Down Round (Finance) – Definition

Cite this article as:"Down Round (Finance) – Definition," in The Business Professor, updated November 23, 2018, last accessed September 23, 2020, https://thebusinessprofessor.com/lesson/down-round-finance-explained/.

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Down Round Definition

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.

A Little More on What is a Down Round

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 round occurs 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.

References for Down Round

Academic Research on Down Round

Understanding price-based antidilution protection: Five principles to apply when negotiating a downround financing, Bartlett III, R. P. (2003). Bus. Law., 59, 23.

This article describes the protection that minimizes the dilution that occurs when a company issues down-round financing by increasing the rate at which shares of preferred stock held by common investors are converted into common stock. This article is in response to the venture investment opportunities that arose after the financial crash of the early 2000s.

The Private Finance Initiative: clarification of a future research agenda, Broadbent, J., & Laughlin, R. (1999). Financial accountability & management, 15(2), 95-114. This article provides an overview of the Private Finance Initiative (PFI). The author also gives a quick survey of the practice of seeking private finance for development in the UK’s services and buildings prior to the formation of this initiative. This paper concludes with a summary that offers up a future research agenda for the PFI.

Angels: personal investors in the venture capital market, Freear, J., Sohl, J. E., & Wetzel Jr, W. E. (1995). Entrepreneurship & Regional Development, 7(1), 85-94. This article shows the role that private money plays in the equity financing of new tech-based ventures. The authors’ research suggests that private financing is the most common form of financing, especially if the round of financing is less than $500,000. This form of financing is found to be faster and less costly than receiving financing from large venture capital funds.

Venture capitalists and the decision to go public, Lerner, J. (1994). Journal of financial Economics, 35(3), 293-316.

The author uses a sample of 350 privately held, venture-backed biotechnology firms to show that these companies are more likely to provide a public offering when equity valuations are high, and they’ll use private financing when the equity values are lower. These results and their implications regarding controls and alternative explanations are discussed.

Financing decisions as a source of conflict in venture boards, Forbes, D. P., Korsgaard, M. A., & Sapienza, H. J. (2010). Journal of Business Venturing, 25(6), 579-592. This article challenges the traditional notion that venture boards should be structures so as to stimulate internal conflict. This piece shows that conflict is sometimes dysfunctional, and not a reliable indicator of effectiveness. Decisions regarding financing and the behavior of founder-CEOs versus non-founder CEOs are found to have a significant effect on board conflict and effectiveness.

One Hat Too Many? Investment Desegregation in Private Equity, Birdthistle, W. A., & Henderson, M. T. (2009). The university of Chicago law Review, 45-82. The authors of this article explore the new tensions that arise when a firm has a mix of funding that includes both private equity and public shareholders. A discussion of this new dynamic is offered, and the authors also propose and examine a variety of ways that this conflict can be eliminated or at least alleviated.

Beyond banks: the local logic of informal finance and private sector development in China, Tsai, K. S. (2009). Informal finance in China: American and Chinese perspectives, 80-103.

This article examines the ‚Äúmiracle‚ÄĚ of China‚Äôs private sector development, even when private entrepreneurs have not benefitted directly from the centrally mandated preferential treatment from state banks. The authors show that a mix of informal financing, undercover strategies that firms use to get financing from state banks, and a lax local regulatory system that makes the first two possible. The article concludes with a consideration of the implications that arise from these financial systems.

Preferred risk allocation in China’s public‚Äďprivate¬†partnership (PPP) projects, Ke, Y., Wang, S., Chan, A. P., & Lam, P. T. (2010).¬†International Journal of Project Management,¬†28(5), 482-492. This research project used a survey of public-private partnership (PPP) practitioners to determine how risk was allocated in the Chinese PPP market. This study analyzes the allocation of over a dozen different risk factors. Further analysis of the reasoning behind these decisions was conducted, and recommendations regarding commercial and contract terms for public and private entities are offered.

The US angel and venture capital market: Recent trends and developments, Sohl, J. E. (2003). The Journal of Private Equity, 6(2), 7-17. This article examines the growth and downturn of the angel and venture capital markets beginning in the early 1990s. The reasons for the upward and downward movements of this market are examined. The author concludes with a prediction about future market movements.

Early-stage entrepreneurial financing: A signaling perspective, Kim, J. H., & Wagman, L. (2016). Early-stage entrepreneurial financing: A signaling perspective. Journal of Banking & Finance, 67, 12-22. This research provides an analytical look at how an entrepreneur might choose between angel and venture capital financing. The authors present an entrepreneur who seeks to maintain ownership as well as equity value. Varying styles of entrepreneurs, industries, and investors are discussed.

Bridge financing over troubled waters, Harris, T. J. (2002). The Journal of Private Equity, 59-63. This article provides a survey of the history of bridge financing. The author defines the practice and explains how it played a role in various economic periods. An analysis of current bridge financing practices is offered, and recommendations about the future of bridge financing are discussed.

 

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