What Is a Down Round?
Last Updated: By Michaela Dale
Valuation is everything in the world of startup funding — especially for a private company. If a startup's valuation decreases, however, the company may have to raise a down round. This involves raising a funding round at a lower valuation than previous rounds.
This guide answers the question: What is a down round? Plus, what causes a down round, and how your startup can avoid one.
What Is a Down Financing Round?
A down round occurs when private companies raise money at a valuation lower than the valuation set during its previous financing round — also called a post-money valuation. This means investors are buying shares of the company at a lower price than before, indicating the market or investors now think the company is worth less than it was in the past.
What Causes a Down Round?
While poor management and a lack of innovation can cause a down round, decreased private market valuations are not always the fault of the startup. Some factors are beyond a startup's control. Several circumstances may trigger a down round, such as regulatory changes or financial hardship. Below, you’ll find the most common causes of a down round.
Poor Performance
If the company's revenue, profit margins, or other key financial metrics fall short of expectations, investors may value the company at a lower amount. This could stem from slower sales growth, higher-than-expected costs, or the loss of key customers.
Additionally, failure to meet product development milestones, issues with product quality, or negative customer feedback can diminish investor confidence.
Market Conditions
Economic challenges, like a recession, also can lead to a down round. During tough economic times, investors become more risk-averse, valuing companies more conservatively. If a company’s industry faces a downturn or technological disruption, the company’s future profitability and growth prospects might come into question thus affecting its valuation.
Competition
The emergence of new competitors in an industry with better products, services, or technology can threaten a company's market position. Similarly, a company’s valuation can suffer if its offering is outdated or lacking in innovation.
Regulatory Changes
Changes in government regulation (e.g., new taxes, strict industry regulations, or legal obstacles) can impact a startup's operations and decrease its valuation.
Internal and Operational Failures
Changes in leadership, internal disputes, or scandals involving the management team can erode investor confidence and lead to a down round. Additionally, ineffective supply chain management and logistical challenges can impact the company.
The Effects of Down Rounds
While startups can overcome a setback like a decreased valuation that leads to a down round, this type of event comes with some significant impacts. Raising a down round has an impact on three key areas.
Dilution
Current shareholders, including you and your existing investors, now own a smaller percentage of the business because new shares get issued at a lower price. This dilution means your ownership is less valuable.
If existing investors have provisions for anti-dilution protection included in their terms from a previous round, however, they can buy more shares at the lower share price to maintain their ownership percentage.
Perception
A down round signals to the market that a company might be facing challenges. As investors and competitors see the company's valuation decrease, that might affect confidence and, in turn, impact future venture capital funding for the business.
Employee Morale
For you and your team, it can be disheartening to see the company's value decrease. This can impact not only employee morale, but also future hiring. While raising down rounds can be a lifeline for a startup with decreasing value, it also may signal top talent to leave your company to obtain more security.
Additionally, a down round may negatively impact the shares of employees who hold common stock in the company. You can choose to mitigate this as a founder by offering new equity grants, offering liquidity options like cash payouts, or restructuring stock options.
How to Avoid a Down Round
Startup founders can employ several strategies to avoid taking a down round, which can dilute existing ownership and potentially signal challenges to the market. These strategies focus on financial management, growth, and strategic planning.
The first step involves optimizing cash flow and extending the cash runway as far as the startup is able. Carefully managing operating expenses, cutting unnecessary costs, and renegotiating contracts can help to extend a company’s cash runway. Prioritizing projects like core products and services as well as revenue-generating sales strategies also can help.
Additionally, rather than raising funding rounds through equity financing, founders looking to avoid a down round can explore alternative financing options. Some examples include venture debt, revenue-based funding, business loans, or crowdfunding to raise non-dilutive capital.
Frequently Asked Questions
What is an example of a down round?
Imagine a tech startup, for example, raised a $5 million Series A funding round at a pre-money valuation of $20 million. Then, the company undergoes unforeseen market conditions or grows at a slower rate than anticipated. During the next round, Series B, the startup's pre-money valuation is only $17 million. If the startup still raises money with this lower valuation, that’s considered a down round.
What is the difference between up rounds and down rounds?
In startup funding, up rounds are funding rounds raised as a startup's valuation increases. Alternatively, down rounds involve raising capital when the company's valuation has decreased.
What are the implications of a down round?
A down round — where a company raises capital at a lower valuation than in previous funding rounds — has several implications for the company, its existing investors, and its founders. These may include dilution of ownership, a negative signal to the market, and an impact on employee morale and retention.
