1. What Is a Down Round?
2. Why Is a Down Round Important?
3. Why Do Down Rounds Happen?
4. What to Do During a Down Round
5. Mistakes to Avoid

What Is a Down Round?

A "down round" is a round of financing where investors pay less for the company's stock than the previous investors. If it happens to your company, it doesn't mean the end times are coming, but it is a major wake-up call and a sign that something needs to change.

The companies that can go through down rounds are startups and other private businesses that don't trade stocks on a public exchange. With no public trading, they sell stock in rounds to private investors. Since a stock exchange can't set the company's value, the company and the investors have to work out their value instead. And when this sets the company's value to lower than it was before, it creates a down round.

Why Is a Down Round Important?

In an ideal world, every round brings in more money, since the business is always growing and expanding. However, sometimes a business can't grow. Other times, investors overvalue a business during one round and have to cut back for the next one. Either way, it's not a good sign.

The biggest problem with down rounds is that the company's founders and employees have to dilute, or give away, more control over their company to meet their financial goals. This can happen in two ways:

  • A company starts an investment round to get a certain amount of money. This money is for expanding the business, covering debts, or some other known cost. During a down round, each stock is worth less value. Therefore, the founders and employees have to sell more of them to get the money they need.
  • The investors in earlier rounds often have a "make whole" clause. This means the company has to give them extra stock based on the company's new value.

Why Do Down Rounds Happen?

  • Missed benchmarks. The company didn't meet the goals it set during the last investment round. Maybe the company was too ambitious, maybe it was bad management, or maybe it was bad timing with the economy. But whatever the reason, it tells investors the company is in trouble and might not pay off later.
  • Too much optimism. The company got a bright valuation during the last round and the new one is more realistic.
  • The economy. The economy or the company's industry is going downhill. When the economy is going up, investors are more likely to value companies higher, but when it's going down, so do valuations. This can even hurt companies that are doing everything right.
  • Extra competition. In most industries, a little competition is a good thing. However, it makes finding investors harder, since some customers will leave and some investors will choose the competition. The ones who are left can then demand an investment on better terms.
  • Tough Negotiations. With few investors and no public trading, companies can lose value just for accepting a hard bargain.

What to Do During a Down Round

You have to step carefully when it comes to holding a down round, and not just because a down round hurts a company's reputation. In most cases, at least one of the company's founders or executives will get money that doesn't go to the company. You need to prove the down round helps the company, too. That's why it's a good idea to take one or more of the following steps:

  • Create a committee of objective directors, investment bankers, and lawyers to take a close look at the deal and approve it.
  • Ask for a vote from all the stockholders.
  • Be careful about what extra rights the new investors get. If they get to be paid first or paid extra after a sale or a public offering, the value of everyone else's shares will go down. That's fine if the company is a huge success. But it hurts the stockholders in every other case.
  • Consider giving extra rights to the current stockholders if you have to give some to the new investors.

Remember, down rounds always hurt the first stockholders the hardest. That's a problem because they're the owners and the employees, the ones doing all the work. If they see the value of their work go down, they won't want to work as hard. To make sure they keep working hard (and for legal reasons), you should clearly explain to everyone why taking a down round is good for the company.

Mistakes to Avoid

  • Don't panic. Going through a down round isn't the end of the world, and it's not the end of the company. You may need to think about the company's direction, but think about it carefully first.
  • A haircut is not a down round. "Getting a haircut" means a company gives itself one value but accepts an investment for a lower value. It may look disappointing, but that's just how negotiations work. It's only a down round if the investor's valuation is lower than it was last time. So if the company says it's worth $200 million, the new investor says the company is worth $180 million, and the last investor said the company was worth $130 million a year ago, that's a haircut and not a down round.
  • Don't bargain away the company's future profits. Even if a new investor shows up and offers ample money and a high company valuation, it could cost the current stockholders. Let's say there's a company worth $100 million with 100 shares, with the employees owning $50 million and Investor A owning $50 million.
    Investor B shows up, says the company is worth $130 million, and wants to buy 38 shares for $50 million, but only if he or she's paid first and 30 percent extra after a sale or a public offering. If someone buys the company at its new value of $180 million, Investor B will get $89 million, Investor A will get $90 million (since he or she didn't sell any shares), and the employees will get the leftover scraps.
  • Don't take it personally. A down round can still be a success, even if it's not the success you wanted. After all, if the company gets all the money it wanted, it can still move forward the way it planned. What's worse is when the company only gets some of the money. Even if the company value doesn't go down, investors will see that and think no one trusts the company.
  • Try to fix your problems first. It might not make sense, but the best time to raise money is when you don't need any. If your company is in trouble and needs money, investors won't trust you to pay them back. Moreover, the ones who will take the risk will demand a lot of terms in return. The best thing you can do to avoid a down round is to make sure the company is in a good place before you ask anyone for money.

Up rounds are exciting for everyone, but down rounds can be an important way to let the company know that something has to change. Just make sure you put the money to good use, remember to think in the long-term, and build your business so that next time, your company's value will go up.

If you have any questions about a down round, you can post your question or legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel attended law schools such as Harvard Law and Yale Law, and they average 14 years of legal experience. They have worked with or on behalf of companies such as Menlo Ventures, Google, and Airbnb.