What Is a Down Round and How Does It Impact Your Startup?
So you've successfully raised funding for your startup—congratulations!
But what happens if your next funding round values your company at a lower amount than the previous round? This is known as a "down round," and it can be a tricky situation to navigate as a founder. You have to figure out how to keep your existing investors happy while still bringing in new money to keep the lights on. A down round often means your growth hasn't met expectations and you have some work left to do to get your startup back on track. But don't panic—a down round isn't necessarily the end of the world. Many successful companies have gone through down rounds at some point, including Facebook, Twitter, and Slack. Here's what you need to know about down rounds, how to prepare for them, and strategies to emerge with your startup intact.
What Is a Down Round?
A down round refers to when a startup raises funding at a lower valuation than in their previous round. This means existing investors get diluted since the new investors are buying in at a lower price.
Founders, don't panic if you end up doing a down round. It happens to many startups, especially in economic downturns or if growth slowed unexpectedly. The important thing is raising enough capital to continue operating and executing your vision.
Why do down rounds occur?
There are a few common reasons down rounds occur:
- Poor company performance or missed milestones. If you're not hitting key metrics, investors may see more risk and offer a lower valuation.
- Market conditions change. Macroeconomic issues like recessions can impact startups and funding. Investor sentiment may become more negative.
- Running out of cash. If you're running low on runway, you may not have much choice but to raise at a lower valuation to keep the doors open.
- Investor motivation changes. Early investors aim for higher potential returns. New investors may have different motivations and risk tolerances impacting the valuation.
While down rounds are never ideal, the funding can be critical for startups to continue operating. The key is using the capital strategically to get growth and metrics back on track to position yourself for an up round in the future at an increased valuation. Stay focused on executing your vision and build value for a comeback!
The Effects of a Down Round on Startup Valuation
A down round refers to a round of funding where a startup raises capital at a lower valuation than a previous round. This can negatively impact your startup in a few ways:
With a lower valuation, you have less leverage to negotiate the terms of the deal. Investors will likely gain more control and ownership in exchange for their capital. They may demand additional equity, board seats, or more shareholder rights. As a founder, you'll have to give up more of your company to raise the necessary funds.
Reduced Team Morale
A down round can hurt team morale and confidence in the startup's direction. Employees may feel their equity is worth less or worry about job security. It's critical to be transparent about the situation, reiterate your vision, and keep the team motivated. Offer reassurance that the down round is a temporary setback and their contributions are still highly valued.
Down rounds often make it harder to raise capital in the future as investors see it as a sign the company has lost value or momentum. You'll need to work twice as hard to rebuild credibility and attract new backers.
Look for alternative funding sources, double down on key metrics and milestones, and try to raise on improved terms to signal an upward trend. With time and perseverance, you can overcome the stigma of a down round.
The effects of a down round can be managed and mitigated with the right strategy and leadership. Stay focused on the long-term vision, strengthen your team, and keep executing on growth. While a down round may be a temporary stumble, with hard work and determination, it won't define the future success of your startup. Keep your head high—the journey of an entrepreneur is filled with ups and downs, but resilience and grit will see you through.
How a Down Round Impacts Investors and Employees
A down round means raising capital at a lower valuation than your previous round. This impacts investors and employees in a few key ways:
Investors face dilution and reduced returns
Investors from your previous round will see their ownership percentage decrease, diluting their shares. They were expecting a higher return based on the initial valuation, so a down round reduces potential gains. Early investors are often the most impacted since they took the biggest risks.
New investors gain more ownership and control
The new investors putting money into the down round gain a larger ownership stake for less capital. This also means they may gain more control and influence over the company's direction. The founders and previous investors will have to negotiate to avoid losing too much control.
Employee equity and motivation may suffer
Employees who received equity or options as part of their compensation may see the value of that equity decline significantly. This can hurt motivation and retention, especially for key talent. The company will have to work to re-incentivize and retain employees.
Additional down rounds become more likely
Once a startup does a down round, it signals challenges that make future down rounds more probable. Investors see increased risk, so they demand lower valuations. This pattern is known as the "down round spiral" and it's difficult to recover from. The company must show clear progress to restore confidence.
Down rounds are not uncommon, especially for startups, but they should be avoided when possible. Having a well-defined vision, hitting key milestones, and maintaining a strong balance sheet are the best ways to maximize your valuation and avoid the dreaded down round. By understanding the impact a down round has on investors, employees, and the company itself, founders can make better strategic decisions and navigate this scenario if it arises.
Strategies for Startups to Handle a Down Round
When faced with a down round, startups have a few strategies to consider for handling this challenging situation.
Renegotiate the Terms
Go back to your investors and try to renegotiate the terms of the down round to make them more founder-friendly. For example, you may be able to negotiate a higher valuation, get warrants or options, reduce the liquidation preference, or limit other investor protections. Any improvements you can get will help motivate you and your team through this difficult time.
Raise Alternative Funding
Look for other sources of funding so you can avoid the down round altogether. You could pursue angel funding, crowdfunding, venture debt, or apply for grants. While unlikely to cover a full funding round, any amount can help reduce the size of your down round.
Restructure Your Cap Table
This is an opportunity to bring in new investors and restructure your cap table to reduce the ownership of earlier investors. You may offer new investors a large stake in the company in exchange for their investment.
This strategy does come with risks, as earlier investors may feel mistreated, but can be worthwhile if it significantly improves the terms of your round.
Consider an M&A
If funding options seem dire, it may be time to consider acquisition offers.
While not ideal, an acquisition can provide a stable outcome for at least some shareholders and employees. Make sure any offer accounts for the value of your technology, customer base, and growth potential. Don't sell yourself short.
Going through a down round is difficult, but by focusing on renegotiating with your existing investors, finding alternative funding sources, restructuring your cap table, or considering M&A offers, you can navigate this challenge successfully. Stay focused on your vision, learn from your mistakes, and work to make the best of the situation. With hard work and perseverance, your startup can come out the other side in a better position.
So there you have it. You now know what a down round is and how it can impact your startup. While not ideal, down rounds are a reality of startup life and fundraising. The key is to go in with realistic expectations, focus on the long game, and make the strategic decisions that will set your company up for success down the road. Stay optimistic, keep your vision and mission top of mind, and work to build value in your company each and every day. A down round may sting in the moment but if you play your cards right, it won't define the future of your startup. Keep your head high
- the journey is long but rewarding for those able to navigate the ups and downs. With perseverance and grit, you've got this!