Down rounds explained: How worried should founders be at the prospect of a falling valuation?

Benjamin Chong aussie startup investment

Right Click Capital partner Benjamin Chong.

What goes up too quickly often comes crashing down. Or in the case of companies with lofty valuations, a correction is inevitable.

This is true of all businesses, from listed tech giants to early-stage fledgling companies seeking seed funding. But how worried should investors and founders be at the prospect of a falling valuation?

Valuations are fluid and ever-changing.

Even the seemingly infallible Facebook has had a bumpy ride. Microsoft invested $240 million for 1.6% of the company in 2007, valuing the business at $15 billion. Just two years later, and in spite of millions more users, Digital Sky Technologies bought 2% of Facebook for the lesser amount of $200 million, wiping $5 billion off the valuation.

There was further turbulence when Facebook listed in 2012 — its $US38 share price and $90 billion market capitalisation tumbled by 47% in three months to just $US20 a share.

Why is it the case that large businesses can lose billions in market capitalisation when share prices fluctuate wildly, but investors appear to become more spooked by a downward adjustment in the value of an early-stage business?

Firstly, a reduced valuation often comes to light when a startup is running out of runway and seeking funding to stay afloat. This process, known as a down round, has historically been considered as a funding round of last resort and a strong indication that a business is failing.

Investors will also be left wondering whether the original valuation was too expensive, whether there were holes in the business strategy or whether the founder simply over-promised and couldn’t deliver.

Sometimes none of these factors are to blame.

The tech sector has gone from boom to bust and back again over the last 20 years, and a certain proportion of the valuation of any tech business will reflect the stage of the cycle and the external environment. As all boats rise with the tide, so shall they fall.

Investors need to understand the reasons for the reduction in the valuation and founders need to be able to tell the story openly and honestly.

Britain’s Lending Club is a great example of a startup that fell victim to its external environment but was able to recover after a down round.

Down rounds are also more likely to occur when founders have pushed for high valuations in their early rounds of funding. The valuation of early-stage businesses is not an exact science and often in sectors with unprecedented disruption, it can be difficult to forecast growth. However, in some instances, founders may push for a high valuation early based on overconfidence in their ability to achieve aspirational milestones in unrealistic timeframes. This often results in the founder losing out, pushed into a down round leading to a lack confidence among employees and investors.

None of these situations mean the business is doomed. It may just indicate there were unforeseen challenges that have since been overcome, although not without implications for the value of the startup.

The value of a business is just an estimate until there is a liquidity event, such as an IPO, trade sale or liquidation. The biggest fear for most investors at the prospect of a down round is the dilution of equity for founders and employees, largely because early-stage investors often have anti-dilution clauses which see founders bearing the brunt of the declining valuation when the capitalisation table is reset.

Investors will, therefore, be looking to see that founders and employees have enough equity to stay motivated. If a founder and key people within the startup have their equity squeezed too tightly, it may be tempting to give up, cut their losses and start again.

Although it is natural that all parties will disdain a down round, these shouldn’t be avoided at all costs. The alternative may be that the business collapses.

The greatest chance for success after a down round comes when the founder is open and transparent about the areas where the business has fallen short and shows a clear path forward.

Experienced investors who take the time to understand the founder and the business are rarely surprised by a down round. Conversely, the investor who is in the dark and then finds themselves faced with a tight schedule for an emergency down round has good reason to be concerned.

If handled well, a down round can be completed with the support of existing shareholders and may even be oversubscribed like any other funding round if investors see the value of the investment opportunity. Honesty from the founders is paramount to success.

Investing in a down round is not dissimilar to investing in property when the market has taken a dive. Investors will look for signs that a property will increase in value in the future, but if the fundamentals are right, they will not be put off by a decreased valuation.

Investing in a down round is no different as long as the opportunity is still compelling, and the founder has enough incentive to follow it through.

NOW READ: Startup maths: What is a valuation and how do I get one?

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