Last week I was talking to an entrepreneur that was out raising money. As they had raised their Series A in the middle of 2021, made good but not great progress, and spent all their capital, they were in a tough spot. When I asked how much they were looking to raise, and at what valuation, I received the expected answer: we’re raising X as an extension of our A round at the same valuation.
Entrepreneurs that raised rounds at 20, 30, 50, or even 100x revenues have a challenge on their hands. The public market multiples for cloud companies have gone down 40 – 80% this year. Companies that were previously trading for 20x run rate, with strong metrics, are now routinely trading for 6x run rate. Public market multiples have a serious influence on private market multiples.
Why the push for an extension of the Series A round at the same valuation? Simple, to avoid a down round and provide an easy path forward. When a startup raises money at a valuation less than the last round, anti-dilution measures kick in. Say investors put in $10M in the last round at a $100M post-money valuation and own 10% of the company. If the new round is at a $50M post-money valuation, those previous investors that owned 10% of the company for $10M now own 20% of the company ($10M is 20% of the new $50M valuation) and didn’t put any additional capital in the business (assuming basic anti-dilution rights). Everyone, especially the founders and employees, are heavily diluted by both the existing investors owning a larger percentage of the business as well as the new investors that supplied capital in this most recent round. It’s a tough pill to swallow after things were frothy for so long.
Down rounds also create challenges around employee equity, especially stock options. If some employees were issued options at a strike price of X, and now the company is valued at 50% of X, those options are much less desirable. Does the company issue new options at the new strike price for everyone? Only some employees? Do they issue the new options at the lower price with an aggregate dollar value that’s the same as before resulting in more option pool dilution? There are ramifications throughout.
Entrepreneurs would do well to seek new capital as an extension of the last round if the startup hasn’t made enough progress for an up round. When it hasn’t, and a down round is inevitable, it’s much more challenging, but all is not lost. Figure out the options, get capital in the business, and most importantly, get momentum back.