What is Down Round?
Down Round refers to raising equity capital by a privately held company at a company valuation that is lower than the previous financing round and, therefore, 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.
Explanation
- It is an indication that the company looks less promising in its competitive industry, and therefore its value has declined, and also it 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 at driving up the performance.
- There might be specific criteria and a timeline which the company might not have been able to fulfill, and therefore, this might have to lead up to a reduction in its valuation. The company needs to keep track of such red flags and try to avoid their frequent occurrence.
Importance
#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 current financial position of the company. 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. The process of down round 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 takes to analyzing 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 share of the company. This analysis helps the company in the development of the future strategy.
Impact of Down Round
#1 – Additional Funding
One of the most obvious impacts of the process is that a company is able to generate new funds which are required for its future strategies and continued existence.
#2 – Austerity
When the company is able to attribute the causes of the emergence of the down round, it is able to think in the direction of what it could do better in the future to upgrade its valuation in the future. In this process, it takes austere measure as to cutting down expenses, which are not necessary, such as reducing the employees to the right required number or reducing sales promotions, which eat into the profits of the company.
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#3 – Find Alternatives
If, ultimately, the company feels that the price it is getting for the new issue is not sufficient, it may look for alternatives such as a short term financing route and later try again from a new issue after upgrading its performance.
#4 – Ownership Dilution
As for any company, the new share issue leads to a dilution in the ownership, so the same is a result of the down round 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 of the 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 it costs other shareholders.
- It may lead to restricted funding with clauses such as staggered funding, or 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 either 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 of 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 in itself 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 the prospective investors because due to revaluation, they get an update on the company 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 company, 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. It is a demoralizing affair 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 can lead it into future down rounds. 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.
Conclusion
Overall, down round 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 control in the hands of the new investors. If there is a possibility of avoiding this situation by meeting the current needs through short term financing, 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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