What is a 'Down Round'
A down round occurs in private financing when investors purchase stock or convertible bonds from a company at a lower valuation than the preceding round. Lower valuations in private companies occur for many of the same reasons as publicly traded stocks, including the rise of new competition, stock market declines and changing investor perceptions on company valuations.
BREAKING DOWN 'Down Round'
While each funding round typically results in the dilution of ownership percentages for existing investors, the need to sell a higher number of shares to meet financing requirements in a down round increases the dilutive effect. Due to the potential for drastically lower ownership percentages, raising capital in a down round is often a company’s last resort, but the new funding may represent the company’s only chance of staying in business.
Startup companies often raise capital with a series of funding phases, referred to as rounds. Generally speaking, as a business develops, the sequential funding rounds are executed at progressively higher prices to reflect the increasing valuation of the company. There are, however, several conditions under which the latest investors may demand a lower price than the preceding funding phase, referred to as a down round.
Failure to Meet Benchmarks
While the earliest investors in startup companies tend to buy at the lowest prices, investors in subsequent rounds have the advantage of seeing whether companies have been able to meet stated benchmarks including product development, key hires and revenues. When benchmarks are missed, subsequent investors may insist on lower company valuations for a variety of reasons including concerns over inexperienced management, early hype versus reality and questions about a company’s ability to execute its business plan.
Emergence of Competition
Businesses that have a clear advantage over their competition, especially if they are in a lucrative field, are often in a great position for raising capital from investors. However, if that edge disappears due to the emergence of competition, investors may seek to hedge their bets by demanding lower valuations on subsequent funding rounds. Generally speaking, investors compare the product development stage, management capabilities and a variety of other metrics of competing companies to determine a fair valuation for the next funding round.
Funding From Venture Capital Firms
Down rounds can occur even when a company has done everything right. To manage risk, venture capital firms often demand lower valuations along with measures such as seats on the board of directors and participation in decision-making processes. While these situations can result in significant dilution and loss of control by the founders of a company, the involvement of a venture capital firm may be exactly what the company requires to reach its primary objectives.