Why startup founders shouldn’t avoid downrounds at all costs
Every company is feeling a degree of discomfort at the moment, particularly those in their early stages. A dip in tech valuations, mass lay-offs, the cost-of-living crisis and political uncertainty have all led to a pretty unfriendly economic environment for founders growing a business.
Despite these challenging times, it’s important that founders don’t make knee-jerk decisions that may hinder their progress in the long term.
In this market, commanding a premium valuation is going to be a struggle for some companies and that’s an unfortunate reality. But too many VCs and startup founders seem desperate to avoid a downround at all costs.
They would be wise to think again.
In their efforts to swerve the dreaded downround – when a company sells equity at a lower value than previous rounds – founders are agreeing to more exotic and complicated structures.
This includes 2x or 3x return preferences, massively discounted convertible loan notes and highly complicated ratchets, which are all being used to make a downround in principle look like a flat or even an up round.
Whilst this may seem like a good idea at the time for all parties, it will come back to bite them later.
As a VC, we’ve seen countless scenarios where a ‘funky’ structure just makes it incredibly hard for a new investor to come in after that round.
In my opinion, if startup founders or investors are considering a downround, then it would be better for everyone if that fundraising round was simply priced appropriately. The previous round price has very little relevance to the current situation; and as such, it should largely be ignored in respect of the current fundraise.
Startup downrounds were inevitable
We all remember the record-breaking valuations of 2021, where we saw investors paying over-inflated prices for businesses based on unrealistic multiples. Whilst this effect was mostly seen in later-stage funding rounds, some companies were overvalued last year.
This year’s valuations are in line with the strong growth trend we’ve seen in tech over the last ten years, but we were always going to see corrections from 2021 valuations, which was an anomaly year. This will inevitably result in down rounds for certain businesses that haven’t hit their growth projections.
And if that does result in a downround that dilutes management significantly, we would favour a simple mechanism to reward management for future performance. Or simply aim for a fundraise that strikes a fair balance for everyone involved.
And as with all investment negotiations, honest and transparent communication is always the best policy. Everyone sat around the table knows what fair ‘feels like’ and that should, ultimately, be the aim.
And, for the avoidance of doubt, founders should be prepared to walk away from a bad investor that isn’t aiming for ‘fair’. The money simply isn’t worth the headaches they may cause later down the line.
If your business needs money then you may have to make some difficult decisions. But avoiding a down round by inserting some funky structure often isn’t worth it in the long run. The world of VC is based on the longer-term holding of assets, not simply reporting on the next cycle.
Ultimately, it is the exit price that matters most to all parties involved.
David Foreman is managing director of Praetura Ventures.