Navigating Downrounds

A downround occurs when a startup secures funding by selling shares at a price lower than in its previous fundraising round. This can have significant repercussions for founders, employees, and investors when the company’s value decreases. Here’s our guide to help you navigate through one.

2023 Valuations vs 2021 Valuations

In 2023, the startup ecosystem grappled with the aftermath of the 2021 VC bubble and a depressed tech stock market, leading to a significant increase in downrounds. Data shows about 20% of established startups’ funding rounds are downrounds.

Companies and founders with a higher chance of surviving downrounds are those who communicate regularly with their investors, have a solid plan to navigate the downturn, operate in a promising industry, and secured great initial investors. Although influencing these factors retroactively is challenging, we will provide some guidance on how to effectively deal with a downround.

What is a downround?

A downround is a funding round where a startup sells its shares at a lower valuation than the previous round, making the company worth less than before. This can have significant motivational and morale issues for founders, employees, and investors and can send a negative signal to the market. Moreover, it brings financial consequences due to the types of preference shares investors purchase and the impact on employee options. Now, let’s explore why some founders face a decrease in valuation.

Factors leading to a downround

Several factors can trigger a downround, including:

• Massive market drop in tech market valuations: Many companies raised in 2021 now face decreased valuations due to a drop of up to 10x in tech valuations in certain sectors.
• Raising too much too soon: Rushing fundraising rounds, like going for a Series B shortly after a Series A, can hinder subsequent rounds’ strong valuations as growth metrics may not justify it.
• Sector-specific downturns: Downturns in a startup’s sector can reduce investor appetite, leading to lower valuations even for well-performing companies.
• Financial underperformance: Falling short of projections or missing milestones can prompt investors to demand a lower valuation in the next funding round.
• Company-specific issues: Specific businesses may fall out of favour due to unique reasons, such as high burn rates, executive team turmoil, or increased competition.

The most common reason for downrounds in 2023 is the dramatic market drop, resulting in many companies’ decreased worth despite achieving growth metrics and milestones.

Strategies to avoid a downround

As a rational founder, your aim is to steer clear of a downround. Apart from securing a new investor at the same or higher valuation, consider these strategies to avoid one:

• Investor-driven financial engineering: Avoid aggressive terms like preferred stock with a high liquidation preference, participation rights, and paid in kind dividends, which may be employed by late-stage investors to inject capital at a flat valuation.
• Bridge financing: Secure a bridge round from existing investors through convertible instruments (e.g., SAFE or convertible debt) to sustain company growth until better funding terms become available. Present a well-developed financial model showing the path to a higher valuation.
• Extend runway: Take aggressive measures to lengthen the runway and delay the need for immediate fundraising:
  • Increase revenue through discounts, aggressive sales, prepayments, etc.
  • Generate services-based revenue (consulting work, one-off engineering) as a temporary solution, although it may not enhance the startup’s long-term value.
  • Cut expenses, including potential layoffs, to reach profitability.
• Venture debt: Consider venture debt if the startup has solid customer contracts, low churn, and a rational expense structure. However, avoid relying on it as a backstop for a company that should ideally undergo a downround.

As a founder, carefully assess the chosen strategies’ impact on the company’s value and sustainability, ensuring they lead to a stronger position for potential funding or sustained growth.

What to watch out for

When raising funds at a lower valuation, having experienced advisors, especially lawyers or VCFOs, is crucial. Venture investors can get aggressive during downrounds, so being prepared to protect the company’s and your interests is essential. Watch out for the following measures that less kind investors may use during a downround:

Anti-Dilution Provisions: When investor safeguards backfire in a downroad

VC investors buy preference shares with protective anti-dilution provisions. These provisions adjust the conversion rate of preferred shares to common shares in a downround, safeguarding the investor’s stake at the cost of other shareholders. If faced with a downround, there’s little you can do about these provisions, so it’s better to avoid them when negotiating with investors initially.

There are two methods of anti-dilution provisions in downrounds:

1. Full ratchet: This method adjusts the conversion price of existing preferred shares to match the new share price, without considering the number of new shares issued. While it protects investors, it severely dilutes founders and stakeholders.
2. Weighted average: This method adjusts the conversion price based on both the price and number of new shares issued, striking a balance between existing and new shareholders’ interests and reducing dilution impact on founders.

Negotiating to lessen or waive these provisions is possible, but it’s essential to consider the impact on management’s equity stake and motivation to run the business. Making investors believe in your dedication is crucial, as losing their confidence may lead to funding challenges.

Pay-to-Play Provisions: Incentivizing continued investor support

Pay-to-play provisions are contractual clauses that strongly encourage existing investors to participate in the new funding round. These clauses aim to make investors invest on a pro rata basis, and failure to do so may result in penalties, such as their preferred shares converting to ordinary shares or less powerful preference shares.

These provisions guarantee ongoing financial support from existing investors, but they can be perceived as punitive, especially in a downround where investors may already face losses. Founders may find themselves caught between conflicting investor groups when a pay-to-play provision is enforced, diverting their attention from saving the company, which is far from ideal.

Cramdowns: Tough but vital during a downround

A cramdown occurs when new investors significantly dilute the ownership stakes of existing shareholders, especially prior investors who can’t or choose not to participate in a downround. It’s a tough but sometimes necessary strategy to secure funding for a startup. However, cramdowns can lead to strained relationships between existing and new investors, leaving no one pleased.

Founders’ common shares are heavily diluted during a cramdown, affecting both their ownership percentage and the potential value of their shares, especially if the company is sold or goes public. Option holders, particularly those who exercised their shares and left the company, can also face significant losses.

Wiping out or cramming down former founders and employees should be approached with caution. CEOs need to consider the financial implications for their former associates and be aware of the negative market perception it may cause. While cleaning up the cap table may be necessary, advocating for cramdowns should be done carefully, as they are not employee or founder friendly.

Survival demands tough choices: Saving your startup

In a downround, raising money at a lower valuation can lead to painful consequences. However, it’s a reality that sometimes cannot be avoided. Let’s explore the negative implications that may arise during or after such a situation.

Negative Implications of a Downround:

Previous Investors:

• Dilution: Reduction in company ownership for early supporters like seed investors, advisors, and common shareholders (founders and employees).
• Decreased Influence: Diminished decision-making power over company matters, potential exits, and key personnel hiring.
• Markdowns: Professional investors may be reluctant to lower the investment’s value, affecting their funds’ performance.
• Change in Share Class: Preference shareholders may lose preferential rights if they can’t participate in pay-to-play or cramdowns.

Option Holders (i.e. Staff):

• Dilution: Similar to previous investors, option holders see their ownership stake diluted.
• Decreased Potential Returns: Economic value of options decreases as their fraction of the company shrinks.
• Exercise Price vs. Share Price: Options may become ‘underwater’ if the new financing event price is lower than the options’ exercise price, leading to higher exercise costs.
• Employee Morale: Underwater options can impact employee dedication and morale.

Ordinary shareholders (Including Founders and staff who have exercised options):

• Significant Ownership Dilution: Ordinary shareholders are heavily affected by dilution without anti-dilution protection.
• Loss of Control: Founders and ordinary shareholders may lose control over the company’s direction due to reduced voting power.
• Reduced Financial Upside: Potential financial gain upon a liquidity event diminishes as each share holds a smaller piece of equity.
• Employee Morale: Ordinary shareholders may experience decreased morale and motivation if their options fall underwater.

Investor strategies in a downround

Understanding investor strategies in a downround is essential to grasp the expectations and approaches of new investors.

Existing Investor Behavior

• Limited capital availability for follow-on investments.
• Consideration of potential dilution and impact on ownership.
• Evaluation of pay-to-play provisions and future funding rounds.
• Influence over the company’s direction and long-term prospects. 

Influence of Preference Stack on Existing VCs

• Impact of liquidation preferences on exit payouts.
• Different motivations of later-stage and early-stage investors.
• Complexities in managing stakeholder interests during recapitalization. 

New Investors’ Concerns

• Leading and negotiating a downround is challenging and has reputational risk.
• Balancing terms to protect new investments and satisfy existing shareholders.
• Avoidance of downrounds as a matter of principle. 

Terms Investors Seek in a Downround

• High liquidation preferences to secure greater returns on exit.
• Participating preference shares for double-dip benefits.
• Dividend rights agreements to dilute existing shareholders over time.
• Pay-to-play provisions to consolidate control and impact subsequent rounds. 

Understanding these strategies and terms is crucial for founders, existing shareholders, and reupping investors when navigating a downround situation. Legal expertise can be valuable when negotiating downround provisions and terms.

Strategies to handle downrounds:

Navigating a downround successfully demands a multifaceted approach that encompasses several key strategies. 

Communication is key, requiring transparency and honesty when interacting with investors. Keeping investors informed about the company’s situation and articulating the reasons behind the downround is crucial. Regular updates and open discussions play a pivotal role in managing expectations and upholding investor confidence, fostering an environment of trust that is vital during challenging times.

Simultaneously, proactive adjustments to the company’s financial budget are important. By trimming unnecessary expenses and enhancing operational efficiency, the company can stretch its runway. Many businesses might focus on profitable revenue lines or implement staffing changes. Demonstrating fiscal sensibility not only aids in weathering the storm but also builds investor trust. A disciplined financial approach showcases the company’s commitment to sustainability, positioning it favorably in the eyes of investors.

Effective negotiation skills become paramount during a downround. Thorough preparation for discussions surrounding valuations, ownership stakes, and future funding terms is essential. While safeguarding the company’s interests, preserving relationships with investors also remains a priority. Striking a balance between securing necessary capital and maintaining positive investor relations requires finesse.

Central to the process is the need to address employee morale. Initiating share option top-offs is an effective tool to retain key personnel who may have been affected by the downround. Reinforcing the company’s vision and mission not only reestablishes the sense of purpose but also reaffirms the importance of individual roles in the larger scheme. Transparently explaining the recovery plan and the company’s priorities fosters a sense of inclusivity, aligning the entire workforce towards common objectives.

The company’s market perception and brand reputation must also be strategically managed. Consistently providing updates on progress and recovery efforts assures stakeholders that positive momentum is being maintained. Crafting a public relations strategy that highlights the company’s resilience and adaptability can positively influence market perception. Additionally, considering the opinions of customers and prospects and addressing their concerns can help solidify brand reputation and regain trust.

Recovering from a downround is a formidable task for tech companies. Conquering the aftermath of a downround requires resilience, strong financial budgeting, honest dialogue, and a forward-looking approach. Connect with us at Fullstack for further guidance from our virtual CFO service.