Understanding Down Rounds in Funding

"I raised $20M at a $120M valuation while my existing investor tried to force a flat round." Following up on my post from yesterday about VCs trying to force a flat or down round, here's how to protect yourself from down round manipulation: 1. Limit veto/blocking rights with "Qualified Financing" clauses Existing investors can only block objectively bad deals. Define "Qualified Financing" as any round above last round's valuation from legitimate investors. 2. Consider including founder-friendly "Pay-to-Play" provisions If existing investors don't participate at fair valuations, they lose liquidation preferences or anti-dilution protections. 3. Structure anti-dilution Use narrow-based weighted average anti-dilution, not full ratchet. Full ratchet gives disproportionate benefits to existing investors in a down round, potentially giving existing investors motivation to produce a down round to increase their holdings. 4. Secure independent board members Ensure at least one board seat has no economic interest in forcing down rounds. One founder I know learned this the hard way. His company created significant IP but didn't do very well on GTM. Without protections, investors forced three consecutive down rounds over 24 months, diluting him from 22% to 3% ownership. When the company sold for $180M, he received $5.4M while manipulative investors made $100M+. Down round manipulation works because founders don't understand it's happening until too late. VCs frame these moves as "market realities" while systematically transferring wealth from founders to their funds. Companies with anti-manipulation provisions can achieve higher exit valuations - because VCs focus on building value rather than extracting ownership. The best time to prevent down round manipulation is during your first institutional round when you have leverage. Build these protections early, and ensure your investors' incentives align with maximum company value. #VentureCapital #TermSheets #FounderProtection

The D-word is back in the VC landscape: Down-Rounds. The down-round is when the valuation of a startup is lower than a previous round. This is considered worse than the equally feared flat round – where the valuation remains the same as the previous round. Founders and VCs don’t want to hear the word and bend backwards to avoid them. VCs fear the wrath of their investors when they need to admit their previous valuation was over-priced. Founders are terrified that a down-round will be the last equity they will be able to sell, and it will fully dilute them out of their positions.  With market valuations dropping everywhere, it is almost impossible to avoid them. Valuations in the secondary markets have dropped close to 50%-80%, and primary rounds are equally low across almost all sectors (except AI/ML). The question is what founders should do? For founders that fear the down round, they will take evasive measures to ensure their next round is at least a flat round. This includes cutting costs to extend their runway as far as possible in the hopes that they can weather through the tough market. Others take venture debt to bridge the gap to the next round (often at steep terms). Some will include incredibly favorable terms such as 3x liquidation preferences to new investors to compensate for the higher valuation (in other words, artificially increasing the value by absorbing more risk). Yet, this should not be seen as the only path. More VCs and founders have started to embrace the down round. In many ways, the private market should be seen similarly to the public market. People instinctively understand that the public market can become overvalued, and prices can drop – while the underlying company is no worse than it was before. However, this is not the case for the private market – while it should be. There are times when the market is hot and valuations can be high, but similarly the market valuations can come down without representing a worse underlying company. According to a study by Pitchbook, between 2008 and 2014, 1,421 companies raised a down round and only 188 of them (13%) weren't able to raise another round of fundraising or sell their company. That means that even with a down round, there is over an 87% chance of being successful! Just as an example, Facebook (now Meta) was valued at $15B in 2007 and then had to raise a down round with a $10B valuation in 2009. While it may be scary to think about having to lower your valuation, it is important to realize that it does not mean your startup is a failure or that you can’t lead a successful VC startup. On the contrary, it means the market was overheated and has become more realistic. Most founders with down rounds still end up successful. __________________________________________ I originally wrote this post for Thunder. Make sure to follow them, Jason Kirby, and Alex Pattis for more amazing content.

19% of venture rounds are down rounds in 2023. That's up from only 5% down rounds in 2021. And these down rounds are seeing companies take significant haircuts vs the prior valuation (anywhere from 30-60% drops). Nobody's idea of a good time. Of course, company valuations in the public market decline all the time so I believe the stigma of a down round in private tech is a bit unwarranted...but I digress. First off - just how common are down rounds today? If you focus on the black bars in the chart below, they illustrate the percentage of all rounds in a given stage and year that were down rounds. For Series A, the percentage jumps from 8% to 16% year over year. Series B 8% --> 14% Series C 8% --> 19% Series D 13% --> 31% Series E 15% --> 24% Youch. But the frequency of these down rounds isn't the only metric we care about. We're also interested in how much the valuation declines for each company. So now focus on the salmon-colored bars. The median post-money valuation decline in a down round for a Series A company is -34% this year. The median decline in a Series E down round? -56%. Obviously you'd expect the declines to increase as a company gets later stage (since they are closer to the public markets which have not been kind to tech companies over the past year + some recent IPOs failing to take off) but damn. A 56% haircut is no joke. These are difficult moments in a company's lifecycle. They require a ton of explaining - to new investors, to current investors, to the wider employee base. But there are many examples of startups achieving major exits after undertaking a down round - so hang in there 🙏 #cartadata #downround #startups #founders #fundraising #venturecapital