Down Round (Finance) - Explained
What is a Down Round?
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Table of ContentsWhat is a Down Round?When does a Down Round Happen?Academic Research on Down Round
What is a Down Round?
When a company's valuation at the time of an investment round is lower than its valuation during the preceding round, it is called the down round. During the down round, the investors pay a lower price to purchase the company's stocks and convertible bonds than the previous investors. There are several reasons which may lead to a down round, including: fall in the stock market, competition in the market, and change of perception of the investors on company valuation.
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When does a Down Round Happen?
Startups raise their funds from the investors through a series of funding phases, knows as rounds. Typically, as the business grows with time a company gets a chance to increase the price of their stocks with a higher valuation of the company.
Down rounds occur in a situation when the investors insist to pay less for the company's stock than the previous round. While down round does not necessarily mean the end of all it is definitely a wake-up call for the owners of the business. Down round often occurs when a company fails to reach the benchmark.
A company sets some benchmarks while raising funds from its investors, benchmark includes product development, key hires, and revenue. In the subsequent rounds, the investors have the advantage of scrutinizing whether the company has been able to meet the benchmark. As meeting the benchmark reflects the company's performance, it is often a matter of concern for the investors if the benchmark is missed and they may demand a lower price for the stocks.
The emergence of a competitor in the market often leads to a down round. It becomes harder to raise fund from the investors while another company poses tough competition. On such occasions, the investor may try to hedge their bet by insisting on lowering the value of the stocks. The investors compare different aspects of the competing companies to determine the valuation for the next funding round.
Even after performing well in business, a down round may occur if the investing venture capital firms demand a lower valuation for their risk management purpose. The venture capitalists often demand seats on the board of directors or the power to alter the decisions as their risk management measure along with lowering the valuation.
The founders often agree to these conditions in order to secure the funding from venture capital firms knowing well that would result in loss of control by the founders. In a down round, a company needs to sell a higher number of shares to meet their ends. This typically leads to an increased level of dilution and lowers the ownership percentage of the existing investors drastically.
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