Here's how to survive the coming down rounds.
While the market is doing well, companies can typically raise at some pretty absurd valuations, basically knowing they will raise money. Companies will often raise hundreds of millions from VCs despite little to no revenue and barely any product. This, obviously, is the minority of companies run by rockstar founders innovating in a growing industry. However, the absurdity is still there. The idea is that it doesn’t really matter what the valuation is now because the potential is so massive that it will make up for it in the long run. If you invest at a $1 billion valuation vs. a $2 billion or $3 billion, then who cares if they IPO at $10 billion? That's the logic anyway. This means VCs will pay absurd amounts and top dollar for the right promising startups.
However, during recessions. funding tends to dry up. and valuations tend to be more reasonable in an attempt to compete for funds. A “down round” is when a company. rather than increasing their valuation in a subsequent raise, actually ends up raising at a lower valuation. For example, if a company were to raise at a $100 million dollar valuation, then go on and raise at an $80 million valuation in the next funding round.
People tend to see this as a negative for several reasons. The biggest downside is dilution because if they raise large amounts of money in a down round, that would dilute most others quite substantially, which could be an issue. If we’re going by the “It will even itself out in the long run approach” then it might not be too big of a deal, but no one likes to be diluted. and waiting a year just to be diluted and technically lose money isn’t favorable.
For example, let’s say a company raises $10 million at a $100 million valuation. The post-money valuations would end up being $110 million. and let's say it's a $1.10 share price. If the company then goes on to raise $10 million at a $75 million valuation, the share price would then end up being diluted to $.75 at an $85 million valuation. and thus. if it goes back up to a valuation of $110 million, the share price is only $.975. In order to go back up to where they invested at $1.10, it’d need to be at a valuation of $124 million in order to break even. If this was an up-round, the dilution would be much less significant as well, and it’d be offset by any gains so most people wouldn't care.
Why do down rounds happen?
Generally, they happen for a few reasons. Companies raising more money is not only encouraged but expected. You can bootstrap a startup, but that is going to take a lot longer than just raising money and re-investing it. If you bootstrap, you’re doing it all yourself until you can sustain a second person, and you’re just constantly running on limited funds. If you raise money, you’re operating at a loss, but you can grow much faster. If you’re growing, you can raise money.
So, when a company goes to raise money, they usually keep growing using the money since their growing, the valuation increases until they’re either profitable or big enough to IPO. A down round will happen if they are having trouble during that time either because they failed to grow at a fast enough rate YoY, there was significant valuation compression in the space due to a downturn in that specific industry, or they simply haven't had any luck raising at the current valuation.
What to do as an Investor in a down-round
If you’re an investor and your company is in a down-round, there are a few pretty simple options. First things first: Don’t throw good money after bad. The dilution isn’t likely to completely kill the profitability of the investment, but if it’s going under, then your money isn’t going to save it. Throwing good money after bad is pointless in startup investing. It’s best to cut your losses and let the rest of your investments make up for the hit you’re going to take there.
What if they’re doing well? Well, if you invested in them once and now they’re at a lower valuation than what you invested… but grew, then you can consider just re-investing at the lower valuation and upping your stake. Just because they’re raising at a lower valuation doesn’t mean they didn’t grow, it just means they don’t want to potentially sabotage their raise by raising at too high of a valuation in a time in which other companies are also compressing their valuations and funding is tight. So, a company might have doubled revenue and moved towards profitability, but their valuation compressed due to external market factors. At that point, it might be a good time to re-invest and up your stake because now, if it succeeds post-downturn, then the upside will be much higher, and you will have a higher stake in the company.
Alternatives to a down round
Obviously, nobody WANTS a down round. It looks bad for the startup, investors might be unhappy, and it feels like you’re losing progress. However, it wouldn’t make much sense to go out of business because you didn’t want to do a down round. So, is there any way around it?
A lateral raise
A lateral raise is a very simple concept. Where a down round is where a subsequent valuation round is below the previous round, a lateral raise is just re-using the same valuation as the previous raise. So, if you had a previous funding round at $100m, then just re-open the next funding round at $100m to raise funds.
This has been a pretty popular one that I have seen recently with many of the startups that I have personally invested in. They don’t want to do a down round, but too much higher of a valuation won’t raise funds. Instead, many companies will simply open up another raise at the same valuation as the previous raise. Many will just outright say this is an “extension” of the previous raise. Which this makes sense because, ideally, the startup has grown in the past year so if it was reasonable before, and now it’s grown a lot and raising at the same valuation, many will consider it very reasonable. As well, this might allow investors to double down on their favorites, or realistically, they won’t be too upset since it’s not a loss. You could also just do a slight up round to account for dilution or to represent mild gains “despite the recession.” For example, if it was a share price of $1 and a valuation of $100m. If you raised $5 million, then the valuation would be $1 and a $105m valuation after, so raising at a $110 million valuation and a share price of $1.09 would mean slight gains, technically an up round, and the valuation isn’t subject to some absurd valuation premium.
Re-approach old investors & Provide new value
Sure, some businesses deserve to just fail. Poor business models and bad ideas aren’t going to get funded, but some really do just need more time. Whether it’s to get that perfect product out the door or to hone down that marketing and scalability strategy. Whatever the case, doing a down round to survive for the long term is much better than just calling it quits and going out of business. Investors will be disappointed if there’s a down round, but they will be significantly more disappointed if the company goes bankrupt. Here are some ways to potentially ease the pain.
For companies that I believe in, I would, and have, reinvest into them at the same or lower valuation. Some examples of this have been lateral raises, or one that I personally like is a lateral raise with prior investors having the ability to re-invest at a lower valuation.
For example, one company had a $20 million valuation, then reopened funding at a $20 million valuation with the option for old investors the ability to invest at a $10 million valuation within a certain time period and funding limit. This means that I get to ensure that I am not too heavily diluted, and I can even get a discount on some more shares. The company had nearly doubled revenue YoY, so my bull case is still the same, but I was able to lower my average in the investment by about 50%. I am happy because my average in the company is lower, they grew revenue exponentially, and they are now getting the funding they need to continue to expand. I am getting value out of my old investments, so that works out as well.
If this isn’t something you want to do, even still, simply approaching prior investors and giving them ‘first dibs’ at an investment could be smart as well. They know they’re being diluted, but simply allowing them the ability to at least offset the dilution or re-invest under the new terms might be favorable. This is likely going to be successful if you have made growth within the company YoY. If you had $1m revenue last year, and stayed the same or declined then investors might consider this throwing good money after bad. However, if there’s been significant growth YoY, then it’s a pretty easy sell. Same terms, except we doubled revenue will likely be attractive to investors that believe in the product and vision.
Do You actually need funding?
Obviously, there’s no such thing as too much money, but if you don’t actually need more money, then you probably don’t need to do a down round. It’s probably better to have a smaller funding round than you would like at a higher valuation than a larger one and upsetting all of your old investors and diluting everyone rather than raising more money you might not actually need. Many companies tend to go on acquisition sprees or burn through those massive money piles once they get them, but going into a recession, if you’re sitting on $60m, don’t slow down growth and kill marketing, but definitely be more conservative with the stockpile. Maintain as close to profitability as you can, continue to grow, cut costs, and use that time to your advantage.
Companies that survive downturns often benefit because they will be established in a market where there’s much less competition. Due to this, they have a massive first movers advantage and little competition in a previously crowded space. Any new companies are startups, whereas you’re now several years seasoned in the industry and ready to move.