What is a Down Round? How Does it Work?

When seeking an answer to the question “What is a down round?”, the simple answer is that it is a finance event in which a company that is raising new capital does so at a valuation lower than in previous funding rounds. Yet, it’s important to understand that it’s a complex situation in which share dilution and perceived decreased company value affects a range of stakeholders, including investors, founders, and employees.

We’ve created this article to provide an objective and globally relevant overview of down rounds. It explores how they work, what triggers them, what their implications are, and how companies can respond effectively.

Understanding What is a Down Round

By definition, a down round involves a private company raising capital at a time when its valuation is lower than it had received during previous rounds of funding. This is very different from typical fundraising, as it can indicate that internal or external factors have negatively impacted a company’s worth, enabling investors to purchase equity at a cheaper rate than those that had engaged in earlier rounds. Comparatively, fundraising during up rounds or flat rounds tends to mean earlier investors are rewarded. The differences between the round valuations tend to serve as benchmarks that are used to assess growth rates and potential, with drops signaling the need for changes in operations or strategy.

Causes of a Down Round

So, what can trigger a down round? One of the common factors is missed milestones, in which failure to meet targets in product development, user growth, or revenue generation affects valuations. Indeed, prior high valuations in themselves can contribute if they set benchmark expectations the company is unable to meet.

Market downturns are common influences, too, as these affect revenue, often resulting in poor financials that impact overall value. This can be further exacerbated by poor macroeconomic conditions or industry-wide devaluations, which may result in reductions in capital availability and investor engagement, in turn making it more challenging to maintain a previously high valuation.

Mechanics of Down Round Financing

What is a down-round financing from a structural perspective? It represents a significant shift in equity ownership access. Typically, new shares will be issued at prices lower than those in the previous rounds. As a result, newer investors are able to gain a greater share of the business for a smaller investment, which also reduces the value of shares that are already held by existing investors.

This discounted equity must be approached carefully, maintaining legal and accounting compliance standards. For instance, the business’ cap table needs to be updated to provide clarity on the new share distribution and financial disclosures need to reflect the revised terms.

Impact on Founders and Existing Shareholders

One of the key challenges of down rounds is that they can significantly dilute the shares and ownership stakes of existing shareholders. Dilution isn’t only an issue due to the effect it has on the financial value of each share. Rather, the ability for new shareholders to acquire a larger stake percentage in a company due to the lower price point can see founders losing some or all control of their companies, reducing influence over its strategic direction.

Additionally, employees holding stock options may see the value of their equity in the company diminished. This can reduce morale, potentially impacting engagement and retention.

Protective Provisions and Investor Rights

In some instances, investors will negotiate anti-dilution provisions with companies at the time of investment in order to safeguard against the potential negative effects of down rounds. This can include weighted average and full ratchet clauses. Full ratchet clauses enable existing investors to reprice their shares to match the new valuation, while weighted average factors the number of shares in the new round alongside the price to make more balanced adjustments. In either case, while these clauses may protect certain applicable shareholders’ rights and interests, they can cause further dilution for founders and common shareholders, exacerbating the impact of the down round.

How Companies Navigate a Down-Round

Effective navigation of a down round can hinge on careful strategy and communication. This begins with negotiating terms with both existing and new investors, clarifying the circumstances and effect of the down round by restructuring the cap tables, and discussing methods to mitigate negative impact. Sometimes, companies can obtain bridge financing,  issue convertible notes, or weigh up venture debt vs equity financing options as alternatives to utilizing a valuation event, which extends their runway with minimal impact on shareholders.

Above all else, transparency and open communication with all relevant stakeholders is vital throughout the process. Maintaining an honest dialogue with employees, shareholders, and other key parties helps to manage expectations and bolster trust despite the difficult circumstances.

Legal and Regulatory Considerations

Down rounds tend to see securities being issued at a discount, which draws significant regulatory scrutiny. Compliance obligations that companies must maintain will include alignment with the securities laws relevant to their jurisdiction and potentially involve updating disclosures to shareholders and regulatory filings. The specifics will depend on the location. For instance, while the U.S. doesn’t have specific down round legislation, Rule 701 of the Securities Act of 1933 may require additional disclosures if the down round affects employee stock options. In the E.U., legislation varies between individual states, making gaining a full understanding of the nuances of the relevant jurisdiction essential.

Strategic Considerations for Startups

Startups experience some significant challenges and while a down round can seem like a setback in this early stage, it can also be something of a lifeline. Particularly in circumstances where capital is needed to maintain operational functioning, issuing shares at a lower valuation can be preferable to bankruptcy or stalled growth. A down round can also offer strategic opportunities to reposition a startup’s business model or pivot to an alternative market focus that might more positively affect long-term value. In these situations, the timing and messaging must be carefully considered, with honest communication with stakeholders essential for reassurance and retention.

Role of a Venture Capital Consultant

When exploring how to invest in venture capital and matters surrounding the practice​, a venture capital consultant often guides companies preparing and executing a down round. They utilize their experience and expertise to assist businesses with performing valuation analyses, negotiating with investors, and developing effective fundraising strategies. Importantly, they collaborate with businesses in preparing financial documentation to boost clarity and confidence, alongside strategizing stakeholder communication to preserve the company’s reputation and relationships. Above all else, these consultants act as objective sources of expertise that drive positive yet realistic outcomes rather than offer purely promotional services.

Down Rounds in the Current Market Context

Among the key current trends, we see that down rounding has become more common of late in the wake of high growth periods that were then followed by market corrections. Many companies previously benefitted from aggressive valuations during boom periods but are now having to adjust to meet investor expectations for more sustainable growth. There have been various specific sectors—such as tech, biotech, and fintech—that have been especially prone to these down rounds due to being focuses of such booms and now need to reset.

FAQs

What is a down round in business?

It is when a company fundraises at a lower valuation than previous funding rounds, reducing share value.

Are down rounds common?

Yes, particularly in volatile markets or when valuations exceed performance benchmarks from earlier rounds.

What happens to existing shareholders in a down round?

They can face dilution, reducing their ownership percentage unless protected by specific clauses.

Can a company recover from a down round?

Yes, resetting after valuation, executing strategic pivots, or performance improvements helps many companies recover.

Why would investors agree to a down round?

They may see long-term value or want to protect earlier investments by helping the company maintain operations.

How can down rounds be prevented?

Prudent valuation, realistic forecasting, and milestone-driven fundraising can reduce the potential necessity for down rounds.

References

Fernando, J. (2021, December 31). Full Ratchet Anti-Dilution: Definition, Example, and Alternative Investopedia. https://www.investopedia.com/terms/f/fullratchet.asp

U.S. Securities and Exchange Commission. (2024, June 29). Employee Benefit Plans – Rule 701. U.S. S.E.C. https://www.sec.gov/resources-small-businesses/exempt-offerings/employee-benefit-plans-rule-701-0

Masson, G. (2023, October 9). After pandemic sugar rush, a market ‘hangover’ opens biotech to funding approaches steeped in stigma. Fierce Biotech. https://www.fiercebiotech.com/biotech/market-hangover-why-down-rounds-are-rising-and-what-it-means