A down round is a later round of financing where investors buy stock from a company at a lower valuation than the valuation created by earlier investors.
Lower valuations occur with the rise of new competition, stock market declines and changing investor perceptions on company valuations.
As a company grows, the need to sell a higher number of shares to meet financing requirements grows as well. Because down rounds can drastically lowering ownership percentages, they are often seen as a last resort, AKA the company’s only chance of staying in business.
Startups usually raise funds over a series of funding phases, which are aptly referred to as rounds. As the startup develops, each funding round theoretically SHOULD be executed at a higher price each time. There are, however, several conditions under which the latest investors may demand a lower price than the preceding funding phase, referred to as a down round.
The earliest investors in startups get the lowest prices on stocks because they are making the investment pretty blindly since the company has nothing to show for itself yet. Investors who come in for later rounds can see how the startup is actually performing rather than just guessing. When a startup is performing well and hitting all its benchmarks, that’s a good sign and therefore, that next round will likely command a higher price. However, when a startup has missteps, investors notice that too and that can trigger the lower valuation that leads to a down round.
Startups with clear advantage over their competition can usually raise a lot of capital from investors. However, if that edge disappears due to a growing market of competition, investors can demand lower valuations for that reason too.
The bummer news is that even if a startup does everything right, a down round could still happen. Venture capital firms often use this tactic, but sometimes it’s also just what a startup needs to reach the next level, so oftentimes it ends up working out for everyone. How sweet.
We’re about to move into the last phase of our investment and it better not be a down round. We’ve done everything right!!!