What's a down round, and should you consider one?

Down rounds aren’t exactly the best of news. But are they always negative?

The aim of this blog post is you demystify down-round funding. We’ll explain what it is and whether or not you should consider it. 

We’ll cover: 

• The definition of a down round
• The implications of a down round
• Reasons to consider down-round funding
• Things to keep in mind before going with down-round funding
• How to manage a down round effectively 
• A quick-fire round of pros and cons

Let’s get started. 

What is a down round?

In the simplest terms, a down round happens when a company needs more funding, but — for whatever reason — investors aren't willing to give it the same valuation as before.

This means the valuation is lower than in the previous financing round. As a result, the new shares are sold at a lower price.

Imagine this: Your company was the talk of the town a year ago. Everyone wanted a piece. But now, things have cooled a bit. Maybe the market's shifted, or your growth hasn't been as explosive as predicted. 

When you go back to investors for more cash, they might say, "We still believe in you, but... let's be realistic about the price."

Down rounds vs. up rounds

To truly understand the nature of down rounds, we have to contrast them with up rounds:

• Up round: Each funding round brings in money at a higher share price. Why? Because the valuation is now higher than in the previous round. This is what every founder dreams of. It means investors are increasingly confident in your company's value.
• Down round: This is the opposite of an up round. The lower share prices signal potentially less investor enthusiasm or a market correction.

When do down rounds happen?

There are a few classic scenarios:

• Projections missed the mark. The company hasn't hit its growth targets or product milestones, which causes investors to get nervous. It also becomes harder to secure future investments at favorable terms.
• The competition heats up. Suddenly, a rival appears on the scene, or the market gets crowded. Your company's unique edge becomes less sharp.
• The market chills. The economy is experiencing a downturn, and investors are cautious. They want safer bets, and even promising startups can look risky.
• A VC demands more. Venture capitalists, those big players in startup funding, might flex their muscles. They want more control or a better deal in exchange for their cash.

Implications of a down round

Let's face it: A down round isn't anyone's ideal scenario. It comes with some serious implications that can shake things up for everyone involved:

• Valuation taking a hit: Your company's perceived value drops. Think of it like a house that doesn't appraise for as much as you hoped. It doesn't necessarily mean your house is falling apart, but it does mean you can't sell it for as much.
• Dilution dilemmas: Down rounds lead to dilution. Existing shares become less valuable because there are more of them floating around. Founders and early investors feel this the most. Their ownership stake gets smaller, which can be a tough pill to swallow.
• Market perception shifts: A down round can make investors raise an eyebrow. It might signal that your company is struggling, or its early promise was overhyped. Rebuilding that trust can be an uphill battle.
• Less employee morale: Top talent might jump ship. Recruiting new people becomes harder when your company's valuation declines.

Is it always a bad sign?

A down round is not necessarily bad. Sometimes, it’s just a reality check. Early valuations can be overly optimistic, fueled by hype. A down round can be a bump in the road, not the end of it. Even healthy companies can face down rounds, especially in tough economic times.

The key is how a company handles it. With the right strategy, a down round can be a chance to regroup, refocus, and emerge even stronger. 

Should you consider a down round?

Nobody wants a down round. But let's be honest, sometimes it's the only lifeline you've got. Here are a few scenarios where a down round might be worth considering:

1. Funding needs have become urgent

Down-round funding might be your only option when your runway is getting short and you need cash to keep the lights on. 

It's not pretty, but it's better than closing shop altogether. Securing funding can buy you time to turn things around, even with a lower valuation.

2. The market takes a nosedive

Sometimes, it's not about you — it's about the economy. A recession, industry slump, or a general loss of investor confidence can make fundraising tough. In these cases, a down round might be the price of survival.

3. Your business pivots

Maybe you're making a significant change to your business model or product. It's exciting, but it also comes with risk.

Investors might not be willing to bet on your new direction at the old valuation. A down round can help you get the funds you need to make that pivot successful.

4. Growth opportunities appear

Occasionally, a unique opportunity falls in your lap. But it requires immediate cash, and you don't have time to wait for the perfect terms. A down round can be a strategic sacrifice to seize that opportunity and catapult your company forward.

Evaluating the need for a down round of funding

Before you jump into a down round, take a deep breath and assess the situation. It's a big decision with lasting consequences. Here's what you need to consider:

Evaluate your financial situation

Get real about your company's financial health. How much cash do you have left? How quickly are you burning through it? 

Be brutally honest — there's no room for wishful thinking here. If you're having serious financial issues, a down round might be the bitter pill you must swallow.

But if you still have some runway, it's time to explore other options before making such a drastic move.

Explore alternative funding

There are other ways to get the money you need. You should consider other options such as:

• Bridge loans: These short-term loans can tide you over until you're better positioned to raise funds at a higher valuation. You'll have to pay it back (with interest), but it gets you through a tight spot.
• Convertible notes: These loans convert into equity in a future funding round. They're a good option if you believe your company's value will rebound soon but you need immediate cash flow.
• Strategic partnerships: Teaming up with another company can sometimes unlock funding or resources you wouldn't have access to otherwise. It's a win-win — you get the cash you need, and they get a valuable partner.

Think of the long-term impact

Down rounds have consequences that can linger long after the ink dries on the term sheet. Consider the impact on your valuation, employees, and overall company culture. Will a short-term cash infusion really be worth the potential long-term setbacks?

It's a balancing act. Sometimes, a down round is the only way to keep your company alive. But if other paths are available, it's worth exploring them first. Take the time to weigh the pros and cons. Talk to your advisors and make a decision that aligns with your long-term goals.

How to manage a down round effectively

Once you've decided a down round is the way to go, here's how to handle it like an expert:

Master your communication strategy

Transparency is key. Don't sugarcoat the situation. Explain to your investors, employees, and stakeholders why the down round is happening and what it means for them. 

Be open about your challenges and highlight your plan to overcome them. The more honest you are, the more trust you'll build.

Get the best deal possible

Negotiate hard with your investors. Push for better terms, like a higher valuation. You should also negotiate fewer investor-friendly clauses or less dilution for existing shareholders. Remember, you're not just asking for money — you're forging a partnership.

Remember legal considerations 

Down rounds come with legal complexities. Review your shareholder agreements carefully and consult with an experienced attorney to ensure you're protecting your interests. This includes understanding anti-dilution provisions and how they might affect your shareholders.

Keep your team engaged

Your employees are your most valuable asset. Don't let down rounds crush their spirits and demoralize them. Consider offering new stock options.

You could also adjust existing stock options by either lowering the exercise price or offering to exchange them for a greater number of shares at the new, lower price. 

This is a common practice for companies navigating a down round, and it’s often referred to as "repricing" or "recapitalization" of stock options.

Either way, you want to provide incentives to keep them motivated and loyal. Remember, down rounds should be seen as temporary setbacks.

Pros and cons of a down round for SaaS businesses

Down rounds are like that double-edged sword. For SaaS companies, here are the benefits and downsides:

Pros

• Cash infusion: Often, down rounds are necessary to keep operations running. A down round gets cash in the door fast, so you can keep the servers running and the team paid.
• The pivot potential: If your current strategy isn't working, a down round can catalyze change. It forces you to refocus or maybe even pivot to a new product or market. 
• New investors, new perspectives: A down round can attract a new wave of investors specializing in turnaround situations. They bring experience and connections that could be invaluable as you chart a new course.

Cons

• Valuation reset: Your company's value takes a hit. It's a harsh reality check but sets the stage for a more realistic growth trajectory.
• Dilution: Your pie gets sliced into more pieces. Founders and early investors feel the sting of reduced ownership.
• Negative market perception: A down round can be a red flag for some investors and customers. It might raise questions about your long-term viability or product-market fit.
• Morale issues: Your team might feel discouraged, stock options might lose their luster, and top talent might start looking for greener pastures.

Final thoughts

Choosing a down round is like choosing a trailhead for a challenging hike. You wouldn't set out without weighing the terrain, your supplies, and your ultimate destination. Similarly, a down round should be a calculated decision, not a desperate leap.

Consider a down round if you:

• Absolutely need that cash injection to survive
• See a major opportunity that outweighs the risks
• Are prepared to rebuild trust and motivate your team through the transition

Seek alternatives if you:

• Still, have some breathing room in your finances
• Can negotiate better terms with your existing investors
• Believe your valuation will rebound quickly

Sometimes, the road to a down round can be caused by something as simple as a leaky revenue bucket. If your billing system isn't airtight, you might lose money without realizing it.

That's where Orb comes in.

Orb is a billing management platform designed to handle billing for you, from invoicing to usage tracking. 

Learn how Orb can fix billing issues you might have so you don’t need to use down-round funding in the first place.