A down round is a financing round in which a company raises capital at a lower valuation than its previous financing round. In other words, the company's shares are sold at a lower price per share, which means that investors who purchased shares in the previous round may experience a decrease in the value of their holdings.
Down round is not rare news these days. After the recent funding winter in the ecosystem, founders are often faced with this decision to raise funds at a lower valuation. For example, Flipkart raised funding at a 30% lower valuation than its previous funding in 2016-17. The ramification of a down round is severe and many startups will see its effects in 2023 because of the funding winter.
Instead of looking at everything from a white, black lens, we need to understand that Down Round is not always a bad opportunity. When presented with no options, any Down Round can also be a harbinger for many in need of the required funds. Startups should judge every Down Round critically and assess their options well. It is not that they can never regain their value, but they may come close to the edge of closing their startup if they run out of funds.
Valuation is also like Stock Price; it goes up and down from time to time. What is more important is to understand that it is important for the founders to maintain transparency with their employees and understand the ramifications of the same on Employee Equity.
Various sorts of shareholders typically experience a down round in various ways. For employees, it can put your share options underwater, meaning that your strike price—the amount you will pay to exercise your options when they vest—is now higher than the fair market value (FMV) of the shares. If you were to exercise them, you would be losing money on your shares as a result.
You won’t face any major changes if your startup is still in the early stages as you will have enough time to see your shares regain their value before you go into a liquidity event.
Employees who are at a higher risk of losing money because of a down round are those who joined the startup recently and their strike price depends on the FMV of the company at an inflated valuation. For them, it may take even longer to overcome the currently high strike price.
Employees also suffer when their firm is bought based on the lower valuation in a down round. Share options typically become exercisable when a firm is bought. After that, employees have a constrained window (typically just 90 days) to buy their shares at the strike price. However, if a low valuation places your shares underwater during the exercise period, you will either need to purchase them at a price above their present value (i.e., pay a strike price over the share price), or you will completely lose the value of your stock.
The first thing that every founder needs to ensure is transparency between them and the employees. It is important that you explain to your employees the current situation and explain to them their options in such a situation.
Companies may also attempt to make up for the declining value of the stock holdings held by their employees by granting each one of them extra options with a lower strike price or by repricing the options. The latter scenario sees the corporation reissuing fresh options with a lower strike price, essentially cancelling the original options.
Companies might also increase the exercise window from 90 days to five or even ten years to assist minimize the impact of a down cycle. Employees can now access that wealth since share prices have had time to increase and into the black. In circumstances when individuals have been laid off, it is especially crucial. Even while losing one's pay is difficult, at least a longer exercise window ensures that employees will continue to get the benefits of their earned equity if the company's financial situation improves.
Employers and Employees need to not give up in the face of any Down Round. As explained before, it can put your share underwater, but it is temporary and can regain its value over time. If the company can reuse the new funds wisely, restructure things for company’s growth, then any down round will only be a small obstacle in your fight to sustain in the startup world.