What are down rounds?
A down round is when investors purchase a stake in the startup at a lesser value than the previous round of funding. When a startup seeks funding, a pre-money valuation must be set in advance with the assent of the investors. The pre-money valuation marks the startup's value before the funds are raised.
While funds are being raised, the company issues a predetermined amount of new shares in anticipation of how much capital they expect to raise. The capital expected is then divided among the shares issued, creating the price of each share. When the round ends, if the overall value of the company or post-money valuation is lesser than the pre-money valuation, then it is declared as a down round. This indicates that the valuation has either dropped since the previous round of funding or that the previous round of investment was done on overvalued shares. There can be various reasons for a down round. Increased competition in the market, general economic condition, stock market declines, or any other change in material facts or circumstances.
Down rounds evoke apprehension, and hence the topic is usually avoided instead of comprehensively addressed.
Is overvaluation connected to down rounds?
The recent 75% fall in the value of Paytm since its IPO has raised some alarm bells for investors. Paytm has been India's biggest Fintech unicorn for a while, so why did they feel the need to overvalue themselves? Paytm had a down round back in 2019 when their investors purchased the shares at Rs.16000 per share, a whopping 20% reduction from their previous valuation of Rs. 20,200 per share.
This was not a major setback for Paytm yet. The reduction in value was due to external factors like UPI that levelled the playing field for payment apps leading to the unforeseen growth of rivals like PhonePe. However, the real problem started during the IPO when they decided to value themselves at $19.5 to $20 billion, a big leap from their previous valuation of $16 billion. With no supporting factors for this rise in valuation, one may wonder if they overvalued themselves, fearing another down round. The focus on getting higher valuations rather than being profitable is a result of startups trying to reach unicorn status.
Are down rounds the end of the road?
There are a lot of stigmas attached to down rounds; however, it is not necessarily the end of a startup’s growth. Investors and founders need to understand that a down round doesn't necessarily indicate a drop in the startup’s inherent value. Down rounds are reflections of changes in the broader market and the willingness of investors to spend a certain amount. While down rounds can be speed bumps, new opportunities, or even a wake-up call, they are not the end of a startup unless the startup allows it to be.
How to avoid down rounds
Here are some generally accepted methods recommended by investors to avoid going through a down round.
Increasing cost efficiency
When the circumstances are against your startup, it is prudent to make existing funds last longer rather than seek funds from an unfavourable position. Stretching out existing funds gives the startup a fighting chance to begin the next round of raising funds at a more favourable valuation.
This method is for startups that have temporary revenue inflow problems but are set for the long run. In this case, a temporary instrument of financing that keeps the startup functioning until the next inflow of revenue is the ideal route to take. Convertible notes and short-term loans are some options that founders can consider for their businesses in this situation.
Negotiating terms of the anti-dilution agreements with original investors
Convincing investors to dilute their share value by creating more shares to sell is an option if they are understanding and truly invested in the greater good of the company. The creation of new shares can help the startup as a whole raise more funds without losing any value.
Getting back up after a down round
Despite all the measures one may take, down rounds may be inevitable in the current economic climate. Reports indicate a rise in down rounds for Q3 of 2022. So when a down round seems imminent, here are some ways to recover from it.
Evaluate the reasons behind the down round
Down rounds happen for various reasons, and not all of these reasons are in the control of the startup or its promoters. If it is due to external factors like policy changes, global investment circumstances, or changes in government, then the key is to be patient and wait for a change in circumstances while adapting to be more sustainable in the given environment. If the fall in valuation has been caused by factors within the control of the startup, like failure to cut costs, lack of revenue inflow, or competitors getting a part of the market share, then such issues must be dealt with on a war footing before proceeding with business.
Keep up employee morale
The impact of a down round must not be felt by the employees. In the case of any ESOPS, founders can consider giving employees cash payout options to increase liquidity while simultaneously compensating employees. Issuing bonus shares from unsubscribed capital can also help employees keep their interest vested.
Look up alternative sources of financing
When investors are unable to inject a large number of funds into the startup despite seeing the value of the startup, they could turn to tranche financing. This is a form of financing that was popularised after the 2008 recession. Tranche financing allows investors to periodically inject partial instalments of capital into the startup. This can ease the pressure that potential investors feel, which can reduce the chances of shares being bought at a discount.
Many times, businesses lose out on getting the funding at their desired valuation, not because of flaws in them but because conventional investors have biases in the way they invest. The founder’s background could be a victim of preconceived notions. For instance, Clive Reffell has covered how women founders have been let down by VCs in this insightful read. Crowdfunding is a potential solution to such problems since it democratises the process of raising capital and evens out single-track perceptions. One may also note that Crowdfunding has other benefits as well, including helping you gain customers without spending too much on acquiring them.
CrowdInvest is a cross-border equity crowdfunding platform offering UK-based sophisticated investors opportunities to invest in impact-driven, high-growth tech startups from emerging markets. Fundraisers will be able to consider how to employ any of these other added benefits of crowdfunding that we have outlined here, plus the major benefit of acquiring customers as well as raising investment funding. You can join the waitlist today at https://www.crowdinvest.com/ to stay up to date with developments on how to be involved.