Down rounds are becoming more common in the private company ecosystem in 2023. If you’re preparing for a down round — or considering one in this difficult market — you’re not alone.
We’ve operated in a startup-friendly venture capital (VC) market for most of the last decade. The only companies that raised down rounds, aka decreased their valuation from a previous financing round, had often run into serious hiccups.
That’s not the case anymore. In 2023, we need to destigmatize the down round.
A slashed valuation is a reality for more companies than ever before. Down rounds hit near five-year highs towards the end of 2022, and that trend has continued into 2023 as the fundraising power dynamic continues to swing towards venture capital.
Even the darlings of the private company world aren’t immune. A major payment processing platform reduced its valuation by nearly 50% in its latest round in March 2023.
A down round should no longer be a “scarlet letter” of shame next to a company logo. Many believe that the size and velocity of VCs deals handed out in 2020 and 2021 was largely unsustainable — and that we're simply experiencing a correction to market norms. Companies usually aren’t failing independently; we’re just adapting to the realities of the market with necessary valuation resets.
If your private company is considering a down round, we’re here to help. Let’s examine the cause of the down round boom and discuss some potential ways to prepare for — or prevent — a future down round.
What is a down round?
A down round is an equity financing round in which a private company raises capital at a lower valuation than its previous financing event. In other words, the company’s valuation has decreased since the last time it raised money. This can happen for a variety of reasons, including a lack of traction, poor financial performance or — most relevant to today —a change in market conditions.
For example, a few years ago, a payment processing company raised several million dollars at a considerably high valuation over $95 billion and two years later it raised money at a lower valuation of $50 billion.
Down rounds can affect companies across industries and stages. Even some software companies that have achieved billion-dollar valuations have taken on strategic down rounds in the past two years.
Despite their prevalence, down rounds have often been viewed as a negative signal. They can indicate that a company is struggling or that its growth prospects are not as strong as previously thought. As a result, down rounds can be stigmatized, and companies may try to avoid them at all costs.
What’s causing down rounds in 2023?
Simply put, the craziness of 2020 and 2021 had a strong impact on the current market correction.
COVID created a fertile funding environment for private companies, due in part to low-interest rates and the rise in remote work. Trying to secure a fundraising check from a VC firm became significantly easier. Growth metrics were deprioritized and a “growth at all costs” mentality won out.
Companies with as low as $10 million in ARR were suddenly handed billion-dollar valuations. That’s a revenue multiple of 100X in a world where a 10X multiple is highly recognized. It would be nearly impossible for any company to live up to that sort of valuation.
Now amidst the economic downturn, VCs are tightening their deal flow. Term sheets are getting stricter. Companies are restructuring their cap tables and doing what they can to endure current market situation — but they still need capital.
Offers with 100X revenue multiples are rare. Anyone that raised above their britches might need to do a reality check.
Avoiding a down round
One possible way to avoid a down round is to approach financing events with a sustainable, realistic approach. You may raise a sum of capital that helps you achieve your strategic growth goals, rather than seeking the highest valuation or largest sum of cash. Before you even start talking with investors, you should consider having a thorough plan for how you’d use every dollar.
There are still options even if you’re already headed towards a down round. Budget cuts and layoffs can help you maintain a lean operation, but they’re obviously not everyone’s first choice. A few possibilities you could pursue are bridge financing to extend your runway or seeking out a venture debt deal that won’t dilute your equity quite as much.
How to approach a down round
A down round doesn’t have to be a disaster. Here’s how you may prepare yourself for a valuation drop:
Reframe your mindset.
In many cases, your down round isn’t a sign of failure. Private companies across the world got swept up in the valuation frenzy. Not many people were resisting large checks from VC a couple of years ago.
It can be helpful to think of a down round as a move to sanity, instead of a punitive measure. It’s a “necessary valuation reset.”
Ask yourself: “What’s my alternative?”
A down round might feel crappy. But in the long run, it’s probably one of the best things for your company. Short-term pain can be offset by more reasonable expectations and a strategic path to profitability. Plus, if you remove the unrealistic valuation point from your graph, your company may still probably be on an upward trajectory from where it was pre-2020.
Maybe after evaluating all of the factors, a down round may not be the worst option — especially if you want to avoid layoffs or budget cuts or an unfavorable VC deal with aggressive liquidation preferences.
Be transparent with existing investors.
Raising a down round will require board consent and stockholder approval. Existing investors could have their ownership percentages diluted, which rarely feels great. However, if a down round is necessary, it may be best to be transparent and consult your investors early and often as you navigate that path.
Existing investors might hold anti-dilution provisions that empower them to purchase more shares at the new reduced price to retain their previous percentage of ownership. Investors without anti-dilution safeguards may encounter a substantial decline in their ownership percentage and investment value. If existing investors are partaking in your down round, they can bargain for terms to modify these protections and potentially enhancing their outcome if your company is acquired or shut down.
Consult your legal counsel before getting too far. They’ll help you read the fine print of your previous equity financing deals and interpret any new term sheets.
Simplify your financing with Fidelity
If your private company is considering a down round, the last thing you want to worry about is maintaining your cap table and executing legal documents. Fidelity’s equity management platform is designed to help take the stress out of financing by combining corporate governance, fundraising tools, and an automated cap table all in one easy-to-use hub.
The platform’s Next Round Planner feature allows private company leaders to model different financing scenarios based on the potential parameters of their next investment round. Users can enter new stock classes and investors to visualize post-round ownership — and generate a Pro Forma cap table.
Fidelity also brings fundraising expertise to help you evaluate all of your financing options. This year hasn’t been kind to many private companies, but we’re in your corner.
Need help with fundraising? Check out our platform for all of your equity management needs.
Fidelity does not provide legal or tax advice.
A link to third-party material is included for your convenience. The content owner is not affiliated with Fidelity.
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