Down Rounds in Business Valuation – Guide

We present you a deft guide on down round in business valuation.

If you are a startup seeking to expand, you need to show your investors that your business has a high growth potential. For a startup, a down round of financing might be a bleak prospect. However, you shouldn’t be discouraged by it. The fact that you are conducting a down round indicates that you successfully raised money. Even though a down round may dilute your economics, it cannot shut down your business, unlike a lack of funding. Thus, there is no need to be afraid of a down round but rather understand it. We present you a deft guide on down round in business valuation.

Down round and business valuation

Business valuation is a term that pops up at almost every stage of doing business. Being familiar with its technicalities will help your business prosper. Scroll down to have a better understanding of down rounds and business valuation.

Understand business valuation

The process of calculating the present value of a business, an investment, a startup, or an asset is referred to as business valuation. The fair value of a company can be established through a company valuation for several purposes, such as sale price, determining partner ownership, taxation, etc. For an unbiased assessment of the value of the business, owners frequently resort to qualified professional business assessors.

How does business valuation work?

A review of a company’s management, financial structure, potential for future earnings, or market worth of its assets may be included in a business valuation. Depending on the evaluator, the company, and the industry, many tools may be employed for appraisal. Examining financial records, discounting cash flow models, and comparisons with other similar companies are common methods for valuing businesses. Business valuation is usually done through asset-based methods, earning value methods, or market value methods.

Benefits of business valuation

One of the finest ways to assess your company’s financial situation is through a business valuation. Also, it is quite helpful if you want to sell your firm or attract more investors based on a specific valuation. Some of the major benefits of a business valuation are:

Benefits of business valuation

  • Vast knowledge of company assets – Business owners can decide how much to reinvest in their companies by having an understanding of a more accurate financial figure. A valuation will give you more knowledge about your company in concrete numbers, helping you make better decisions for your business.
  • Accurate Business Value – Business owners must get a precise evaluation of their assets. Estimates are inappropriate because they can be interpreted as generalisations.
  • More Negotiating Power During Mergers and Acquisitions – You can negotiate the acquisition price using a business valuation to demonstrate a consistent trend in value increase during mergers and acquisitions.

What is the down round in business valuation?

During a “down round”, an investor places a lower value on a company than it did during a prior period or financing round. When a company is in a down round, investors often pay less for equity in the company than they did in earlier rounds. This also probably applies to convertible bonds. There are many possible causes for a down round, but some of the more prevalent ones are greater market rivalry, general economic or stock market falls, or a shift in investor view of the company’s worth during fundraising.

Down rounds occur when a company learns it needs more money than it thought and when that company also comes to the realization that its value has decreased relative to its previous fundraising round. When this happens, the company’s equity or shares are sold for less than they’re worth.

What you should know about mechanics of dunning in business

The practice of business owners engaging with consumers to collect payment for goods or services rendered is referred to as dunning. The kind of dunning a firm does is determined mainly by the amount of debt owed, its relationships with clients, and how long payments have been due.

While an organisation’s accounts receivable department typically handles dunning, missed payments may eventually be forwarded to internal collections departments before being sent to outside collections firms. The majority of jurisdictions prohibit coercion and intimidation. The mechanics of dunning involves increasing levels of intensity, typically as follows:

  • Customers are gently reminded over the phone of the due payments.
  • Formal letters are sent asking for payment.
  • Visits in person are made, requesting payment.
  • Outside collection agencies are used to pressure late-paying clients.
  • Warning of legal actions is made.
  • Litigations are carried out at the end.

How does down round work in business valuation?

During a “down round”, an investor places a lower value on a company than it did during a prior period or financing round. When a company is in a down round, investors often pay less for equity in the company than they did in earlier rounds. This also probably applies to convertible bonds. There are many possible causes for a down round, but some of the more prevalent ones are greater market rivalry, general economic or stock market falls, or a shift in investor view of the company’s worth during fundraising.

Down rounds occur when a company learns it needs more money than it thought and when that company also comes to the realization that its value has decreased relative to its previous fundraising round. When this happens, the company’s equity or shares are sold for less than they’re worth.

Implications of a down round in business valuation

If a company fails to accomplish its milestones, investors use it as a reason to reduce share prices and the overall valuation of the company. When a new company enters the market, it increases competition, causing a down round. Businesses may find it difficult to persuade investors of their worth when they are up against stiff competition. Investors typically reduce the value of share prices in such cases to account for the risk involved with the investments. Down-round implications should not be taken lightly as these can hinder the growth of a company.

The alternative of a down round in valuation

As a down round can be a demotivating factor for companies, there are several down round alternatives to opt for. Below is a list of four down-round alternatives:

  • Bridge Financing – Bridge financing or short-term financing is a type of temporary funding meant to meet a company’s immediate expenses until normal long-term financing is obtained.
  • Renegotiating – It is possible to renegotiate the terms of the round with the investor. This can be done by reducing the anti-dilution protection or trading these rights for additional investor benefits like upside protection.
  • Cutting costs – Cutting costs will delay the requirement for an external fundraising effort, but it could not be practical for a very lean organisation or one with a small income.
  • Shutting the business – It can be wiser to close your company and start again if there are too many issues, unhappy staff, and investors that no longer support you.

Example of a Down Round

Consider a business that has raised $150,000 in one round from friends and family at a pre-money valuation of $1 million. The founders initially owned 100% shares. The ownership split after the post-money valuation will be 87% owned by the founders and 13% owned by the investor. Imagine that this business expands and receives additional funding rounds until the investor owns 60% shares, and the founders own 40%. Further, consider that the company now needs a $1.5 M investment. As a result, in a down round, the worth of the shares falls sharply, and the dilution effect is escalated. The founders merely own 50% shares; the old investor owns 34% shares, while the new investor owns 16% shares.

Why does a down round happen?

Down rounds happen for private as well as publicly traded businesses for the following reasons:

  • Failure to meet investors’ earnings targets – The growth of the investors’ estimations will need to be revised downward if a firm doesn’t meet the required benchmarks, which will also affect the company’s valuation.
  • Deteriorated competitive environment – Expectations about a company’s capacity to capture market share will also affect valuation if new rivals emerge.
  • Tightening of general funding conditions – A decline in the interest of the investor in private company stock will result in lower valuations for all companies.

How to prepare for a down round?

Being cautious and intelligent while soliciting finances is the greatest approach to prepare for down rounds. Keep in mind the following advice to prepare for a down round:

  • It is more efficient to raise the money required to meet realistic growth objectives rather than engaging in ongoing, stressful fundraising.
  • Have a look at the Corporate Charter and finance agreements from previous rounds.
  • Make sure you have put together a spreadsheet that will enable you to assess the effect of financings at various price points on the current cap table if your shareholders have anti-dilution rights.
  • The Board of Directors should shop financings around to other investors to minimise this risk, and it ought to put these efforts in writing. To thoroughly comprehend market concepts, the Board should also perform market research.

How a down round affects your 409a valuation?

Down rounds eventually influence a company’s key performance metrics (customer churn, long-term revenue growth, profit margin, etc.), which can have an impact on businesses that use a discounted cash flow technique for their 409A valuation. Employees who own common stock will likely have less ownership following a down round because preferred stockholders sometimes have anti-dilution clauses, leading to a low 409A valuation. In an up round or a flat round, there are not many dire consequences of dilution since the resulting 409A valuation remains higher. On the contrary, a down round causes a low valuation of the company leading to low stock prices.

A low 409A valuation might not always be hazardous for a company. A lower 409A valuation for new hires results in a lower base cost of equity, which may increase the value of the salary package since a decline in valuation does not necessarily indicate that the company will not have a successful exit. Present employees might spend less to exercise their options and plan for a potential exit more efficiently.

To not be tangled in such labyrinths of 409A valuation, you should get assistance from a professional valuation service provider. Eqvista holds a NACVA (National Association of Certified Valuators and Analysts) certification and is a well-known authority in providing reliable 409A valuations for various businesses in every size, sector, and stage. With our expert team of valuators, you will have nothing to worry about.

Get a business valuation from Eqvista!

Due to the constant threat of dilution or even disenfranchisement of the existing shareholders and the transfer of power to the new investors, down-round financing is not a very beneficial position for a firm. However, getting professional assistance can help you get away with unpleasant conditions created by down round. With leading valuation services, Eqvista’s expert team can help you to qualify for your funding rounds! Contact us today to learn more about our valuation services.

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