Startable – Healy Jones’ & Prasad Thammineni’s Blog

Mark MacLeod pointed me to a recent publication by Fenwick & West (a well known tech law firm) on the increasing number of down rounds for venture funded companies. According to Fenwick, for the past two quarters, “down rounds” have exceeded “up rounds” when venture backed companies are raising follow on financing. To go into a little more depth here, a down round is when a company that has already raised venture capital raises additional capital (another “round”) at a valuation that is lower than the valuation from the previous round. In other words, the company is worth LESS than it was after the completion of its last fund raise. So, for the past couple of quarters, many previously venture backed companies are falling in value.

Why 2009 Q2 valuations are falling

The decrease in valuation for these companies has averaged about -50% for the past three quarters – a pretty hefty drop. This is probably caused by a few horrible issues converging all at once: 1) the NASDAQ is off by 30%ish from its two year high, and was at one point 50%ish off its high – obviously valuations for private technology companies are going to be impacted; 2) the difficult market conditions have made it harder for venture backed companies to achieve their goals and hit their value creation milestones, therefore many of them have probably failed to really move the needle on their valuation in the positive direction; and 3) there is less venture capital floating around, so as supply of follow on financing drops valuations should follow downwards.

The hidden cost of a down round for a venture funded company – anti-dilution provisions

The problem with a decreased valuation, from the startup founder’s perspective, is that the venture capitalists are going to significantly increase their ownership in the business at the expense of the company’s management team. Not only is the price per share that the VCs are investing in down (thus they buy more of the company) but they also will benefit from a standard term in venture capital fund raising – the anti-dilution provision.

The anti-dilution provision is intended to protect the investor in the event of a down round by resetting the conversion price from the VC’s previous investment(s) in the company. This provision resets (much like a “do over”) the price paid per share from a previous investment to the new price per share, or to a calculated price per share in between the previously paid price per share and the new, lower share price paid by the investors in the current round.

I’ll run through a quick mathematical exercise so you can see the impact of a down round on a company with a “weighted average” anti-dilution provision. This is the standard anti dilution provision, and is much more founder friendly than its less standard cousin,  the “full ratchet” antidilution provision.

For this example, let’s assume your startup has raised a Series A with the following terms:

$5 million from VCs at a $5 million pre-money valuation. This means the investors own half the company, and management owns the other half. Also, let’s assume that there are 10 million shares outstanding, so the investors own 5,000,000 and management owns the same. Thus, the price per share is $1.00. Post money, after the Series A, is $10 million.

The company needs another $5 million.

Up round – Say that everything is great, and the company is able to raise capital at $2.00 a share. Ownership post financing will be:

60% investors
40% management

Flat round – $1.00 a share, so the company’s pre-money valuation is still $10 million, the post from the last round.

67% investors
33% management

Down round – Here is where things get complicated due to the anti-dilution provision. Assume there is a new investor coming into the company, and they are willing to pay a $5 million pre-money valuation for the business. You’d assume that this translates to a $0.50 per share price, and that it would dilute management’s ownership to 25%. Painful. But with a weighted average anti-dilution provision the existing shareholders have their conversion price reset downwards. The new investor doesn’t really want to have to deal with this change to your capital structure – they want to own half the business. So the ownership dilution that occurs comes out of management’s pocket. This means that the effective share price on this down round is $0.40! Ownership will look as follows:

80% investors
20% management

Steps you can take to prevent a painful down round when you are first raising capital – i.e. planning for the future

Get a weighted average anti-dilution provision NOT a full ratchet. Weighted-average is standard; full ratchet is not. If you look at Fenwick’s analysis, 97% of down rounds had a weighted-average, only 3% are full ratchet (note that 0% have no anti-dilution provision.) As a startup founder closing your first venture capital round you are right to insist on the standard provision here, and that is clearly the less punitive weighted average anti-dilution provision.

Don’t push the valuation. High valuations in your initial round are great because they cause less ownership dilution for you and your team because you give less of the company to the VC. However, you also really raise the bar for your next financing round. There is a fine line between getting the most that you can in your initial financing round and making your Series B messy.

Hit your valuation creation milestones. Know what your company will look like as you are running out of the current financing round, and make sure you add value with your initial financing round – more then you spend!

If your startup is running low on capital and facing a down round

If you need money to keep the business going and achieve your goals, then you have to take the money. Getting funding sure beats going out of business….

Try a bridge financing with your current investors – assuming that there is a specific goal this capital can help you achieve. If there isn’t, then take your lump and get the lower-valuation round out of the way. Bridges and other short-term financings can be very expensive, and may end up further diluting the management team if the bridge financing doesn’t lead to real added value in the business (as in value that the next round’s investor will appreciate.) I think that the time for “buying time” with a bridge is over. The new valuation reality is here, and it’s not going away.

If you have to take a down round and the team is getting their ownership “crushed” then work with the VCs to refresh the option pool. The investors should want to keep the employees focused and positive on the business, so work with them to reload the team with lower-priced options.

I sincerely hope that your startup never has to deal with a down round. Good luck as you try to grow your business!