Venture capital and private equity financing: Down round decoded

In today’s volatile market, many startups face the prospect of a down round – a fundraising round at a lower valuation than in prior rounds.

While down rounds carry a negative stigma, they often reflect broader economic pressures rather than a fundamental flaw in the business. Founders, investors and early employees may understandably worry about dilution of equity stakes and a signal of weakness to the market. However, with the right approach, a down round may not necessarily be a failure. By taking strategic steps to shore up the company’s fundamentals and structuring deals wisely, startups can navigate down rounds and emerge resilient. This article provides practical measures to minimize the risk of a down round and legal strategies to protect the startup’s long-term health if one occurs.

Preventive measures

The best way to handle a down round is to avoid one in the first place. Founders should focus on strengthening the company’s financial position and credibility before a valuation dip becomes inevitable. Key preventive strategies include:

• Avoid the trap of overinflated valuations. An unrealistically high valuation in good times can set expectations that are impossible to meet in leaner times. Setting a credible valuation early on builds trust and makes it less likely that the next round’s price will need to fall. A startup that consistently raises funds at reasonable valuations is less prone to a dramatic down round that can damage its reputation. 
• Cash is key for startup survival, and it is crucial for companies to implement regular cash flow forecasting and scenario planning to anticipate potential shortfalls well in advance. Through proactive cash flow management, a company can extend its runway or adjust spending before it is forced to raise capital on unfavorable terms. This approach offers companies the bargaining power to time their fundraising optimally.
• Investors are more comfortable investing at steady or higher valuations when they see clear evidence of growth. Just as importantly, it is crucial to communicate such wins to current and prospective investors. By emphasizing milestones achieved, companies can make a compelling case for their value, even if market conditions are tough.
• To avoid equity dilution in a downturn, companies should actively consider alternative financing options. By pursuing convertible notes and other similar instruments, companies can avail themselves of financing without dilution so long as close attention is paid to critical terms such as valuation caps and conversion discounts. By diversifying the funding sources, companies can buy time and avoid an equity down round altogether.

Legal protections in down rounds

If a down round does become necessary, careful deal structuring and legal protections can preserve the company’s integrity and position stakeholders for future success. Important legal strategies and safeguards include:

• In any financing, especially one with a lower valuation, founders should seek protective provisions that safeguard critical decisions. These provisions give certain investors (often the major ones) the right to approve or veto significant corporate actions. While on the surface these rights protect investors, they also encourage collaborative decision-making and prevent rash moves that could impact the valuation further. By thoughtfully negotiating the scope of protective provisions, founders can align investor interests with the company’s long-term health while retaining operational flexibility.
• Companies may consider offering preemptive rights to existing shareholders to allow them to buy additional shares in the new round before new investors are invited. This way the existing shareholders can maintain their pro rata ownership. At the same time, provisions should offer flexibility for the company to bring in fresh capital and new strategic investors.
• Companies may consider having pay-to-play mechanisms in the investor agreements to require existing preferred investors to participate in the down round to maintain their preferential rights to avoid a potential conversion of their shares into common shares or loss of privileges. This will incentivize investors who opt to step up to support the company while maintaining fairness for all parties in the long run.

Conclusion

Down rounds are never a founder’s first choice, but with prudent planning and savvy execution they can be navigated successfully. By focusing on financial transparency, startups can often avoid a down round or lessen its severity. If a down round is inevitable, using well-crafted legal protections and investor incentives will help keep the company on stable footing.