The case for down rounds

·9 min read

Media outfits reported earlier this week that the crypto lending platform BlockFi is looking to raise roughly $100 million in fresh funding in a round that would value the company at about $1 billion. Very notably, when BlockFi last raised money from investors -- $350 million in March of last year -- the investors assigned the company a $3 billion valuation.

That's a pretty breathtaking drop, and in the world of venture-backed startups, where everyone feels compelled at all times to be "killing it," the price adjustment could be construed as a black mark against the company.

It may be the smartest play, however. Many companies are now facing a Hobson's choice between trying to maintain the high-flying valuation they've established over the last year -- no matter the contortions necessary to do it -- or conducting a "down round," a financing that results in a lower valuation. And industry experts suggest the latter often makes more sense.

Brad Feld, who has been a venture capitalist for more than 25 years, is among those who advocate for embracing the down round in cases where a company needs capital and hasn't yet grown into a previously established valuation. Feld says that he has participated in financing rounds for startups so married to a particular number that they've agreed to anything to maintain it. He has also participated in deals where the company and its board agreed to bite the bullet and readjust the company's valuation downward.

Based on both experiences, he says his "strong belief" that "just doing a clean resetting -- at whatever the valuation so that everybody is aligned and dealing with reality -- is much, much better for a company."

He's not alone. "As a young investor in the early 2000s, I ended up spending a lot of time restructuring cap tables" after the dot com bust, says Frederic Court, founder of the early-stage firm Felix Capital in London. Court says he learned then that "trying to readjust things or maintain an artificially inflated price through structure is a recipe for disaster."

The best-laid plans

Down rounds are no one's preferred starting point. In the roughly three months since the winds shifted in the startup market, the messaging to startups has been to reduce burn and do it quickly by laying off employees, shelving projects, freezing research and development, and slashing other expenses to become more self-sustaining.

Still, after years of chasing growth, many startups won't be able to shift gears fast enough. They'll need to raise more capital, and while the strongest startups might continue to do so with few strings attached, others will face two options: raise more money at the same valuation but also more "structure," in VC parlance, or start over from a valuation standpoint.

Right now, says Lauren Kolodny, a co-founder of the Bay Area venture firm Acrew Capital, a lot of teams both inside and outside of Acrew's portfolio are agreeing to more structured "flat and extension rounds -- that's the most common thing we're seeing at this moment." Because so many Series A- and Series B-stage companies raised rounds at rich valuations with little in the way of product-market fit, "they might have fundamentals and be doing well," she adds, "but they haven't had the opportunity to grow into those valuations," which is leading them to have "harder conversations about more punitive rounds."

Why not discuss other alternatives? Part of the reason investors are using these extension rounds as a starting point ties to their experience, Kolodny suggests. A recapitalization -- which essentially describes a down round -- "is a muscle that hasn't been flexed by investors in a long time," she says. There are also "a lot of VCs who have never done recaps before," she adds, positing that "part of what we're seeing is a lack of comfort on both sides when it comes to doing a recap, so people move to the discussion of an overly structured flat round pretty quickly."

Founders and their investors are also hesitant to reset valuations because no one yet knows how long current conditions will last. While Feld is right now anticipating a long correction, Michael Sullivan, a veteran startup and venture capital lawyer at the law firm Orrick, thinks the readjustment the market is experiencing could be mild comparatively.

"I tell the young lawyers that I work with that I don't think we'll see another 2002," says Sullivan. "I don't think the venture recession will be as bad as 2001 and 2002, where all we did was bury companies."

In the meantime, there is a litany of other reasons that founders might strike tortuous deals right now with VCs. The most obvious of these is appearances. No team wants to look weak. The "optics of a flat round are so much better than a down round" that founders will agree to "all sorts of crazy terms to accomplish that," observes investor Justin Fishner-Wolfson, co-founder of the investment firm 137 Ventures.

Founders worry, too, about a "morale spiral," says Sullivan, who describes a "vicious cycle where employees find out [the value of their shares is suddenly far less], which leads to attrition, which accelerates the morale problem."

The problem with Plan B

Such fears are hardly irrational. Perception counts in the business world. Naturally, too, not every startup is in the same boat right now. Terms of a fresh round depend entirely on how much leverage a startup wields based on how it is performing relative to the rest of the market.

All that said, taking a valuation hit instead of green-lighting a highly structured deal to maintain the status quo makes sense more often than not, even while it requires agreement from all the major stakeholders. (The value of everyone's equity drops in a down round.)

For one thing, "You can only put in so much structure," says Kolodny, who notes that term sheets have enduring ripple effects. Once a founder agrees to them, "you're setting up a precedent for layering in these terms over and over again, considering that most companies will need to raise a couple -- if not more -- subsequent rounds of financing," she says.

Court says the same, explaining that "If you give this [deal term] to an investor now, the next investor will come after" and demand the same, and "then you create this massive misalignment."

The terms can grow surprisingly hairy, too. Michael Torosian, an attorney with Baker Botts who serves as outside general counsel to emerging companies and their investors, says he has already seen liquidation preferences put in place that guarantee investors will get three times their invested capital before anyone else sees a dime.

Over time, more onerous provisions tend to also appear, including participating preferred provisions, where investors receive back not only the rate that they've specified they are entitled to but also an additional dividend based on some predetermined condition. (Torosian describes this as "having your cake and eating it, too," adding that he "hasn't seen that much, but I think that will come if the downturn trend continues.")

When things really drag on, other provisions start to pop up. Among these are anti-dilution provisions, or clauses that allow investors the right to maintain their ownership stake in the event that new shares are issued.

It's not all wine and roses for VCs, by the way. Something else the startup world hasn't seen in many years but might again are pay-to-play provisions, which VCs truly despise and for good reason. Pay to play means that if a company needs to raise money and resorts to insiders for it, those who can’t or don’t want to contribute their pro rata share will see their preferred shares reduced to either common stock or some other subset of equity with fewer rights.

An investor who doesn’t pay up -- or can't afford to do so -- can forget about getting paid before others or any other guarantees. Those terms and conditions put in place in exchange for that lofty valuation? Gone.

Plan C is not so terrible

None of these scenarios are great for relationship building, which is why people who have seen this movie before say that painful as they are, down rounds -- without structure -- could quickly become the smartest fundraising option for many startups.

"If you're just doing a financing to survive and the equity in the business is currently not worth anything, it's way better to just deal with reality," says Feld. That way, "You have a chance of being able to raise additional capital going forward and the people who are working for the business going forward are the ones that are accruing the value," he adds.

Moving quickly is probably a good idea, too, especially if a startup is "executing on the business plan but not outperforming it and has maybe six months of runway," says Torosian. Even while he remains optimistic about the overall state of venture funding, founders "have to make the assumption that things will get worse from here, and that it's going to take you twice as long to raise half as much money as you're looking for."

Founders "never want to be in a position where you're three months out, trying to raise money," he says. "People will smell blood in the water."

At least, startups can take comfort in knowing some big-name brands are already moving in the same direction. In addition to BlockFi, the buy-now-pay-later giant Klarna is reportedly looking to raise money at a $30 billion valuation, a massive decrease from the $45.6 billion valuation it was assigned by its investors last year.

Neither outfit may have a choice. Sullivan notes that one of his VC clients backed out of a deal six weeks ago when, based on falling public tech stocks, she asked a startup to accept her check at a lower valuation and it refused.

Her decision was "rational," Sullivan says," and I'm urging other companies to accept fair valuations even if they are down rounds" given the alternative to a down round today may be no round at all. "It's like an old Brazilian saying," says Sullivan. "If it fell into the net, it's fish."

Either way, as more startups embrace down rounds, other founders may feel less reluctant to do the same, which could save them more agony later. "As the market starts to turn and more and more companies do down rounds, then it will become more socially acceptable to do a down round," says Fishner-Wolfson.

It's just human nature, he suggests. "You never want to be the first guy because you're going to get killed in the press. But once 200 companies have articles written about how they had a down round, the next guy doesn't care anymore, because no one's going to pay attention."

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