Writing about down rounds in a bull market feels like shopping for an umbrella in this historic California drought. You are bound to get some strange looks if you walk into a department store and ask for an umbrella. I also bet that once we hit our El Nino winter we will suddenly have a shortage of umbrellas. In other words, it pays to be prepared. When the current market climate does change, capital will become more scarce and will put downward pressure on valuations. Historically, the frequency of down rounds has always spiked during bear markets.
Practically speaking, down rounds are very simple events in which the valuation of a subsequent capital raise is lower than the previous capital raise. It creates minor legal and financial complexity, but any lawyer or investors can easily navigate that complexity. It is likely that the previous investment round negotiated an anti-dilution provision. This simply means that there will be additional dilution from the previous round in addition to the current round. Therefore it is safe to assume that a down round can be more dilutive than a founder would prefer. But you got your capital in, you have a new investor, and you can go back to executing, right? Wrong.
It turns out that the reality of a down round is much grimmer. Investors buy momentum and a company that is raising a down round is perceived to have lost that momentum. Over two-thirds of investors will automatically pass. They may give you various other feedback which will make a fundraise that much more difficult and confusing. Those that would consider a down round will likely want additional concessions. They may ask existing investors to reduce their existing preferences. They may want materially better terms than your existing investors. They may have strong points of view about needed changes with strategy or management. And they will use their leverage to get what they want. They know that a down round is rarely competitive.
Life inside a start-up can be even worse. Startups are like sharks. They need to keep moving, water flowing over the gills breathing life into the animal or risk sinking. A down round feels like a pause in that movement, or worse, a step backwards. Founders often become disenfranchised. Employees get poached for higher momentum opportunities. Infighting occurs and overall market opportunity comes under scrutiny. Existing investors become anxious leading to micro-management by the board. Everything becomes more difficult.
A down round can occur to anyone, but a mindful founder can minimize the risk. Making sure that you raise at a reasonable valuation today will do a lot to ensure that you do not have this challenge tomorrow. Of course a smart reader would highlight the hypocrisy of investors recommending lower valuation. After all, that maximizes their interest and not that of the founders. But there is lots of room between minimizing and maximizing valuation.
When you raise, ask yourself, can you achieve profitability with the current capital? If the answer is yes, you know that you never have to raise again and will be in no risk of a down round (so do everything you can to maximize the valuation).
Many companies will need more capital though. If your company is one of those create a very conservative plan and find the point where you will likely need to raise again. What kind of multiple does the market need to support for you to achieve an upround at that point? How likely is that in the current climate? In a steady-state climate? Remember that multiples compress as growth compresses.
We see experienced entrepreneurs do this analysis frequently. They know that they want to maximize their ownership today, but they also know that they do not want to bet everything on one spin of the wheel. After all, building a company is much more of a marathon than a sprint.