Facing a Down Round? Don’t Panic…

The path to startup success is rarely straightforward—it can be fraught with uncertainty, especially when it comes to raising money.

You need to keep the money coming in—and in order to do that, you need to prove to investors not only that your story is worth buying into, but also that your growth trajectory is sustainable and that you’re spending money wisely.

If you can’t, you risk losing investor interest (or scaring them away)… and ultimately, your startup sinking before it ever really gets off the ground.

That’s why a “down round” can be an alarming prospect for any entrepreneur.

But down rounds aren’t necessarily a death knell for your business. Here’s everything you need to know about down rounds… why they happen… and why they’re not as scary as you might think.

When a startup goes to raise money for its business, it typically does so through a series of funding rounds (Series A, B, and C), during which it tries to attract outside investors in exchange for equity in the business.

In an ideal scenario, the company’s valuation would rise with each subsequent round of fundraising.

But that’s not always how it works…

A “down round” is the term of a round of financing when the company’s pre-money valuation is lower than its post-money valuation following the last round of financing. In other words, the company’s shares are priced lower than they were during the prior round of financing.

Down rounds may also include less desirable terms, both for the company and for investors. These might range from “milestone payments”—when the company only receives a portion of the funding until it meets certain benchmarks… to “pay-to-play”—when investors much commit to future funding rounds or lose their preferred stock.

In addition to scaring off investors, a down round can impact morale and send your top talent running for greener pastures.

That’s because a down round can indicate that a company’s growth is slowing… it’s missing important business milestones (like product releases or revenue growth)… or new competition has emerged that makes the company’s solutions less valuable. Or it might signal that investors during the first round might have overestimated the company’s growth story—and new investors require a revaluation to reflect the true growth trajectory. 

But even the best businesses can suffer a down round for no obvious reason. This is especially true during tough economic or market conditions when investors are more reticent to part with their cash—or demand more proof of concept to justify valuations.

For instance, in the wake of the dot-com bubble bust, down rounds made up a staggering 61% of all fundraising rounds… and they made up 40% of financing rounds following the housing crisis of 2008.

It’s worth noting that in both the above cases, the number of down rounds started dramatically increasing about five quarters following the Nasdaq’s peak… reaching their highest level about two years later before beginning to come down again. 

In short, when the economy turns, sometimes even the best businesses are forced to raise more money at lower valuations.

Luckily, there are several terms you can incorporate into down rounds to entice investors, from accrued dividends… to higher-priced liquidation options… to anti-dilution protection… to “pull-throughs”—when investors who contribute at a certain level can exchange their older shares from the previous financing round for more shares at a lower price during the down round.

The good news is that many businesses that raised funds below their valuation have gone on to thrive, IPO, and deliver huge gains to investors—including the likes of Facebook, DraftKings, Airbnb, Lending Club, Credit Karma, and Grubhub.

So if you’re facing a down round, try not to panic—it doesn’t have to mean the end of the world.