem is temporary, startups can opt for this. 

How Does A Down Round Affect Employees And Their Stock Options?

In the case of employees, their share options may become underwater, indicating that the strike price (the price at which they can exercise their options) exceeds the fair market value (FMV) of the shares. 

Can It Be A Good Thing For A Company?

Even if companies are on track with their business goals, down rounds can still happen and it is not usually a bad thing. For instance, it can attract strategic investors, reduce valuation pressure, simplify the company’s capital structure, align incentives and provide a fresh start. However, companies should still try to avoid it and focus on building sustainable growth and value over the long term.

In some cases, if a company refuses to accept a down round, it may not be able to raise capital at that time, and there is a risk that it may not be able to raise capital at all, which could ultimately lead to its closure.

How Do Investors React To A Down Round?

A down round is generally viewed negatively by investors as it signals a decrease in a company’s valuation. This can lead to concerns about the company’s financial health, leadership and growth prospects.