The pain is here.
By volume, size, velocity, and valuation angel deals are down. Series A deals are down. The whole alphabet of deals is down. We’re seeing founders take a lot of meetings—a lot of meetings—without much success. And that seems to be the case in the midwest and everywhere else.
One result is that when deals do happen, the terms aren’t great.
If you’re raising capital you already know this.
Valuations are taking a pounding! That means we’re seeing a return of the down round.
Startups tend to raise capital every 18 to 24 months. Each investment round is priced higher than the last one—meaning the startup’s equity is selling for a higher price than it did last time. As a result, the early investors (and founders and employees) have an appreciating asset. That’s the structure of startup finance.
For startups that raised in 2020 or 2021, cash is running out. The cycle is up. It’s time to raise.
But even if these companies can find an interested investor—the first hurdle—valuations are nowhere what they were two years ago. That means their next round will be priced lower than the last one: a down round.
In a down round the balance of power has tilted dramatically toward investors. The normal cycle of things is out of whack. Down rounds are messy.
Down rounds are driven by economic urgency—limited runway. Cash is out and the company needs cash.
Down rounds involve conflicting interests and result in real pain for the founders and employees. They often introduce financing terms not seen in normal markets: cramdowns, cumulative dividends, and liquidation preferences higher than 1x.
For founders and employees, the main problem with down rounds is dilution. Getting enough money to keep the lights on at a discounted valuation means giving up more of the company, which means there’s less for the founders and employees.
But that’s just the beginning.
Existing investors typically have anti dilution rights that effectively reprice their last investment to the new price, or, more often, to a weighted-average price between the old and the new one. The effect of that anti dilution repricing is additional dilution for insiders—an even smaller piece of the pie in an exit or IPO. In other words, in a down round not only do you have to sell more of the company than expected, but your prior investors stake automatically increases even when they don’t put in new capital. Double dilution.
It’s not all good news for the existing investors though.
Typically a down round happens when existing investors can’t or won’t continue funding the company and the founders need to bring in outside help. The new investors will often “punish” existing investors by imposing pay-to-play terms or a cram down that results in existing investors taking dilution, losing preferred rights, or both. The basic structure here is that the non-participating investors get converted to common stock, lose their liquidation preference, lose their vote, or all of those things at once. (Unfortunately for the founders, this generally happens after existing investors get their anti-dilution adjustments.)
Meanwhile, the new investors come in at a better price than the earlier investors, get superior voting rights—both by virtue of other investors losing their vote and often through special voting rights and extra board seats—they may also end up with cumulative dividends that add up over time and pay out on exit—essentially additional dilution for everyone else—and sometimes they negotiate for a 2x or 3x liquidation preferences, meaning the founders get nothing until the new investors see a 2x or 3x return. All of this adds up to downside protection not seen since Britney Spears was in the Mickey Mouse Club.
So down rounds are awful.
But, unfortunately, in this market they’re inevitable. At least for some.
That said, the pain of a down round is directly proportional to a company’s need for capital. And need for capital is a function of available capital divided by burn. That’s your runway.
In a market like this, you minimize your down-round pain—and maybe avoid it entirely—by extending your runway, which you do by minimizing burn: your month-to-month net loss.
So as much as you can, cut your burn. Stay out of the market. Get through this. And hold on for better times.
Or buckle in and brace for pain.