Expecting down rounds
Learning from history
In December 2008, when the largest financial crisis of my lifetime was raging, the number of down rounds in Silicon Valley almost equaled the number of up rounds. To be more precise: 45% down rounds, 48% up rounds, and 7% flat rounds, according to an analysis of 128 venture financing completed in Q4 2008 done by Fenwick and West.
In many blog posts, published media articles, and interviews, I expressed my concern about investing in the late stages of a boom. I was a pessimist at a point in the market cycle when being a pessimist was unfashionable and when optimists looked best.
Appearances aside, my common sense proved solid, and my dark expectations came to reality. The pandemic caused the boom period to end a little sooner than it should have but much more abruptly, pushing the economy into recession.
Investors’ attitude towards risk is swinging from exuberance to panic and founders’ sentiment is getting gloomy. It sounds like a good time to discuss down rounds, which means new investments done at a pre-money valuation lower than the post-money valuation of the previous round. Here is food for thought.
1 Firstly, investors will consider follow-on rounds only in the companies that were fast and decisive in implementing damage containment and cost-cutting measures. Those who proved late to act or hesitant will be left on their own — as investors won’t be willing to back founders that showed a lack of respect for the capital already raised.
2 Secondly, most of these financings will be down rounds or bridge rounds. Two primary drivers will determine the valuations to be decreased:
i) the scale-down of the sales target for the next quarters — the revenue projections and the profit prospects will be lowered, which means that the company is worth less than previously expected. It’s a correction of an inflated valuation.
and ii) the obligation of the VC funds to attract private co-investors in the follow-on rounds — all co-investors will be price-sensitive and will only adhere to termsheets that offer new capital for a reasonable (read: reduced) price per share.
3 Thirdly, with down rounds comes the issue of anti-dilution (compensating existing investors for the dilution they suffer in the down round, by issuing new shares in their favor).
As an addendum, in small markets such as Romania, where the number of active investors is in single digits, and everyone knows everyone, there will be reluctance from VCs to cram down other VCs in a down round. In other words, each VC will stick with making down rounds in their own portfolio companies and will not pursue deals at lower valuations that will force fellow investors to mark a loss on their sheets. Also, there are other issues with managing co-investors relations while investing in a down round outside your own portfolio. Consider, for example, the impact of the liquidity preference and seniority of the new shares on the distribution of proceeds.
On a closing note, I would like to touch on the sensitive topic of the psychological damage of the down rounds.
It is difficult for founders to accept lower valuations for causes outside of their control — such as adverse market conditions. But it is equally unfair for them to ask investors to accept valuations that are no longer correlated with the company’s prospects for growth and profits.
Hard times are the right times to judge characters. Abusive investors will show their true colors, ask for absurd and unacceptable terms — avoid these bullies in the future; no crisis lasts forever. On the other hand, immature founders and good-weather-CEOs won’t accept the harsh new reality and will continue to write phantasy novels in Excel — no one will believe them and, most importantly, no one will buy it.
