Natasha Ketabchi
Natasha transitioned to venture capital after a career in banking, built in prestigious firms such as JPMorgan and A&M.
Anyone vaguely familiar with the venture capital industry knows that down rounds are bad news. But what exactly are they, and why do they occur? What alternatives do founders have to avoid a down round?
Anyone vaguely familiar with the venture capital industry knows that down rounds are bad news. But what exactly are they, and why do they occur? What alternatives do founders have to avoid a down round?
Natasha transitioned to venture capital after a career in banking, built in prestigious firms such as JPMorgan and A&M.
Arguably one of the most influential news companies to have emerged from the internet era, Buzzfeed is a global media powerhouse, racking up over six billion views per month, and generating nearly $300 million in revenue in 2017. All of this in just six years, a period in which it has raised nearly $500 million across eight funding rounds.
But whilst a few years ago Buzzfeed was one of the hottest venture-backed companies around, things have changed in the last couple of years. A few weeks ago, the company announced a 15% cut in its workforce, the third round of layoffs since 2017. These follow a 2016 Series G “flat” financing round, after having missed 2015 revenue targets.
The string of negative news may lead one to think that the company is in deep trouble. But in reality, topline grew by ~7% in 2017, and in a May 2018 interview, Buzzfeed CEO Jonah Peretti mentioned the company was posting “strong double-digit growth.” Why would a company growing so nicely announce such a steady stream of layoffs?
The answer is likely found in a note Peretti sent to employees following the latest round of cuts. The letter, titled Difficult Changes mentioned that “[u]nfortunately, revenue growth by itself isn’t enough to be successful in the long run. The restructuring we are undertaking will reduce our costs and improve our operating model so we can thrive and control our own destiny, without ever needing to raise funding again”. Paraphrasing, Buzzfeed needed to wean itself off its funding path, particularly in the short term if it wanted to avoid a down round.
Readers even vaguely familiar with the venture capital industry likely know that down rounds are considered a very negative thing. In a recent podcast, Motley Fool Money radio host Chris Hill sums it up nicely: “A down round is…such a catastrophic sign….it’s the worst possible thing that can happen outside of a tragic accident of some sort.” But what exactly are down rounds, and why are they so calamitous? Why do they occur and can they be avoided? In this article, I will cover the mechanics of funding rounds and potential tools from the points of view of both the entrepreneur and the investor, and then try to offer some (hopefully) helpful considerations.
Every time a company raises money, it needs to agree on a pre- and a post-money valuation with its investors. The pre-money valuation is the value of the company at the time of the investment, and it is a fundamental starting point of the process of fundraising. It will give investors an idea of the amount of ownership of the company, of the level of control of the founders, and the incentive alignment between them, their investors and their key employees.
During a capital raising transaction, the company issues a set number of new shares against a fixed amount of capital. Each share is then priced at a fraction of the new capital base in the company. We thus will have two resulting valuations, a pre and a post-money. We call a round a down round if the pre-money valuation of a subsequent round is lower than the post-money valuation of the round previous. The difference between the two is the amount of capital raised. We will go through a numerical example in the section below.
Let’s imagine a company that has raised one round of £150,000 from friends and family at a valuation of £1 million pre-money. The founders originally had 100 shares.
This is what happens to the company:
Let’s imagine that this company then grows and goes on to raise other rounds of funding until the shareholder split looks as follows:
Company valuation: £10,000,000
Founders ownership: 40%
Investor ownership: 60%
The founders still own 100 shares, so we can calculate the share price as follows:
40%*£10m=£4m
£4m/100 = £40,000
Investors now hold:
60%*£10m=£6m
£6m/£40k= 150 shares
Let’s assume now that the company needs a £1.5 million investment. Below I run through the mechanics of an up round, a flat round and then finally a down round.
Up Round Example
So the founders and the original investors have been diluted and thus own less of the company, but at the same time, the increase in share price has more than compensated for the dilution.
Flat Round Example:
In this scenario, both the founders and the old investors have given up some of their control and of their upside in exchange for the new capital.
Down Round Example:
Clearly, in this case, the negative effect is even greater: not only are the shares worth less, but the dilution effect is even larger.
N.B. One important factor that we are ignoring in our calculations for simplicity is the employees stock option plan - employees are greatly affected by the fact that more shares need to be issued as well as the reduction in share price.
Down rounds basically occur for private companies for the same reasons they do for publicly traded companies:
For a general discussion on how investors value private companies, please check these resources for startups and more generally for private companies.
Buzzfeed’s example illustrates the conundrum faced by a company seriously entertaining the prospect of a down round. Is there enough savings room in the cost base to avoid going to investors? Can we continue on the right growth trajectory (or perform the right adjustments if needed) with the current cash availability? What will affect employee morale less?
The main implication of a down round, however, is the triggering of anti-dilution protection. Typically, investors will hold a different class of shares from founders and employees. Amongst other different characteristics, the main difference between ordinary shares is anti-dilution protection. In practical terms, this means that when shares get sold at a lower price than the investor had originally paid for them, they will be diluted less than the other parties. This is usually done at the expense of the founders’ shareholding. The two main types of dilution are:
Here is a useful illustration from a great post on the topic.
Types of Anti Dilution Mechanisms
Usually, as the terms in a financing round become more punitive the harder it is for the startup to raise funds.
Obviously, a punitive dilution has consequences for a startup:
So what are the alternatives for an entrepreneur faced with a potential down-round?
The outlook for the global economy is looking weaker and weaker. The IMF recently slashed its economic forecasts, and even Apple cited China’s economic slowdown in its revised earnings guidance. In this climate, entrepreneurs and investors in private companies should prepare themselves for the consequences of an inevitable tightening of funding conditions, especially the dreaded down round. As Fred Wilson points out in his outlook for 2019, even though the tech industry is somewhat immune to macro-economics swings he anticipates that “… a difficult macro business and political environment in the US will lead investors to take a more cautious stance in 2019. It would not surprise me to see total venture capital investments in 2019 decline from 2018. And I think we will see financings take longer, diligence on new investments actually occur, and valuations to come under pressure for even the most attractive opportunities.”
The best way to avoid down rounds is to be prudent and strategic when raising funds. As Y Combinator points out, the temptation to raise as much money as you can is very strong for startups, particularly as large valuations and capital raises are celebrated as markers of success. It is however more effective to raise the cash needed to achieve realistic growth objectives and not be constantly fundraising, which is distracting and stressful.
If, despite good management and good intentions, things do not go according to plan, the main questions to be answered are around what caused the problem: perhaps the valuation was just unrealistic? Is the company just experiencing temporary problems? Do the founders, employees, and investors believe in the company enough to want to tighten the belt and look for a solution? Is it salvageable? Down exits or rounds do not necessarily mean the end of a company but are indeed a great managerial challenge.
We call a financing round a “down” round if the pre-money valuation is lower than the post-money valuation of the round previous
If the pre-money valuation of a financing round is the same as the post-money valuation of the previous financing round, this is called a “flat” round
When shares get sold at a lower price than the investor had originally paid for them, they will be diluted less than the other parties holding different classes of shares
A pre-money valuation is the valuation attributed to a company prior to a capital raise, whereas the post-money valuation is the valuation of the company after the capital raise. The difference is the amount of capital that has been raised
A pre-money valuation is important for a variety of reasons. It obviously determines the price at which new investors will participate, it also determines the capital gains of previous investors. It also serves as a signaling effect to market participants as to the performance of a company
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