A down round happens when a startup sells its shares at a lower price than what it sold them for in previous rounds of financing.
Startups need cash on hand to make it through the resource-intensive and risky growth phase. While startups should ideally increase in value over time, sometimes their value decreases. In this situation, it can make sense for startups to do a down round. However, this is usually done as a last resort to keep the business afloat.
How down rounds work
Startups raise capital in funding rounds. In a perfect world, startups would need just one round of financing to achieve their goals, but sometimes they need more cash to stay afloat.
Ideally, a startup increases in value in every round. For example, it would be worth $2M during Series A, $5M in Series B, and so on.
A down round happens when a business is worth less today than in previous rounds. For example, this occurs when a business that was worth $2M during Series A is only valued at $1M for Series B.
Down rounds give investors shares at a lower price than what preceding investors paid. That’s understandably upsetting for earlier investors, who invested early in a business only to see a lower return on their investment.
However, if a business needs to attract new investors, the investors will typically want to pay a lower price per share. It means they get more equity in the business for the same price, which incentivizes new investors to hedge their bets in a potentially risky deal.
Why down rounds happen
Business valuations can change frequently. But if a startup isn’t increasing its value over time, it might be due to:
- Failure to meet its benchmarks
- Increased competition
- Leadership issues
- Too much hype during its initial valuation
- A bad economy
It’s possible for a startup to do a down round through no fault of its own, like in the case of an economic downturn. However, the public and your investors will usually see a down round as a business failure, and that’s why it’s usually a last resort for startups.
The dangers of a down round
Down rounds might be beneficial for new investors, but they’re dangerous for business owners and existing investors.
Down rounds can cause problems like:
- Declining morale: Your team works hard to get results. No one wants to see a business decline in value because it indicates they’re on a sinking ship.
- Decreased market confidence: A decrease in business value tells the market that you aren’t performing as well as you should be. This negative perception can even make it more difficult to raise funds.
- Dilution: A lower valuation means your stocks are worth less, and that means you need to give away more equity to raise funds. For example, if your business needs $200,000 and your shares dropped from $50 to $10 per share, you’ll need to sell more shares to hit your $200,000 goal. This often means that company owners will have to give up some of their shares (and control in the business).
- Breach of fiduciary duties: In some cases, your existing investors could argue that you’re breaching your duty to them. If your investors didn’t approve a down round, they may have the grounds for a lawsuit.
Down rounds are usually a last resort because they anger existing investors, dilute your interest in the company, and reduce market confidence. However, if you’re a new investor and have the opportunity to invest at a down round, you could get into a startup at a more favorable price and with better perks.
