Down Round

Updated on May 3, 2024
Article byShraddha Sureka
Reviewed byDheeraj Vaidya, CFA, FRM

Down Round Meaning

Down round refers to raising equity capital by a privately held company at a lower company valuation than the previous financing round. Therefore, it may lead to a threat of dilution or even disenfranchisement of the existing shareholders and a change of control in the hands of the new investors.

Down-Round Meaning

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This form of financing is not a highly profitable situation for a company because it always leads to a threat of dilution or even disenfranchisement of the existing shareholders, and a change of controlChange Of ControlThe term "change of control" refers to a situation in which the majority ownership of a company, and thus its business decision-making powers, shifts from one person to another.read more in the hands of the new investors. However, if there is a possibility of avoiding this situation by meeting the current needs through short-term financing, then the entity should go for that.

Down Round Explained

Down round financing is when the company realizes it needs further funding to meet its financial obligations. Still, at the same time, it also recognizes that the company valuation has gone down. Thus it is forced to raise capital at a lower valuation than its previous financing.

It is an indication that the company looks less promising in its competitive industry, and therefore its value has declined, and it also needs new funds to keep afloat. It might also provide a check to the owners and the managers that they need to gear up and actively attempt to drive up the performance.

There might be specific criteria and a timeline that the company might not have been able to fulfill, and therefore, this might have led to a reduction in its valuation. The company needs to keep track of such red flags and avoid their frequent occurrence. If the company has the option to choose short term financing, that is a better method. It is in the best interest of the company and the employees to undertake that route and upgrade performance for a future round of funding, which may be on less strict terms and conditions if not an up round altogether.

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Importance

Let us look at the importance of down round financing.

Down-Round Importance

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#1 – Provides an Opportunity for Revaluation

As valuation is a prerequisite of the new round of funding, it gives the investors a true and fair view of the company’s current financial position. It, therefore, helps them in making an informed decision.

#2 – Provides a Reality Check

The managers and owners might get too comfortable with the previous round of funding and may have misplaced anticipations of the company’s future and current performance. However, the process of down round investment brings the clarity required for them to take the necessary measures to keep the performance up to the mark.

#3 – Analysis of Competitive Space

As part of the process, the company analyzes the competition. Initial idea generation might have given the company a first-mover advantage; however, the present scenario might be such that the new entrants might have emerged and might have the capability of eating into the company’s share. This analysis helps the company in the development of its future strategy.

Thus, the above are the various importance of down round funding.

Example

Let us assume Silver Line Ltd is a pharmaceutical company operating on a global level. They have factories in all major cities of the world and is headquartered in New York. In its first round of financing the company was able to raise an huge sum and meet the necessary requirements. However the business started expanding and more finance was needed. But then the management realized that due to high competition from various pharma companies, the valuation of Silver Line has come down. Due to this, the company will now be unable to raise enough funds to meet its requirements. Thus it is forced to raise capital at a lower valuation. This kind of financing is known as down round funding.  

Benefits

Down-Round Benefits

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#1 – Additional Funding

One of the most obvious impacts of the process is that a company can generate new funds through down round venture capital, that is required for its future strategies and continued existence.

#2 – Austerity

When the company can attribute the causes of the emergence of the down round investment, it can think in the direction of what it could do better to upgrade its valuation in the future. In this process, it takes austere measures to cut down expenses, which are not necessary, such as reducing the employees to the right required number or reducing sales promotions, which eat into the company’s profits.

#3 – Find Alternatives

Suppose, ultimately, the company feels that the price for the new issue is not sufficient. It may look for alternatives such as a short term financingShort Term FinancingShort-term financing refers to financing a business for less than a year in order to generate cash for working and operating expenses, usually for a smaller amount. It include obtaining funds through online loans, credit lines, and invoice financing.read more route and later try again from a new issue after upgrading its performance.

#4 – Ownership Dilution

As for any company, the new share issueNew Share IssueShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owner's equity on the Company's balance sheet.read more leads to a dilution in the ownership, resulting from the down round down round venture capital financing. However, as the company is revalued in a down round; therefore, the value of the existing shareholding also decreases, and these shares are also worthless.

Limitation

  • As an anti-dilutive step, some preference shareholders negotiate for price protection. In such a case, the equity share or warrants and other such subordinate securities bear the dilution of the protected preferred shares and are therefore diluted more. So even though there is a provision of price protection, it is a limitation of the down round that costs other shareholders.
  • It may lead to limited funding with clauses such as staggered funding, mandatory redemption, seniority over existing shares, increased voting rights, or control over the decisions by the new investors. As a company is desperate for funds, it may shut down or accept such terms and conditions.
  • Approval of existing investors and employees is a must in down-round financing due to the heavy dilution they have to bear as a part of the funding. It is not an easy process and requires cooperation and trust in the company. Further, it may cause problems with employee retention as well.

Down Round Vs Up Round

#1 – Meaning

As the name suggests, the Up round is the follow-on funding round where the price of shares is higher than the previous round. Therefore, the definition is one of the significant differences between down round and up round.

#2 – Amount

As a natural outcome of the price, an up round raises a higher amount because the shares are issued at a premium, while the down round raises a lower amount because the shares are issued at a discount.

#3 – Signal to the Investing Community

An up round is a positive signal to the existing and prospective investors because, due to revaluation, they get an update on the company’s performance and can safely say that their existing or upcoming investment is in safe hands where the company is in an uptrend and may continue on the same trajectory in the future, thereby boosting investor confidence. As opposed, the down round is a negative signal and is everything that an up round is not.

#4 – Morale of the Company

From the point of view of the company, and up round is good news as it acts as a reward for the hard work its employees have been putting in and therefore acts as a morale booster for them and helps them in their continued effort for better performance because in case of a privately held companyPrivately Held CompanyA privately held company refers to the separate legal entity registered with SEC having a limited number of outstanding share capital and shareowners. read more, the stock market news and other such publically available means of rewarding news don’t exist so an up round acts as a bearer of good news. But, on the other hand, it is demoralizing for the employees and their owners because they might have to shut down the company if the situation gets too dire.

#5 – Counter-Intuitive Impact

At times an up round may bring in complacency in the company and lead it into future down rounds. On the other hand, a down round may act as a reality check when the employees rise to the challenge and boost their performance leading up to an up round in the future. Therefore it is a subjective situation and may have a counter-intuitive impact.

This article has been a guide to Down Round & its meaning. We explain its differences with up round, along with example, importance, benefits & limitations. You can learn more about it from the following articles –