Understanding and Managing Down Rounds

Understanding and Managing Down Rounds

Date: July 30, 2022

By Tom Bar-Haim, Managing Consultant PwC Israel

The valuations of public tech companies have declined significantly in the past few months. As this trend appears unlikely to change, the question is how the private market will react. There are many reasons for the decline in stock market valuations for public companies, but the one that should concern the start-up ecosystem the most is the slowing growth rates at some public tech companies. With the sharp decline in valuations of publicly traded companies, we are slowly starting to see lower valuations in private companies as well, especially those that are already overvalued (compared to equivalents in the public sector), such as: Instacart, the grocery delivery company, which reduced its valuation from $39B to $24B (-38.5%), Klarna, Swedish fintech BNPL company, which reduced its valuation from $45.6B to $6.7B (-85%(!)) and recently in our Israeli local market Bizzabo, the event planning platform, which reduced its valuation from $285M to $200M (-30%).

It is evident that the private fundraising ecosystem might be a bit laggy as investors wait for the public valuations to rebound, however there is no doubt that we will start seeing more Down Round financing rounds in growth/late-stage start-ups soon.

• What is a Down Round?

Down Round refers to a private company that offers additional shares at a lower price than had been sold in the previous financing event. Simply put, more capital is needed and the company discovers that its valuation is less than it was prior to the previous round of financing. When the company is forced to sell its capital stock at a lower price per share, all other stock in the company is devalued.

• What typically happens in a Down Round?

The Down Round is perceived negatively and can lead to a downward spiral. This can start with investors losing confidence in the business model and employee morale declining because of underwater employee equity compensation. It should be noted that during a broader market decline like we are currently experiencing, down-round implications may be less dire.

Anti-dilution protections are also a big issue in a Down Round. The rationale behind such protections is simply related to risk management. VCs and others want to shift some of the risks from the decline in the value of a business and the cost of dilution to founders and employees. The most compelling reason that VCs use to justify the anti-dilution protection is the informational disadvantage they have relative to the founding shareholders.

The anti-dilution provisions limit the dilution of existing investors when the company sells new equity or equity-linked instruments for a lower price than it sold equity in the previous financing. Typically, the Anti-Dilution provisions lower the strike price of the instrument or increase the conversion rate, thereby increasing the number of shares issued in a conversion. However, they can also adjust the number of shares to be issued. While characterized as “standard anti-dilution” features, down-round protection provides incremental value to investors over traditional adjustments (split, dividends, etc).

• How does the anti-dilution mechanism work?

In the event of a Down Round financing, existing preferred shareholders with Broad-Based Weighted Average anti-dilution protection will be compensated by adjusting their original conversion price based on the number of shares and subscription amount raised in the Down Round (this formula can be made even more company friendly by including any shares reserved under the share incentive plan but not yet awarded):

Consequently, a greater number of securities issued at a lower price will result in a larger anti-dilution adjustment.

Broad-Based Weighted Average (and other common anti-dilution mechanisms like Full-Ratchet) dilute founders and employees to percentages that may negatively affect the company. In addition, as mentioned before, it creates the effect of “Underwater Options” - share options which have an exercise price per share greater than current actual market value of a share for those employees that had already received equity options.

Although investors pursue protection for their stakes, I assume that they will also want to make sure that founders and employees are kept satisfied and engaged. This will force investors to rethink whether and how to exercise their anti-dilution protections. The following are a few ways I suggest investors and companies to consider:

1. Key employees’ Options Issuance — instead of heavily diluting founders and employees, investors can negotiate options packages for key employees to be issued simultaneously with the Down Round. This will ensure that founders and key employees remain engaged and don’t lose interest in the company.
2. Pay to Play Provisions — Investors who wish to receive anti-dilution shares must participate in the Down Round financing by purchasing their pro-rata share of the Down Round shares. In this way, the anti-dilution benefit will only go to active investors who believe in the company and support it through rough patches.
3. Bridge Financing — If there is a likelihood of Down Round financing, delaying the valuation decision is also an option. SAFE, CLA, or venture debt can be viable investment options for companies and investors who believe the current market situation will likely change in the near future and that the company is undervalued.
4. Re-negotiating Anti-Dilution Provisions — Investors can replace the anti-dilution provisions with other economic rights which will shift the risk to liquidation events, such as greater liquidation preference, accruing dividends, “participating” preferred and warrant coverage. Founders should tread carefully as providing these rights could result in the holders of common shares being worse off than they would have been in a down round scenario.

What do we recommend to companies that consider raising new funds in a Down Round?

First, understand that the situation is not completely out of control. Your next actions will make all the difference when moving forward after a Down Round. 

Communicate the reasons for the Down Round, the future and your vision:

• Before consummating the Down Round, make sure your employees are informed with all relevant details. Be transparent about the future ESOP plans and the rationale behind the valuation.
• It is also imperative to inform customers and suppliers that business is continuing as usual. Be transparent about pricing and dealings in the future, as well as any constraints you may have.
• If you decide to accept a lower valuation financing round proposal, you should notify all shareholders as soon as possible. They should be informed of the situation and have a say.
• Make it clear that the company is adapting to market conditions and that the financing round is actually a sign of faith.
• Companies should leave themselves as agile and adaptable to change as possible - continuing investments in automation/digital tech may be wise as well as keeping the cost base as variable as possible. We debated the importance of agility and other issues in our Team's article The importance of this year's Financial Plan and Budget Cycle, which we highly recommend to read as well.  
• Re-strategize to New Normal conditions. Align operational activities to your new strategic goals. Profitability is now your primary goal, alongside growth.  To succeed, you will need to focus not only on customer acquisition, research and development, and employee retention, but also on cost efficiency and operational excellence. To accomplish this, your company must undergo a rigorous analysis of its operations.
• Forecast and manage cash spend and improve cash collections with better control of working capital. You need to have good data to forecast ahead, and investors will want to see very accurate numbers. Don’t exaggerate with your projections – realistic goals may not get you the funds you want, but it will definitely get you the funds you need.
• Consider outsourcing certain business functions for the transition to a leaner operating model.
• Focus on your strong products and lose deadweight R&D initiatives that take your valuable energy and resources.
• While reducing costs is crucial, also think about new income streams and new initiatives. The market expects profitability; however, it doesn’t mean that you need to give up on your innovation endeavors.