Arunangshu Munshi
Editor's Note:-A down round can feel like a barrier, but it doesn’t mean the end of the startup’s journey. In this post, we’ll explore why down rounds happen, how they can impact your company’s valuation, and most importantly, how you can handle or prevent them. Whether you are building your business or investing in one, understanding these situations will help you stay grounded and make smarter decisions moving forward.
If you fully accept the worst that can ever happen in your journey, fear won’t ever be an obstacle in starting up
What if the next round of funding values the company lower than the previous round? This is known as a “Down Round,” and it can be tricky for the founder to command the company’s goal. As a founder, it is important to bring in new money to keep the existing investors happy. A down round for the company means the growth hasn’t met expectations and this hits hard on employee morale and makes recruiting and retaining people more difficult.
But a downturn isn’t the end of the startup. Many successful companies have faced downturns, such as Meesho, Udaan, Pharmeasy, BYJU’S and many more. However, it’s necessary to know about downturns, their effects, and strategies for startups to handle them.
The simpler way to understand what is a Down Round is when a company raises capital for the business by selling shares at a lower price per share than in a previous funding round. This can happen due to a lack of growth in the company’s startup or due to a downturn in the economy.
There are a few common reasons why down rounds occur in a company:
Underperformance or failure to meet the milestone. If the company is not hitting the key metrics, the investors may feel more risk and offer the company a lower valuation.
Macroeconomic challenges, such as recessions, can affect startups by shifting investor sentiment toward a more negative outlook, making funding harder to secure.
If the company is running out of cash or the runway is yet to end, the startup founders do not have much choice but to raise money at a lower valuation for the company's survival.
Investor motivations evolve as a company grows. Early investors usually chase big returns, betting on the potential for rapid growth. Later investors, however, may have different priorities like minimizing risk or ensuring steady profitability which can affect how they value the company.
The down-round funding can be critical for startups so, to continue operations they should use the capital strategically to get back on track and improve the metrics to position the company for an up-round in the future with a high valuation.
After we learn what is a Down Round, it is very necessary to know about the negative impact on the startup:
Impact: When a company is about to raise capital for the business at a lower valuation it becomes hard to negotiate the terms of the deal. Investors are willing to take more equity to get control and ownership in exchange for their capital.
Solution: As a founder, it's their responsibility to get the necessary funds by diluting their stake.
A down round can affect team morale and make people question the startup's path forward. Employees may feel insecure about their job security. It’s a difficult time for a company and its founder but they should be transparent with the situation and clear with the vision so that the team feels motivated also, to assure them that their contribution to the company remains appreciated.
Impact: The founders seem to find it difficult to raise capital for the business from investors in the future due to the down round. While a down round might feel like a setback, it doesn’t define the startup's future.
Solution: The employees should work hard in the company to gain the same momentum to achieve the company’s vision. After a down round, they looked into new funding options, focusing on key milestones, and working towards raising capital for the business on better terms to show the company progress.
Instead of chasing the highest possible fundraising total, consider raising capital for business which is enough to reach your next growth milestone. This approach protects you from unnecessary dilution and limits the number of investors with anti-dilution rights, reducing potential complications.
It’s easy to get optimistic when markets are booming, but setting realistic growth targets is key. Overestimating can backfire if growth slows and more funding is needed, potentially leading to a down round.
The founder should look for alternate sources of funding to avoid a down round. The founder can raise capital for the business through angel funding, crowdfunding, and venture debt. While it might not completely replace a full funding round, every little bit that can be raised can ease the burden of a down round.
A down round can impact the interest of both investors and employees in a few key ways:
The investors who invested their money in the company in the early stages took the biggest risk. So, they expect a higher return on their investment, but a downturn limits the potential returns.
In a down round, the investors who have invested their money gain a large ownership stake for less capital. As a result, they have more rights to control the company’s direction, whereas the previous investors had to negotiate to avoid losing too much control.
For employees with stock options, a significant drop in company value due to a down round can be disheartening, especially for key talent. This can impact employee motivation, so the company may need to find new ways to re-inspire and retain these team members.
A down round can be tough for employees who are holding stock options. Those who’ve already exercised at a higher price may face disappointment, while others with “underwater” options might wonder if their shares will regain value. If the fair market value stays low, some may decide not to exercise, releasing options back into the pool.
Key strategies to handle the challenge of down round:
Reach out to the investors and seek to renegotiate the terms and conditions of the down round. For example: The founder can negotiate for a higher valuation, secure warrants or options, lessen the liquidation preference, or restrict certain investor protections. Any improvements can motivate the founder, previous investors, and the company's team members.
If you generate revenue, consider non-equity options like debt financing or revenue-based financing. These alternatives can help you raise capital for the business needs without the challenges that come with down rounds.
This is a great chance to attract new investors while adjusting your cap table to reduce earlier investors' stakes. Offering fresh investors a larger share can enhance funding opportunities.
While existing investors might feel sidelined, securing better terms could make it worthwhile. Every challenge can lead to new growth opportunities.
So, now that we know what down-round is and how it can impact the startup, It is very common in startup culture. What matters most is approaching them with clear expectations, staying focused on the long-term vision, and making decisions that pave the way for future success. A down round may feel like a setback, but with the right approach, it’s just one part of the story.
Subscribe to stay ahead with expert insights on ESOPs, smart ownership strategies, and more!
Related Content
