Are you ready for the coming wave of VC down rounds?

As North America slowly begins to reopen after nearly two months of sheltering in place and business lockdowns, startups that paused fundraising are starting to get back into the game. But these are shaky economic times, and most founders will be coming back to a different world altogether.

George Arison, founder and co-CEO of Shift, has a few ideas on how entrepreneurs should approach fundraising in “the new normal,” whatever that means.

A tech platform that buys used cars off of individuals and sells them to new buyers, Shift has raised over $225 million over five rounds. But Arison has experience fundraising under difficult circumstances: In 2017, the company’s $38 million Series C was a down round, where Shift had to raise money at a lower valuation than it did for its Series B.

In a fundraising world where many companies have been “massively” overvalued, Arison expects these conditions to shape the new normal.

“I think flat is going to be the new up round, to be honest,” he says. “Some companies will do up rounds — like Stripe. But most companies are going to have a much harder time with capital.” On an episode of How I Raised It, Arison shared his top fundraising tips for when times get tough — from how to pick VC partners strategically to successfully navigating a down round.

Lean in to “no” and go for investors who will reject you

When Arison was trying to raise Shift’s Series A, he cast a wide net in terms of the venture capitalists he spoke to and purposefully connected with VCs who might not invest in the company.

“I’m a big believer in talking to a broader range of people than founders normally would,” Arison says. “There are many benefits to getting to know really great investors, even if they don’t invest in you, because you’ll learn a lot from them. They’ll tell you things you otherwise might not pay attention to — and that information, over time, becomes really critical.”

During Shift’s Series A, in which the company ultimately raised $24 million, Arison was shot down by Josh Kopelman at First Round Capital, Jeff Jordan at Andreessen Horowitz and Geoff Lewis, then at Founders Fund. Yet they were some of “the best investors” he interacted with, because they gave him feedback that ended up being critical to Shift’s success.

“One of the feedback points I got from Josh Koppelman was actually, ‘Hey, this is going to be way more operational than you think,’” says Arison.

As a platform, Shift buys used cars off individuals, fixes them up and then resells them to others. As a business, it’s required a lot more technical operation than he had first anticipated. “It turns out Josh was right,” says Arison. “I didn’t fully appreciate that when we were first getting going — but I do today.”

Date to marry: Pick your VC partners carefully

In the same way the pandemic has, for many, illuminated whether a romantic partner is a good fit — call it trial by fire — hard times also show founders their investors’ true colors.

“When fundraising, a lot of founders pay a ton of attention to the name of a fund and will decide they want to raise money from a fund like Sequoia,” says Arison. “What really matters, though, is the specific individual you’re working with — and whether that individual will be with you through hard times.”

For Shift’s Series A, he and his team ultimately ended up working with Emily Melton at Threshold Ventures and Manish Patel at Highland Ventures. And during Shift’s Series C down round and a 30% drop in business during coronavirus, both investors have remained Shift’s champions “through thick and thin.”

“I can’t express how valuable that is. Picking the right person is so, so critical,” Arison says. “Because when things are great, everyone’s with you. It’s when things get really hard that you can see what really matters and who’s with you.”

Put yourself in the best position possible during a down round

For many startups, fundraising in a post-pandemic world will mean dealing with falling valuations. But raising at a price lower than your previous round isn’t the end of the world. Seriously!

“It’s totally normal,” says Arison. “Stock prices and public markets go up or down. Prices aren’t always the same. So why is it wrong for the same to be true for private companies?”

For Shift, a down round came after the company’s $50 million Series B in 2015. Following that, the global markets weren’t doing well, China’s economy weakened and Shift began to run into operational challenges with its model while growth fell short of expectations.

“Had we raised $100 million [in our Series B], that might have been a different story, but coming out of that, we had to raise a round,” Arison says. “We went into a period where we had about six months of runway, and we needed to do whatever it took — so we ended up having to do a down round.”

The most important step Shift took to prepare for a down round was to seek alignment internally before raising. It was a strategy that worked well for Shift — which raised $38 million in the round — and there are three specific steps Arison recommends all startup founders take before a down round.

1. Before raising, get your insiders to commit to a down round price

For Shift’s Series C in 2017, the company’s board agreed to a down round price and got a commitment from their existing VCs to invest a certain amount of funding if Shift was able to raise a set amount from new investors. That internal alignment made conversations with new investors much easier, since it clarified boundaries.

“It created a positive leverage in our discussions with new investors, because the capital cleanup had been done internally already,” says Arison. “They weren’t coming in to try and force terms that people were unwilling to accept. Rather, it was like, ‘Okay, this is my set of terms, based on the terms that you’ve already said you’re willing to accept.’”

2. Negotiate with existing investors to waive troublesome clauses

“The other thing that’s really complicated in down rounds is anti-dilution,” says Arison, “Basically, existing investors have a preference, which gives them the right to receive extra shares for their old investment, in order to prevent them from being diluted too much. But obviously, common shareholders — including all employees — don’t have that option.”

Having anti-dilution clauses in place make sense to protect investors, but it can lead to existing investors gaining larger ownership of the company than employees — and incoming investors will often want those clauses waived in order to protect the company’s team and keep them in a strong position.

Ideally, existing investors will see how waiving these clauses will strengthen the company as a whole and better entice new investors. And as a founder, that’s your main mission during a down round, says Arison: “You need to really focus on taking care of your existing team as much as possible.”

3. Figure out your liquidation preference stack

During down rounds, liquidation stacks can be changed — they may be tied to specific dollar amounts invested, or they can be tied to the number of shares an individual holds. Incoming investors may be able to negotiate different liquidation stacks, leaving earlier investors or employees in worse positions should the company be liquidated.

No matter what, “try to get as much alignment among your existing shareholders as possible before you go out and raise,” says Arison. That way, no one is surprised, and existing investors, the company’s team and new investors are all on the same page.

Fundraising in more difficult periods is certainly a challenge, but with some preparation, companies can tackle downturns from a strong position. After all, with challenging times comes opportunity. Despite a looming economic downturn, Arison is excited for the future.

“Recessions are when the great founders come out of the woodwork and build great stuff,” he says. “I think we’re going to see some really great companies born in this time period.”