Talking about down rounds in a bull market feels like shopping for an umbrella in this unprecedented California drought. You get some funny looks, but it pays to be prepared.
When the current market shifts, as we know it will, capital will dwindle and shrink valuations. We’ll see down rounds spike, just as they always do when the markets fall. A down round can happen to anyone, but conscious founders can minimize their company’s risk.
Down rounds occur when a company raises capital at a lower valuation than the previous funding round. In addition to jumping through some legal and financial hoops, which any lawyer or investor can handle, you face more dilution. (In all likelihood the previous investment round negotiated an anti-dilution provision, so your dilution is compounded.)
But you got your capital, you have a new investor, and you can get back to business. Right?
The reality is much more grim than just dealing with some dilution. Investors buy momentum, and they see a company that raises a down round as having lost momentum. Two out of three investors will automatically pass.
Those who consider investing will likely want concessions. They may ask existing investors to reduce their preferences, or may request better terms for themselves. They may impose some strong points of view about changes to strategy or management. In any case, they’ll use their leverage to get what they want, because they know a down round is rarely competitive.
The perception of momentum loss within your company can be even worse. Startups, like sharks, need to keep swimming or risk drowning. A down round feels like a pause in forward movement — or worse, a step back.
Founders often become disenfranchised. Employees jump ship for faster moving opportunities. The overall market opportunity comes under scrutiny. Existing investors get anxious, and the board starts to micro-manage. Everything becomes more difficult and wrought with conflict.
The key to avoiding all of this is to minimize the risk of a down round in the first place. Make sure you raise at a reasonable valuation today so you can avoid this challenge in the future.
When you raise a round, ask yourself: Can we achieve profitability with the current capital? If the answer is yes, you know you won’t have to raise again, and face little risk. In other words, you can maximize the valuation without worrying about a down round.
Startups, like sharks, need to keep swimming or risk drowning.
If you find that you’ll need more capital, as many companies do, create a conservative plan and plot the point at which you’ll likely need to raise again. Think about the multiple the market would need to support for you to achieve an up round at that point of fundraising. How likely is that, given the current climate? What about in a steady state climate?
Remember that multiples compress as growth compresses. Calculate value they way investors do: by projecting your revenue and growth rate, and assessing whether your revenue will be greater than the impact of multiple compression over time.
Experienced entrepreneurs do this analysis frequently. They want to maximize their ownership today, but they also don’t want to bet everything on one spin of the wheel. After all, building a company is about playing the long game — as the market inevitably fluctuates, you have to be ready for the storm clouds, umbrella in hand.