Downround
A “down round” is a financing in which a company sells shares of its capital stock at a price per share that is less than the price per share it sold shares for in an earlier financing. What Is a Down Round? A down round refers to a private company offering additional shares for sale at a lower price than had been sold for in the previous financing round. Simply put, more capital is needed and the company discovers that its valuation is lower than it was prior to the previous round of financing. This “discovery” forces them to sell their capital stock at a lower price per share. Private companies raise capital through a series of funding phases, referred to as rounds. Ideally, the initial round should raise the capital needed where subsequent rounds are not required. At times, the burn rate for startups is much higher than anticipated, leaving the company no other option than to go through another round of financing. As a business develops, the expectation is that sequential funding rounds are executed at progressively higher prices to reflect the increasing valuation of the company. The reality is that the actual valuation of a company is subject to variables (failure to meet benchmarks, the emergence of competition, venture capital funding) which could cause it to be lower than it was in the past. In these situations, an investor would only consider participating if the shares, or convertible bonds, were being offered at a lower price than they were in the preceding funding phase. This is referred to as a down round. While the earliest investors in startup companies tend to buy at the lowest prices, investors in subsequent rounds have the advantage of seeing whether companies have been able to meet stated benchmarks including product development, key hires, and revenues. When benchmarks are missed, subsequent investors may insist on lower company valuations for a variety of reasons including concerns over inexperienced management, early hype versus reality, and questions about a company’s ability to execute its business plan. Businesses that have a clear advantage over their competition, especially if they are in a lucrative field, are often in a great position for raising capital from investors. However, if that edge disappears due to the emergence of competition, investors may seek to hedge their bets by demanding lower valuations on subsequent funding rounds. Implications and Alternatives While each funding round typically results in the dilution of ownership percentages for existing investors, the need to sell a higher number of shares to meet financing requirements in a down round increases the dilutive effect. A down round highlights the possibility that the company might have been over-hyped from a valuation standpoint initially and are now reduced to selling their stock at what amounts to a discount. This perception could negatively affect the market’s confidence in the company’s ability to be profitable and also deal a significant blow to employee morale. The alternatives to a down round are: The company cuts its burn rate. This step would only be viable if there were operational inefficiencies else it would be self-defeating in that it could hamper company growth. Management could consider short-term, or bridge, financing. Renegotiate terms with current investors. Shut the company down. Due to the potential for drastically lower ownership percentages, loss of market confidence, negative impact on company morale, and the less than appealing alternatives, raising capital via a down round is often viewed as a company’s last resort, but it may represent its only chance of staying in business. Why Does it Matter if a Company Does a Down Round? Damaging Psychology. Venture-backed companies are typically unprofitable, risky endeavors with illiquid stock that require consistent evidence of rapid growth to continue to attract and retain capital and talent. A signal that a company needs to raise capital and is willing to do so at a declining price can be a significant blow to employee morale. Anti-Dilution Protection. Unlike public companies, investors in venture-backed companies typically own preferred stock, which sometimes has special rights referred to as “anti-dilution protection” that can magnify the dilution to common stockholders from the financing. More on this below. Similarly, if the prior round was at a highly negotiated price and/or the prior price was based on assumptions that have proven to be untrue, investors will sometimes look to renegotiate the price of the prior round to more closely reflect the benefit-of-hindsight value of the company at the time of the investment. Investor Accounting. Venture capital funds account to their limited partners based on the value of the securities in their portfolio, as suggested by the most recent pricing of those securities. When a company does a down round, existing investors may have an obligation to “write down” the value of their existing holdings in their financial statements, which can affect the fund’s fundraising efforts and perhaps even the ability of the general partners to receive distributions. FAQs What is a down round? A down round refers to a financing round in which a company raises capital at a valuation lower than its previous funding round. Why does a down round occur? Down rounds typically occur when a company’s performance or market conditions have deteriorated since its last funding round, leading investors to reevaluate the company’s value downward. What are the implications of a down round for existing investors? Existing investors in a down round often face dilution of their ownership stakes since the new shares issued to investors are priced lower than previous rounds. This dilution can significantly impact the value of their investment. Practice area’s of B K Goyal & Co LLP Income Tax Return Filing | Income Tax Appeal | Income Tax Notice | GST Registration | GST Return Filing | FSSAI Registration | Company Registration | Company Audit | Company Annual Compliance | Income Tax Audit | Nidhi Company Registration| LLP Registration | Accounting in India | NGO Registration | NGO Audit | ESG | BRSR | Private Security Agency | Udyam Registration | Trademark Registration | Copyright Registration | Patent Registration | Import Export Code |