A down round refers to the raising of funding by a company through the selling of shares to an investor, at a price lower than the transacted price in the last financing round.
This means that if the previous round of fund-raising was $1 per share, then the current round at below $1 per share such as $0.90 would constitute to a down round.
The gist would be that if a lower price for shares is agreed and closed, then it effectively (and officially) values the company at a lower valuation than what it was deemed to be worth in the previous fund-raising exercise.
Why down rounds matter
On the surface most people would not seem that a share price that drops is nothing that call for attention for since these figures can fluctuate based on market forces.
But it has more serious implications or a startup company in the world of venture capital funds.
The prospects and outlook for a startup destined for success would incrementally increase as time passes. This implies that it’s value would increase organically over time as the business grows.
Venture capitalists tend to be most interested in companies that has the highest upside. And these companies would presumably never experience a down round as their valuations would grow as the company growths in the marketplace.
This is why when a startup goes through a down round, it sends all the wrong signals to investors that might consider funding the company in the future.
When they observe that the value of a company is decreasing, as indicated in a downround, they can be skeptical about how the startup is really performing in the market. Mismanagement can also be the reason for a company to go down hill.
It is also an indication that the company has a high burn rate which has led to them spending all the raised capital before the projected timeline for the next round of funding.
If an investor is still interested in investing in a company after a down round, then he or she might use it as leverage to get a lower price of the share.
It might be insisted that the company match the share price of the previous round or go lower than that since the trend is going downwards.
Avoiding a down round
A common way to navigate around having to hang the label of down-round on the neck of a company is to issue advisory shares in place of common stock.
This basically means that instead of selling shares of the company to an investor at a lower share value, the previous valuation from the most recent financing round is used. Any additional stock that the investor demands would then be issued as advisory share.
This helps to retain the value of the company without compromising the interest of earlier investors.
Another channel of financing is the traditional way of borrower from lenders such as banks and financial institutions.
The problem here is that approval can be difficult when the company is not profitable and has little or no assets that can be used as collateral.
On top of that, in the event of approval of a working capital term loan or a credit line, lenders can get very aggressive with repossession and liquidation when defaults occur.
This is why debt can be a huge danger to startups.
When the prospect of a down round is increasingly likely, young companies really need to take a look at themselves and look into the real reasons for a high burn rate.
Overspending can be a habit that happens to every company.
