How To Handle Down Rounds Effectively in 2024?

A down round is when the valuation of a company before a fundraising round is lower than the valuation after the round. This can happen to both private and public companies and for similar reasons. For example,

• Failure to meet investors’ earnings targets
• Deteriorated competitive environment
• Tightening of general funding conditions

If you have some knowledge about the venture capital industry, you probably know that down rounds are considered a highly negative thing. In a recent podcast, radio host Chris Hill explains that a down round is a catastrophic sign that can happen outside of a tragic accident.

But what exactly are down rounds? In this article, we will explain the mechanics of down rounds. Additionally, I will provide some helpful considerations on why down rounds occur and how they can be avoided.

What is a Down Round?

A down round refers to a situation in which a company raises funding, typically through the sale of its equity (like stocks), at a valuation lower than its previous funding rounds.

For Example: If a company has raised $30 Million in Series A and $15 Million in Series B, it is a down round of funding. Various factors, including market conditions, company performance changes, or investor sentiment shifts, can influence this decline in valuation.

While a down round may impact existing investors and the company’s overall valuation, it can also provide the necessary capital for the business to continue operating and growing.

Example Of Down Round; Buzzfeed’s Funding History

One of the most influential news companies to have emerged from the internet era, Buzzfeed has raised nearly $565.2 million across eight funding rounds. 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 H “flat” financing round after missing 2015 revenue targets.

Despite the negative news surrounding the company, its topline increased by approximately 7% in 2017. Moreover, in a May 2018 interview, Buzzfeed’s CEO Jonah Peretti stated that the company was experiencing strong double-digit growth. However, the company has announced a steady series of layoffs. This begs the question, why would a growing company resort to laying off employees?

The answer is likely found in a note Peretti sent employees after the latest round of cuts. The letter titled Difficult Changes mentioned that more than revenue growth is needed to succeed in the long run. The restructuring will reduce our costs and improve our operating model so we can thrive and control our 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.

What can contribute to a Down Round in a Startup?

As mentioned earlier, a Down Round can happen for various reasons and have significant implications for the company and its existing investors. Understanding the dynamics of down rounds involves considering several key factors:

• In a down round, the company’s valuation decreases. This may be due to various reasons, like poor financial performance, market conditions, or changes in investor sentiment .
• Down rounds typically result in higher dilution for existing shareholders, including founders and early investors. Since a lower valuation leads to new investment, issuing more equity becomes necessary to raise the same amount of capital.
• Founders and early investors may see a reduction in the value of their ownership stakes. This can discourage the team and may affect morale and motivation. New investors may negotiate more favorable terms, such as liquidation preferences or anti-dilution protection, which can further impact existing shareholders.
• The perceived value of stock options for employees may decrease, affecting morale and the ability to attract and retain talent. Employees holding stock options may see a reduction in the potential financial upside.
• Sometimes, down rounds may trigger contract breaches with lenders or other contractual obligations, adding further financial and operational pressures.
• Companies going through down rounds may need to reassess their business strategies, cut costs, and make operational adjustments to regain investor confidence and improve their financial position.

What are the Rules & Regulatory Considerations for Down Round Negotiations?

TechVerse Solutions, a technology startup, is experiencing financial challenges due to increased competition and a market slowdown. Consequently, the company must raise additional funds through a down round.

Legal and Regulatory Considerations:

Fulfilling Trustee Duties:

The board of directors at TechVerse Solutions must carefully consider the impact on existing shareholders while negotiating the down round. They must ensure that their decisions align with their fiduciary duties.

Ensuring Disclosure and Transparency:

TechVerse Solutions must disclose the reasons for the down round, the challenges faced, and the potential impact on existing shareholders. The company must maintain proper documentation and comply with SEC regulations.

Securing Shareholder Approval:

Depending on the company’s bylaws, shareholder approval may be necessary for the down round. TechVerse Solutions must follow corporate governance procedures to obtain the required approvals.

Addressing Anti-Dilution Protections:

Existing investors in TechVerse Solutions may have anti-dilution protections. Legal advisors should review these provisions, and negotiations may involve discussions on adjustments or waivers to accommodate the down round.

Ensuring Regulatory Compliance:

The company must comply with securities laws, including filing requirements with the SEC. The company must adhere to the exchange’s equity offerings and disclosure rules if listed on a stock exchange.

Reviewing Contractual Obligations:

TechVerse Solutions should review existing contracts, especially debt agreements, to ensure down round does not trigger defaults or other adverse consequences.

Addressing Employee Stock Options and Warrants:

The down round may impact employee stock options. The company must review its equity incentive plans and consider adjustments to maintain employee motivation and retention.

Considering Tax Implications:

The company should consult with tax professionals to understand and address any tax implications for the company and its shareholders arising from the down round.

Engaging Legal Counsel:

Engaging legal counsel with experience in down-round negotiations is important for the company. Legal advisors can guide the company through compliance, negotiation strategies, and documentation.

What Are the Alternatives to a Down Round?

• Cut costs and increase runway: This will postpone external fundraising but may only be feasible for a lean organization or one with significant revenues.
• Raise bridge financing: If the cash flow problem is temporary, a bridge in the form of a convertible note can be an appropriate solution to get the company back on track.
• Renegotiate with investors: The round terms can be renegotiated, for instance, by mitigating the anti-dilution protection or exchanging these rights for other investor perks, such as upside protection.
• Close-up shop: If there are too many problems, employees are disgruntled, and your investors will no longer back you, it may be better to cut your losses and start over.

How do you communicate with stakeholders during the Down Round?

Effectively communicate with stakeholders during down rounds by being open and honest about the reasons behind the situation, whether financial challenges or market conditions.

Provide regular and timely updates, ensuring your message is clear and consistent, aligning with the company’s long-term vision. Show empathy and understanding toward stakeholders, addressing their concerns, whether they are employees, investors, or partners. Reassure stakeholders by highlighting positive aspects of the business and presenting a concrete plan for moving forward, including cost-cutting measures and operational improvements.

Engage in individual outreach to key stakeholders and host Q&A sessions to foster an environment of openness, allowing for direct clarification on any concerns. Prioritize internal communication, especially with employees, addressing their concerns and offering support. By maintaining transparency and trust, you can navigate the challenges of down rounds and position the company for recovery.

Get a Business Valuation From EQVISTA!

Down-round financing is not very beneficial for existing shareholders as it reduces their ownership and influence in the company. But remember that it provides floating money for operations and welcomes new investors.

Considering its complexity, getting help from professionals like Eqvista, with the leading valuation services, can improve your chances of securing funding. Contact us to find out more about how we can assist you.