Recently an article that I read quoted the interviewee as saying startups are broken after a down round. After reading that statement I thought to myself that yep, startups are broken after a down round. A down round is when a startup raises a round of financing at a lower valuation than the previous round of financing. With the high seed and Series A valuations in the Bay Area (e.g. $6M – $14M pre-money), the prospect of more down rounds in the future increases as not all of those startups are going to be able to generate enough traction to warrant an increase in valuation.
On the surface it might not seem that big of a deal, raising money at a lower valuation than the previous round. In reality, most investments have anti-dilution provisions such that if another round of capital is raised at a lower valuation, then the previous investor gets their original number of shares increased to equal out to the previous investment amount but at the new, lower per share price (there are different formulas to calculate how the anti-dilution provision works like weighted-average and this example is to keep it simple).
So, here’s what happens in a down round:
- Previous investors get a larger number of shares due to anti-dilution provisions, which comes out of the entrepreneurs’ stake
- New investors buy a chunk of the company, which comes out of the entrepreneurs’ stake at a lower valuation than the previous round
- Existing employees with stock options get more serious dilution because the startup has sold new shares and increased the number of shares existing investors have
- Entrepreneurs and stock-option-holding-employees get more disillusionment due to dilution and things not going as well in general, as opposed to raising an up round with more excitement and less dilution
So why is a startup broken after a down round? Well, the entrepreneurs, depending on the type of anti-dilution provisions, are often so diluted that they no longer have a meaningful stake in the startup, and are better off leaving. Once the entrepreneurs leave, and the startup already isn’t doing well, it doesn’t bode well that bringing in new leaders will make things successful. Often times the economics no longer make sense and the capitalization table is forever challenged.
What else? What are some other reasons startups are broken after a down round?