Down Rounds in Business Valuation – Guide

After a series of successful funding rounds, your company suddenly needs more capital and discovers that its market worth has significantly dropped. Offering shares at a lower price than before can feel like a setback to your goals and efforts. But what if this challenging situation could actually lead to new opportunities? 

Down rounds are not just signs of distress; they can also be an opportunity for growth. Understanding down rounds is crucial for today’s investment landscape. With nearly 17% of venture funding rounds now classified as down rounds, it’s time for founders and investors to rethink their approach.

This article will help you to understand down rounds in business valuation, particularly focusing on their implications for both founders and investors.

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 like failure to meet performance targets, increased competition and economic conditions.

Down rounds are often viewed negatively by investors because of it associated with potential issues within the company. Also it can affect the company’s ability to secure future investments .

A downround in business valuation occurs when a private company raises additional capital at a lower valuation than in previous financing rounds. This situation arises when the company realizes it needs more funding than anticipated and discovers its value has decreased compared to earlier assessments.

Reasons for Down Rounds

Although down rounds are often perceived negatively, they can also provide companies with an opportunity to recalibrate and concentrate on long-term growth strategies.

• Poor Company Performance – Failure to meet key performance indicators can lead investors to reassess the company’s value.
• Market Conditions – Economic downturns or shifts in investor sentiment can negatively impact valuations.
• Cash Flow Issues – Running low on capital may force companies to accept lower valuations to secure immediate funding.

Implications of a down round in business valuation

A down round in business valuation has several significant implications for companies, investors, and employees.

Implications for Companies

• Companies may have less negotiating power regarding deal structure and investor terms, often needing to concede more control or equity to secure funding.
• Negatively affect employee morale, as staff may perceive their equity stakes as less valuable. 
• Down rounds often signal to the market that a company is struggling or has been overvalued previously, which will break trust among investors.
• 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.

Implications for Investors

• Investors from previous rounds experience a decrease in the value of their holdings. They may need to write down the value of their investments, impacting their portfolio metrics such as Total Value to Paid-In (TVPI) and Internal Rate of Return (IRR).
• New investors entering during a down round typically gain a larger ownership stake for less capital, potentially increasing their influence over company decisions.

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:

• Assess the situation – It is more efficient to raise the money required to meet realistic growth objectives rather than engaging in ongoing, stressful fundraising.
• Financial Analysis – Review your financial health and have a look at the Corporate Charter and finance agreements from previous rounds.
• Cost Management – 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.
• Investor relations – Maintain open communication with investors and stakeholders .Transparency in operations can help to build trust.
• Market research – 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 does a down round affect your 409a valuation?

Down round can impact a company’s 409a valuation, which are crucial in determining the FMV of its common stock, particularly for stock option grants.

• Lower 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. 
• Impact on stock options – 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.
• Employee retention – 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.

Transform Down Rounds Into Growth with Eqvista!

Navigating down rounds can feel like a daunting journey for startups. 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 rounds. Turn your down rounds into a positive signal with Eqvista – our platform simplifies equity management, ensuring you maintain clarity and control over your financial landscape. Whether facing down rounds or planning your next funding strategy, Eqvista provides the tools and insights you need.

Contact us today to learn more about our valuation services.