What Happens to Equity in a Down Round? | Pulley

What Happens to Equity in a Down Round?

October 25, 2022
Yin Wu

You’re probably already familiar with the “ideal” version of the startup narrative. In this version, the startup progresses through a series of funding rounds that propel its valuation higher and higher. This unbroken uptrend of growth eventually leads to an IPO (or some other liquidity event) that creates major wealth for founders and investors alike.

While it’s nice to dream about, this narrative isn’t the only one in play. An alternate version finds the startup’s valuation dipping after a funding round, whether due to subpar performance, a deteriorated economic climate, or some other unforeseen factor. In this version, the startup may look to raise funding in a down round, in which it sells shares of its stock to investors at a lower price per share than the share price set in the previous round.

Is a down round a sure sign that the sky is falling? Not always, and not exactly. But it can come with significant implications for a startup’s equity. In this guide, we’ll take a look at what happens to equity in a down round, and why certain investors may feel the pain of a down round more than others.

What is a down round?

As you’ll recall from our guide to startup funding rounds, private companies often go through a series of fundraising rounds. A down round is a fundraising round in which the company’s pre-money valuation is lower than the post-money valuation of the previous round. This means that investors in a down round can purchase shares of common stock for a lower price per share than investors in the round prior.

As a general rule, down rounds are more of a “bite the bullet” moment than a cause for celebration. Private companies (and the venture capitalists who invest in them) prefer financing options that don’t result in a lower valuation, but in some cases, it can be necessary to adjust the company’s valuation a few notches south.

What circumstances can lead to a down round?

Take a look at the stock market, and you’ll see that many public companies’ stocks rise and fall at various points in time. A company’s stock may dip after it misses earning targets, but investors can also be turned off for a whole litany of other reasons outside of the company’s control.

The same is true for startups, though the realities of startup funding can be even less forgiving than the public markets. A young startup doesn’t have much history to draw upon and may be operating in a relatively uncharted industry (e.g. crypto), which can make it more likely to miss growth benchmarks. If a startup hasn’t proven that it can meet certain benchmarks for revenue, hiring, or product releases, new investors may be reluctant to participate in an upcoming financing round unless shares are offered at a lower price.

Down rounds can also happen for macroeconomic reasons outside the startup’s control. Maybe the previous round took place at a moment of heightened venture capital enthusiasm, which has subsequently cooled off. Or maybe a new batch of competitors has arisen to challenge the startup’s industry primacy. In any case, a down round doesn’t necessarily mean that a company is mismanaged or that its execution is poor.

Why are down rounds viewed so unfavorably?

When a public company like Apple sees its share price fall, many investors rush in to “buy the dip.” People generally think of Apple as a highly valuable company, so few would argue that a brief dip in its share price is a sign that the sky is falling.

But things work differently with startups and other private companies. The types of investors who participate in startup funding rounds generally have a higher appetite for risk, but they’re also more willing to ignore or cut bait on companies that don’t show a consistent upward trajectory. The venture capital principle of “high risk, high reward” doesn’t favor companies that struggle to live up to their early promise.

For this reason, a company that attempts to raise money in a down round may pick up some unwanted psychological baggage. Down rounds have been known to affect not only investor sentiment but also employee morale and public perception. For example, in June 2022 the Swedish startup Klarna closed a down round of financing that saw its valuation fall from nearly $46 billion to a mere $6.5 billion. TechCrunch described the news as a “big fall from grace,” while the Wall Street Journal reported it as “a humbling comedown and a testament to the punishing environment facing startup companies.”

These are not words most founders would want to hear in a funding announcement.

Equity consequences of a down round

Aside from negative perception and shaken investor confidence, down rounds can have some very real effects on equity.

As is true with any funding round, a down round results in the dilution of equity for the company’s founder/co-founders and existing investors. Any time new investors come aboard, those who already have equity may be diluted.

In a typical funding round, this dilution doesn’t sting so much because it’s counteracted by the company’s higher valuation, which raises the price of shares already held by investors. But down rounds have the potential to hurt existing stockholders quite a bit, because they can both dilute equity and lower the stock price of existing shares.

Not all stockholders feel the same level of pain in a down round. Founders and employees who hold common stock may take the brunt of the dilution, because many venture capitalists and outside investors have special anti-dilution protections built into their shares of preferred stock.

What is anti-dilution protection?

When VCs invest in a private company, they often negotiate for shares of preferred stock that come with a variety of special rights. One such right is called anti-dilution protection, because it protects the investor from certain kinds of dilution.

Anti-dilution protections may kick in during a down round. If they do have anti-dilution protections, investors with preferred stock will see their shares diluted less. But all of that dilution still has to come from somewhere, which means that founders, employees, and investors who don’t have anti-dilution protections will see their equity diluted even more.

Exactly how much will depend on the type of anti-dilution protections in play. Generally speaking, there are two types of anti-dilution protections that founders should be aware of.

It’s best to understand how these anti-dilution protections work at the time you’re issuing preferred stock to investors—as opposed to waiting for a down round to figure it all out. VCs will always try to negotiate for the most favorable protections (i.e. full ratchet adjustment), so you’ll need to consider how those protections may play out in the potential event of a down round.

Alternatives to a down round

As you can see, a down round can come with significant consequences for existing shareholders—including founders themselves!

That’s why it’s best to consider your options before moving ahead with a down round. There may be an alternative that allows you to stay afloat without dramatically slashing your ownership percentage and risking low employee morale. Some options may include:

Are down rounds always such a bad thing?

We’ve talked a lot about the negative side of down rounds, but it’s important to remember that these things exist for a reason.

Resetting your company’s valuation at a more realistic level for its current situation can be a painful process, but it can result in happier investors and employees in the long run. Nobody wants to go through a down round, but it beats trying to constantly restructure your cap table around a mythical number that you’ll never be able to justify.

The bottom line is that a down round doesn’t have to mean the end of the world, and there are ways to make the best of a not-ideal situation.