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Raising a down round for your business

In fundraising, a company establishes pre- and post-money valuations to set share prices and investor ownership. When a company’s pre-money valuation in a new funding round is lower than the post-money valuation from the previous round, this event is called a “down round.”

For example, if Company Y had a post-money valuation of $150 million in Series B and later raised Series C funding at a pre-money valuation of $140 million, it has experienced a down round.

While this can lead to dilution and reduced founder control; despite the initial negative connotation, a down round, strategically managed, can provide a lifeline for struggling businesses and can even become a turning point for future growth. In this article, we will explore the necessity of down rounds, their implications, strategies for navigating them, ways to recover, and real-world examples of companies that have faced this scenario.

Why is a down round necessary for companies?

Even well-performing companies can experience down rounds. As funding becomes more challenging for startups, down rounds, flat funds (fundraisers at the previous round’s valuation), and other creatively structured rounds are becoming commonplace, especially if companies have exhausted other options like debt financing. Whether it’s investor pressure, market volatility, or limited fundraising alternatives, a down round can offer a viable solution.

Here are a few reasons why companies might consider a down round:

  • Investor safeguards. With increased competition and market uncertainties, investors often push for lower valuations as a risk-mitigation strategy.

  • Flexible fundraising options. In challenging fundraising environments, companies may opt for down rounds, flat rounds, or creatively structured rounds as necessary adaptations.

  • Employee and boardroom dynamics. Though down rounds can affect employee morale and create boardroom tensions, they are sometimes the least damaging option compared to the alternatives.

  • Limited alternatives. Venture debt is increasingly stringent, and structured rounds can unfairly disadvantage early investors, making down rounds a more straightforward choice.

  • Potential for continued growth. Data shows that most companies that go through a down round still manage to raise subsequent rounds or exit successfully, often through private equity buyouts.

  • Strategic lifeline. Properly managed, a down round can serve as a turning point, allowing companies to continue operations and even thrive post-event.

Companies taking on a down round often continue growth. Just 13% of companies raising a down round from 2008 to 2014 were unable to raise a new round or exit immediately after the down valuation investment. Nearly 20% of post-down round exits occur via PE buyout, which is a significantly higher proportion than what is seen in the broader venture exit dataset.

Implications of a down round for company and investors

The consequences of down rounds extend beyond the company’s valuation and can have far-reaching effects on various stakeholders, including founders, employees, and investors. Existing shareholders may see their ownership percentage decrease, and employee morale can suffer as the perceived value of their stock options and ownership stakes is diminished. Meanwhile, investor confidence in the company’s future prospects may be shaken, making it more difficult for the company to secure future funding.

Effect of down round on company valuation

A down round can shed light on a company’s initial valuation and the possibility of over-hyping its potential. If a company’s valuation was inflated in earlier rounds, a down round may signal a more realistic assessment of its worth. This adjustment can impact investor perceptions, potentially eroding trust and confidence in the company’s management team and strategy.

Ramification of down round on employees

A down round can have a profound impact on employee morale. When a company experiences a valuation decline, it can create a sense of uncertainty among employees about the company’s future prospects. This uncertainty can contribute to a decrease in motivation and loyalty, as employees might perceive the down round as a sign of financial instability.

For employees, it can also lead to their share options being “underwater,” wherein the strike price (the cost to exercise options) exceeds the current fair market value (FMV) of the shares. This situation would result in a loss if they were to exercise these options.

Consequences for investor confidence

Down rounds can shake investor confidence, making it more challenging for the company to secure future funding. This can be particularly problematic for companies that rely heavily on external funding to fuel growth or cover operational expenses. As investor confidence dwindles, the company may struggle to raise the necessary capital to continue operating, potentially leading to a downward spiral that can be difficult to recover from.

Strategies to navigate a down round

While down rounds can present significant challenges for companies and their stakeholders, there are strategies that can be employed to navigate these difficult circumstances. By addressing the root causes of the down round and implementing targeted measures to mitigate its impact, companies can emerge from a down round with a stronger foundation for future growth and success.

Cost cutting and efficiency improvements

By eliminating superfluous expenditures, optimizing processes, and enhancing operational efficiency, companies can reduce their cash burn rate and improve their financial position, which can help you emerge from a down round more quickly. However, cost cutting and efficiency improvements should be approached with caution, as overemphasis on these measures may impede rather than stimulate growth. Layoffs often accompany down rounds as companies need to take measures to show they are improving cost efficiencies.

Renegotiating terms with existing investors

Renegotiating terms with existing investors can help maintain relationships and secure additional funding even while raising money at a lower valuation. By being transparent with investors and employees about the company’s financial situation and the need for additional capital, companies can foster trust and buy-in from all parties involved.

How to recover from a down round

A down round can be tumultuous for founders, but securing capital is just the beginning. The true challenge emerges post down round—reconstructing market perception, reviving reputation, boosting employee morale, and charting a path to long-term recovery.

Techniques for regaining stakeholder trust

Navigating downrounds involves intricate negotiations, focusing on valuations, ownership stakes, and future funding conditions. Effective negotiation isn’t just about capital; it’s about maintaining investor relationships and positioning your company for recovery. Preparedness for conversations matters more than ever. Aligning stakeholder interests is essential.

Down rounds can prompt a reevaluation of shared goals among founders, investors, and employees. Participation fosters unity and uncovers overlooked strategies. Understanding each VC’s needs based on fund situations is crucial.

Some VCs might not be fully transparent due to fund limitations, but understanding their expectations is key. Ensure clarity on investors’ objectives—quick sale, profitability, or growth for an up round—before proceeding. This approach paves the way for effective post-downround success.

Tips for leveraging the down round to drive future growth

By strategically harnessing the lessons learned and implementing smart adjustments, startups can rebuild investor trust and position themselves for even stronger advancement in the future.

Boosting employee morale after a down round

Following a downround, employee morale can suffer due to layoffs and diminished stock options. To address this, take the following steps:

  • Roll out stock options revitalization: Quickly execute a stock option top-up to retain key employees, preventing them from leaving due to decreased stock value.

  • Reinforce vision and mission: Remind employees of the company’s mission and their vital roles in achieving long-term goals.

  • Prioritize transparent communication: Clearly communicate the company’s priorities and plans, ensuring employees understand their role in stabilizing and advancing the business.

  • Highlight professional growth opportunities: Highlight growth opportunities and career advancement prospects within the company, showcasing how their career paths align with the company’s trajectory.

Restoring market perception and brand reputation after a down round

A down round can significantly impact your company’s image. To counter this, take the following steps:

  • Share transparent updates: Regularly share recovery plan progress to rebuild stakeholder trust and confidence.

  • Develop strategic PR strategies: Develop a strategy highlighting your brand’s resilience, reshaping the narrative to one of overcoming challenges.

  • Engage your customers: Reassure customers of your stability and commitment, fostering confidence in your long-term prospects.

  • Reimagine your brand story: Craft a compelling narrative of triumph over adversity, showcasing your determination to thrive.

  • Earn trust with stakeholders: Emphasize your dedication to vital products/services, ensuring customers feel secure in their investments.

Facing a downround necessitates vigilant financial management for founders. Beyond preserving investor confidence, it enables corrections and improves future financial strategies. To achieve this:

  • Maintain investor trust: Transparent financial reporting reinforces investor confidence, showing dedication to fiscal responsibility even in challenging times.

  • Prioritize timely course correction: Regularly comparing actual financial performance against budgeted projections provides early insights into discrepancies, allowing prompt adjustments.

  • Enhance future planning: Accurate financial monitoring post-downround fosters robust planning for sustainable growth, helping founders make informed decisions.

  • Detect issues early: Thorough budgeting and detailed reporting reveal potential financial hurdles in advance, mitigating risks and promoting stability.

Companies that have undergone a down round

Numerous growing startups are facing financial crunch, impacted by recent turmoil in the global equity markets and a lukewarm reception for new offerings. These conditions have led companies to secure funding at significantly lower valuations than their previously higher valuations.Accessible venture capital funding is fading against the backdrop of inflation-induced high interest rates. Private investors are scrutinizing their investment choices carefully, especially as many startups remain distant from achieving profitability.

According to a report by Pitchbook, in the United States, in 2022, a notable 81 companies experienced a reduction in their valuation during their funding rounds. Some of the recent examples of startups undergoing a down round and dropping valuations include the following:

  • Snyk, a cybersecurity startup headquartered in Boston, secured $196.5 million in its Series G funding round at a valuation of $7.4 billion. This marks a 13% decrease from September 2021, when the company, which has accumulated around $1 billion in total funding, concluded a $530 million Series F round at a valuation of $8.5 billion.

  • Dataiku, a company based in New York and focused on AI/ML platform development for enterprises, recently concluded a Series F funding round with $200 million, valuing the company at $3.7 billion. This marks a 20% decrease compared to August 2021, when Dataiku raised $400 million in a Series E round at a $4.6 billion valuation.

  • London-based fintech startup Checkout.com recently undertook a substantial adjustment to its internal valuation, reducing it to around $11 billion. This comes after the company’s valuation stood at $40 billion in January 2022, following a successful $1 billion Series D funding round. The noteworthy shift represents a significant 73% decline in value.

Amid the stock market’s 2022 downturn, venture capitalists have urged their portfolio companies to extend the lifespan of their cash reserves. This approach averts the need for a new funding round, which could entail a decreased valuation due to the evolving market conditions.

As cash reserves gradually deplete, many firms will eventually exhaust these options. Consequently, they will be compelled to seek fresh capital, potentially leading to a down round. Given the prolonged timeline projected for valuations to recover to their former heights, startups poised for fundraising in the upcoming year may likely do so at a diminished valuation.

However, while a down round is not a desirable situation for any startup, it is not the end of the road. With thorough preparation, careful management, and strategic execution, a down round can be turned around into a growth opportunity. The key is to be transparent, stay focused on your goals, and maintain confidence in your business model and team.

Build your business on solid ground with DigitalOcean

At DigitalOcean, we understand the distinct requirements and obstacles faced by startups and small to medium-sized businesses. Amid down rounds, factors such as cost predictability and operational efficiency take on heightened significance. DigitalOcean is unwavering in its dedication to being the ideal cloud partner for startups throughout this period. To explore our transparent, straightforward pricing and developer-oriented cloud computing resources, sign up for an account today.

Startups can also reap the advantages of Hatch, DigitalOcean’s worldwide startup initiative, offering eligible startups infrastructure credits, top-priority support, and additional benefits.

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