Embracing down rounds: a path to long-term equity value

July 2024 | SPOTLIGHT | FINANCE & INVESTMENT

Financier Worldwide Magazine

July 2024 Issue

In the landscape of startup financing, the occurrence of down rounds – when shares are sold at a lower valuation than in the immediately prior raise – has traditionally been viewed with apprehension by companies and investors alike.

However, valuations fuelled by a low interest rate bull market created a unique landscape in which many strong businesses are valued at a multiple much higher than where public comparable companies trade, even on a growth-adjusted basis.

We are therefore seeing a chain reaction in which new financings with clean terms become more difficult to achieve. As a result, many founders and boards are opting to reduce cash burn – and hence revenue growth – to avoid a valuation markdown.

But getting past the negative connotations and outdated misconceptions of down rounds, and utilising a down round as a tool to secure a financing with clean terms, can help a business to continue growing quickly and achieve superior long-term equity value creation.

The aversion to down rounds stems from concern about equity dilution, a perception that it sends a negative signal to the market, and the potential impact on employee morale and talent retention.

But contrary to these perceptions, down rounds can be an opportunity to create significant equity value for shareholders, including founders and existing investors.

Down rounds can provide the capital necessary to fuel growth. An alternative is to reduce burn, but that can also dramatically reduce growth. Another option is to raise a flat, structured round of financing. However, this can potentially create misalignment between founders and investors, or be overly punitive in the long term.

For companies with strong unit economics and business models, the cost of dilution from a down round pales against the value created by sustained revenue growth in the medium to long term. The public markets demonstrate that a unit of revenue growth drives significantly more equity value than a unit of profitability.

Down round strategies

When determining whether a down round or managing burn until valuations rise is the better option, founders and executives should carefully assess the balance between immediate needs and long-term objectives.

In the context of a down round, existing shareholders’ percentage ownership decreases due to the issuance of new shares at a lower valuation. But the dilutive effect can be mitigated by provisions that recalibrate conversion rates for existing preferred shares in the event of a down round.

The silver lining from the bull market of the past decade has been a shift toward cleaner, founder-friendly term sheets, with ‘broad based’ anti-dilution provisions becoming standard. These mechanisms are more favourable to founders than alternatives such as a full ratchet anti-dilution clause.

Founders and executives should therefore have open, transparent discussions with potential and existing investors, as this can lead to more favourable terms, including the adjustment of anti-dilution provisions and the minimisation of dilutive effects.

Secondly, sacrificing near-term profitability for higher long-term revenue growth can create equity value when a business displays strong unit economics. While unit economics vary by industry and sector, they generally follow principles around time to pay back customer acquisition cost, profit margins after variable expenses and customer lifetime. The stronger the unit economics, the more return on investment incremental spend provides to equity value.

Playing the long game

The number of down round financings is rising. According to PitchBook, in the third quarter of 2023 the estimated percentage of down rounds in the US climbed to a 10-year high of 17.1 percent, up from 13.5 percent in the prior three months, while the figure for the whole of 2023 was 14.2 percent of completed financings, the highest since 2017. It was a similar picture in Europe, where 21.3 percent of deals in 2023 were down rounds, compared with 14.4 percent in 2022. Companies should therefore not automatically reject the idea.

Focusing on managing available cash can adversely impact value creation by reducing the ability to properly invest in the systems and talent needed to keep growth on track. Taking a down round, while carefully managing the impact on existing shareholders, can be a key to keeping revenue and equity value growth at a rate that matches, or exceeds, current levels.

As companies that have raised a down round in the past know, there does not need to be a stigma from taking this path. Indeed, in the long run, the alternative may turn out to be significantly worse.

Brian Dudley is a partner at Adams Street Partners.

Brian Dudley

Adams Street Partners