Doing a down round

So let’s start with what types of down rounds are there? Well, let’s put them into a few categories.

Scenario one is in your first funding round, you raised too optimistically at too high a valuation. Often this links to companies doing proud rounds. So when you have experienced investors, they would tell you, “Hey, your valuation is too high. There’s no way your company’s worth 10 million for this pre-product stage.” But when you have a crowd round crowd, investors or friends and family investors don’t know what the valuation should be. And sometimes founders have drunk too much TechCrunch US valuation Kool-Aid and just come up with a valuation based on hype or optimism that is ahead of projections. And when you launch the product and it turns out six months or 12 months post-launch, the traction is nowhere near those optimistic numbers. Then there’s a reset. Or it might be that your crowd investors invested at a 10 million valuation and you now go to a VC. And instead of valuing the company based on that optimism and the business plan that said you’d have 10 million a year, revenue by the end of year one, the fund is now looked and seen that actually your metrics are nowhere near that. And we nowhere near valuing it based on just the optimism, it’s now reality. And dude, your valuation is now 3 million. So scenario one, too optimistic on your first round, reset on the second round.

Scenario two is maybe you last raised in 2020 or 2021 when valuations were at their peak. Business is actually rather good, but valuations overall down since then. So previously you might have got a 10 or 15 x multiple of annual revenue as a valuation, but that’s changed and you’re now struggling to get a valuation that equates to 5 x annual revenue. So even though revenue is up, your valuation overall is down.

Scenario three is business isn’t very good. You’re struggling to get investment at all. And only by dramatically reducing your valuation might you get investors coming in. So let’s explore these different patterns and what it means for your company and a down round. So the first class might be you’ve raised with angel investors, they’ve gotten SEIS and EIS. They’ve got ordinary shares. And here, if all your investors only have ordinary shares, then having a down round is a bit of a downer for them. They may be unhappy, but there’s nothing they can do about it. And there’s no cost in terms of anti-dilution or topping up investors. And in fact, if they’ve got SEIS or EIS shares, you must be careful to never try to top them up or give them more shares because they’ll lose their SEIS and you can leverage that. So if the investors say “it’s a down round, we want more shares”, you can tell them if you do this, they’re going to lose SEIS and have to repay the SEIS tax deduction that they got. They are much better off keeping their SEIS or EIS. You’ll explain that unfortunately, we’re all going to be diluted more by this new round. I’m sorry about that, but we took our best shot at the lost round, things don’t always go to plan.

So when it comes to SEIS investors and investors with ordinary shares, you don’t have any legal obligations to top them up in a down round and there’s no cost to you or the company, other than do your egos.

But where you’ve raised from a fund that got preference shares with anti-dilution protection, it’s very different.

What is anti-dilution protection? A seasoned VC might say, I will buy into your crazy £10 million valuation, but only if you give me anti-dilution protection. That means if you raise at a lower valuation in the next round or subsequently, you’re going to top me up as if my first round had been at this low valuation.

Asking for anti-dilution is a way for investors to invest in a round at a valuation that they may not be comfortable with, but they’ll go for it knowing that if you can’t sustain it in the future, you’re going to top them up. So it’s important that you understand that.

If you then have a down round, how does the top up work? The top up works by the company issuing more shares to these investors with preference shares and anti-dilution such that they would’ve gotten that number of shares in the earlier round had it been this new valuation. There are different formulas that can be used: broad-based, narrow-based and full ratchet anti-dilution. Broad-based is the most founder-friendly and full ratchet is the most investor-friendly. That essentially gives the investor the same number of shares they would’ve gotten before. The other methods have a blended way in between. So try to specify broad-based anti-dilution if the investor asks for anti-dilution – you can easily do that when doing your round on SeedLegals.

The key thing to know is if you have an investor that has preference shares with anti-dilution and you have a down round, then it can actually be quite a significant dilution of the existing shareholders, including the founders. So if you have a significant down round that may significantly dilute your shareholding – that’s something to be aware of. Of course, the down round might be just a little bit lower than the last round you raised at 10 mil and this one’s at eight. No big deal. You won’t get bragging rights that your valuation has gone up. But in the scheme of things, these days quite a few companies are raising at a similar valuation to their last round, or doing down rounds.

The third scenario to consider is where it’s a very down round. This happens to an increasing number of companies these days, and it goes like this: You plan to do a funding round, but you are unable to raise investment. And now you’re either going to run out of money and you’ll need to close the company. So if only there was some way to save the day, even if it’s massive dilution for the existing shareholders… anything is better than nothing. Maybe your last round valuation was £10 million and now you’re going to raise at a £1 million valuation. It’s going to wipe out the shareholders, but it’s better than having to shut the company. Anything is better than nothing. So this may be done in a couple of ways. Way number one, probably the most common is a convertible note.

And then there’s something called last man standing. Imagine you’re trying to raise at a £10 million valuation, the same as your last round, not getting any traction. People see business isn’t that great. Your valuation is now way off. You’ve got a big burn rate, you’re going to run out of money. It’s extremely risky. You can’t raise.

So you go, all right, I’ll try a £5 million valuation. And still, you’re not getting any takers.

In desperation, you’re talking to an investor and they say, I’ll invest £1 million with a convertible note. But if you don’t do a fundraise within the next year, or the company is about to run out of money, it’ll convert into shares at a valuation such that I own 51% of the company.

That’s what’s called last man standing. Someone is taking a big risk. They might be the only one putting themselves out there to invest, but they’re going to own, or substantially own, the company if you don’t raise or get profitable. At which point they may fire you at put in their own management team. In the meantime they might want to be a lot more active in the company. That’s why they took that bet.

So that’s the last man standing, often investing using a convertible note. Or it might be done as a funding round, at a much lower valuation. The investor will want preference shares, a board seat, and they may want to restructure the company.

So now you understand the different types of down rounds, what permissions do you need from shareholders if you need to do one? Generally you don’t need any permission for a down round other than the normal permissions that you need for any issue of new shares. Your existing shareholders always have a preemption right, so they can buy more shares at the low valuation which allows them to top up their shareholder as if they were a new investor. They might be a bit miffed that they’ve lost money (at least on paper) on their last investment and not want to put in more, but you can tell them, sorry, the last round was at £10 million, this one’s at £8 million. If you want to invest more at eight, think of it as a blended mix of investments that protects your earlier investment.

So you have to offer preemption to your existing shareholders. You may also need investor consent to do a new round. If the existing investors withhold consent, the company’s out of money. And you need board approval. The board members – i.e. the directors – might include founders and investor directors who, importantly, they have to make sure they’re not acting in their own best interest, but in the best interests of the company and all shareholders, regardless of what they want themselves. You may have to remind investor directors that even though their shareholding will be diluted, they have to act in the best interests of the company, and that the company remains a going concern, so they need have to approve the down round if that’s the only solution.

The last thing to talk about is the stigma of doing a down round. Obviously down rounds are, well, a downer. But you’re not the only one, the stats suggest a good fraction, maybe 20% or 30% of Series B companies are raising at a lower valuation than before. Now obviously there’s a difference if the valuation is just a bit lower than the last round or hugely lower. But if the survival of the company is the only thing that matters, you put your ego aside, you put the bragging rights aside. Hopefully business will pick up and you can catch up later, and the good times will be back. This was just a blip on the journey. You bet too high on your last round. The bet didn’t work out. This round’s lower, but you know, it’s all about, onwards and upwards.

Any down round questions, reach out to the team at SeedLegals via web chat or reach out to me to ask anything and hope we can help on both the upside rounds and the down rounds.