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May 14th, 2020


Down-Round Financing

By Phil Lodato, General Counsel & Chief Compliance Officer

As startups begin to move forward into a post-COVID-19 environment, fundraising is likely to look very different than it has in recent years. Although we all hope for a smooth and quick economic recovery, it’s crucial for startups to be cognizant of the possible outcomes that companies may face in this new landscape.

According to Pitchbook, 2019 was a record-setting year for venture capital activity. Positive net cash flows led to $46.3 billion of capital raised by US venture funds, making it the second-highest annual total in the past decade (second only to 2018). This higher capital availability led to continued corresponding increases in median deal sizes and, of course, valuations. Now, with the current unfavorable COVID-19-related market conditions, startups should expect to see valuations decrease in spite of strong venture industry trends leading into 2020, likely resulting in an increase in down-round financings.

Later-stage venture-backed companies are not immune to this type of impact. Airbnb recently announced that it would be laying off 25% of its staff in an effort to get through the current economic situation. The layoffs come after reports that the company lowered its internal valuation to $26 billion in April; a 16% drop from a previous valuation of $31 billion. While Airbnb is one of the more high-profile down rounds, it’s important for all startups to be aware of what may lead to a down-round financing, what the implications are, and how they may be able to mitigate such risk.

When does it occur?

A down round occurs when a company raises additional funding at a lower valuation than it had during a previous round of funding. Generally, among other considerations, valuations are set when looking at a company’s present traction as well as its expectations for hitting future milestones. A variety of factors can lead to a lower valuation in a future round of funding; for instance, if a startup did not execute successfully against the aforementioned milestones, its valuation may decrease. Some factors are outside the control of the company, however. The current COVID-19 crisis is one such external factor – it is creating a major negative change in capital market conditions, making it much more difficult for startups to raise money.

No matter the cause, this is a painful experience for founders and earlier investors – primarily from a dilution standpoint. Down-round financings are never an ideal situation but raising money on worse terms is at least a better alternative than having the business fail from running out of money.

What are the implications?
  • Founder dilution. A down round may significantly decrease the financial interest that founders (and often key employees) have in the company due to the impact of new capital invested at a reduced valuation combined with anti-dilution protective rights that many earlier capital investors possess. The resulting dilution can lead to a loss of motivation and control for those founders and employees. The founding team and the team it has built is the most important asset for any startup; it is extremely difficult for a startup to recover from the loss of or distraction to leadership and talent.
  • Employee equity. Raising capital in a down round may cause an adverse effect on talent retention and motivation, in part because employee options may be worth substantially less, if not entirely value-less, after a down round. If your company goes through a down round, be sure to remain transparent with your team to prevent miscommunication and rumors. Further, work with your Board of Directors and company counsel to re-evaluate the company’s equity incentive plan to make sure the company remains able to retain talented individuals.
  • Signaling. Negative signaling in the market can have many unwanted effects. When it is known that a company needs to raise money and must do so at a reduced valuation, it can become significantly more difficult to maintain positive team morale, attract new employees, raise additional funds in the future, create partnerships, obtain customers, and the like.
How can you mitigate the risk of a down round?
  • In some cases, a down round may be unavoidable. If it’s not, there may be some ways for startups to minimize the impact of one, or at least potential alternatives that may lead to a more desirable outcome:
  • Raise more than you think you need when fundraising conditions are company-favorable or otherwise when optimal for the company (know your value inflection points and act on them in a timely manner). Then, when difficult fundraising conditions arrive, your business may be better positioned to outlast those conditions with the extra funds already residing in the company’s bank account.
  • Extend runway to survive until market conditions change for the better. This can be done by reducing costs and streamlining your business’ operating model and efficiency. If possible, control your own destiny by never needing to raise money again or at least until the market improves for more company-favorable fundraising conditions.
  • Whenever possible, be aware of changing market conditions so you are able to act proactively rather than reactively.
  • Raise money from inside investors. Previous investors have a vested interest in keeping your startup running, and they also know more about your company’s ability to navigate, withstand and overcome negative market conditions. They believe in you and want to see you succeed; even if they are not able or willing to invest additional capital in your company, they may (within reason) be willing to consider renegotiating prior financing terms in order to help position themselves and your company for future, mutual success.
  • Be opportunistic to add premium talent to the team when it becomes available in a down market. Startup investors love to support experienced, effective teams with successful startup outcomes in their past. Adding these characteristics to the team may help your company negotiate more favorable financing terms despite challenging fundraising conditions.
  • Consider tranche financing. Investors may see this as more favorable to them and be willing to offer better terms. They can put in a little money at first and then if the company is meeting milestones effectively, they can put in more money. If not, they don’t. It’s a good compromise situation for both parties if executed successfully.
Planning ahead

Down-round financing may not be the route you envisioned your startup taking; however, certain circumstances may call for raising money at challenging terms rather than allowing the company to fail. With current market uncertainties related to the COVID-19 pandemic’s impact on the fundraising landscape, valuations for even the most attractive investment opportunities may well be impacted. Keep in mind that down rounds in tough markets are not necessarily reflective of the current health or future growth prospects of your company but rather merely a function of significantly impaired capital markets. A company can survive a down round as well as the rough period that follows and come out the other end successfully if they plan and execute accordingly.

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