Surviving and thriving - how to navigate a down round

Navigating a down round financing can be one of the most challenging situations an early-stage company may face. A down round occurs when a company raises capital by issuing shares at a lower valuation than in previous funding rounds.

This can lead to negative market perception, dilution of existing shareholders, and potential impacts on employee morale and future fundraising efforts. However, with the right approach, early-stage companies can manage a down round effectively and position themselves for recovery and future success.

Understanding down rounds

A down round is typically driven by broader macro-economic factors that affect company valuations, rather than a direct reflection of the company's intrinsic value. It's important for founders to communicate this context to stakeholders to mitigate the negative perceptions associated with down rounds.

The impact of down rounds

The primary impact of a down round is dilution. Existing shareholders will see their ownership percentage decrease as more shares are issued at a lower price to raise the same amount of capital. Additionally, down rounds can affect venture portfolio values, requiring investors to re-evaluate and account for the declined value of their investments.

Strategies to mitigate down round effects

Founders have several options to consider when facing a down round:

• Bridge financing: businesses can seek bridge financing through instruments like advance subscription agreements (ASAs), simple agreements for future equity (SAFEs), or convertible loan notes, which convert into equity in the next financing round, typically at a discount.
• Alternative investors: exploring other investors who may offer more favourable terms at an increased or flat valuation to the previous round can be a viable option.
•  Anti-dilution provisions: these provisions can protect investors from dilution by issuing additional shares or adjusting the conversion rate of preference shares.

Anti-dilution constructs

Different anti-dilution constructs can be used to protect investors' shareholdings:

• Full ratchet: this method is the most severe from the company's perspective and is rarely used or accepted. It adjusts the price at which preferred shares convert into common shares to the new, lower price, resulting in significant dilution for common shareholders.
• Weighted average ratchet: this method uses a formula to adjust the conversion price based on the new price and the number of shares issued in the down round, resulting in less dilution than the full ratchet.

Preparing for a down round

Preparation is key to successfully navigating a down round:

• Transparent communication: clearly communicate the reasons for the down round and the company's strategy moving forward.
• Reassessing the business plan: look for ways to cut non-essential costs and extend the company's runway.
• Contingency planning: develop a plan to maintain optionality and act in the best interests of the company's creditors.

Legal and tax considerations

Legal and tax implications must be carefully considered during a down round. Founders should consult with legal and tax advisors to understand the potential consequences, including any tax exposure that could arise from alternative funding sources.

In summary

While down rounds are challenging, they do not have to be a death knell for an early-stage company. By understanding the dynamics of down rounds, communicating effectively with stakeholders, exploring alternative financing options, and implementing anti-dilution protections, founders can navigate these turbulent waters.

With careful planning and execution, early-stage companies can emerge from a down round positioned for recovery and future growth, leveraging the lessons learned to build a more resilient business.