Juan José Cervantes Mena
Managing Partner
Trebol Capital

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‘Down Rounds’ Are the Real Normality

By Juan José Cervantes Mena | Mon, 09/12/2022 - 13:00

At a time when the markets are down due to a massive correction, inflation is up and we’ve seen the highest hike in interest rates in 20 years, substantial changes are taking place regarding the investment strategies for different assets. The private equity industry has not escaped these changes.

As a result, several companies that raised capital at high valuations relative to their traction in 2020 and 2021 are no longer doing so.

This is what is often known as a “down round.” Companies currently able to attract venture investments find themselves able to do so only at valuations that are substantially diminished from their prior financing rounds. In other words, you may need to drop your share price to raise more money. Hence, a down round.

Before COVID or the Russia-Ukraine conflict, down rounds were usually the result of excessively high expectations in past rounds or the company's growth was slower than expected or no growth was happening. Nowadays, it’s normal because of a change in the market landscape.

Unicorns, such as payments firm Stripe, cryptocurrency lender BlockFi and delivery startup Instacart, have seen their valuations drop this year, in some cases dramatically. Swedish buy-now-pay-later firm Klarna, for example, cut its valuation by over 80 percent to $6.7 billion.

Trying to maintain the high-flying valuation that a company had would favor the company’s founders and the investors but some experts think a down round makes more sense, especially if the company needs capital and hasn’t yet grown into a previously established valuation. 

Focusing on growth and restructuring will always be better for a company than trying to readjust things or maintain an artificially inflated price through financing to survive.

And how are startups dealing with this? The most common way is to just extend the last round; for example, raising more money on the exact same terms (pre-money valuation, investor rights) as the previous round. That’s called an “extension round.” 

But there are consequences, and not only for entrepreneurs. On the investor side, there are those who are going to take advantage of these valuations and there are those who are already invested and must deal with this scenario.

In one of his last interviews, one of the most influential investors in the world, Warren Buffet, said that “in times of crisis, when the markets are low, is the best time to start buying.” Today is the time to have cash ready to buy at real price valuations. Investors now see several possible targets as an opportunity to make a good transaction much more cheaply than a year ago. Anyone with cash can take advantage of these opportunities.

But what if you are one of the previous or first investors in a company? A down round doesn't just show fluctuation in value like it might at Netflix or Tesla, it strongly suggests no one else, no other investor, believes the check you wrote the last time was "correct."

It creates stress when you inform your investors that the company is now valued less than last time. It makes you look like a fool because the best companies don’t really go through down rounds, not usually. And it creates even more stress when you don´t have money for a follow-on and cannot take advantage of that down round.

Even in the best case, it makes you look like a bit of a poor picker. 

Recently, as an investor, I have experienced this process and at first glance, it is not pleasant at all. However, when things happen, they need to be analyzed from the source. For example, if as an investor I did not anticipate that I would need to follow on with my investment, I did not have the ability to maintain or increase my participation within the company and my dilution will be higher than I would normally expect.

I had to deal with limited partners who wanted to take advantage of the opportunity, others who wanted to fire-sale the company and some others who understood the situation. Everybody has an opinion.

In any of these cases, these transactions can have devastating dilutive effects on the equity interests of founders, employees and early- stage investors alike, and they raise unique liability risks for directors and investors.

Identifying the reason for the down round is more important than the existence of the down round. Make sure all stakeholders understand why the price dropped and how you intend to mitigate this issue in the future.

Either way, given today’s circumstances, a company has to move quickly and assume that things will get worse from here, and that it’s going to take twice as long to raise half as much money as they’re looking for.

And remember, sometimes you have to bite the bullet.