Entrepreneurs are by nature optimistic and first time founders even more so. But once you have raised Series A, B, or C rounds there’s a dark side to taking VC money: the down round.
The number one goal of VC-backed companies is not customer satisfaction, market share, gross revenues, or social impact: it’s growth in the company’s valuation.
The lead investor in any round of financing sets the valuation of the company. Given the many variables involved and unlike real estate, the very few comps, this is a black art. But so long as founders push for growth their capital needs may well outpace their revenue, meaning that they need a cash infusion. While there are other ways, such as a bridge loan, typically VC-backed companies raise another round, which means selling enough shares at a sufficient price to meet the company’s needs, typically for 18 months or more.
For each new round the value of the company is set in order to derive the price per share for existing investors, who may want to invest to maintain their percentage ownership position, or new investors who are eager to get into what to them is an exciting deal. So what’s the down round and why is it kryptonite for founders? A down round occurs when investors purchase stock in a company at a lower valuation than the previous round. The causes of a down round are not only bad news for the company, they are worse for the founders who are almost certainly going to have their ownership diluted, as rare is the founder who is both willing and able to invest enough in their company to drive maintain their equity position.
Causes of down rounds
A down round is a last resort if a company needs cash and can’t draw on a credit line or land a bridge loan. There are several reasons for a down round.
Failure to meet milestones or metrics
Milestones and metrics vary from growth company to growth company, but a major reason for a down round can be a failure to meet milestones that may have been set at the previous round. Milestones can range from gross revenues, gross margin, and market share, to shipping a new version on time. This is why founders need to be conservative when setting milestones – under promise and over deliver. But beware of what the VCs call lowballing – knowingly setting goals that are so very easily met that they can be called layups.
Emergence of competitors
Given how cool entrepreneurship is these days and how universities are fueling the startup fire by not only offering many courses in entrepreneurship but they are also setting up incubators or accelerators, running business plan competitions, and even making grants (equity-free money) to student-led startups. So I tell my mentees that however unique their idea may seem to them, the odds are that some other startup somewhere – and that now includes Israel and western Europe these days – is working on the same thing, or something very similar. And competition doesn’t only come from other startups – the vogue for innovation in large companies has generated internal startups and new product initiatives. While one can use sources like Techcrunch to track competitors, your competition may well be in stealth mode – operating under the radar of Internet media companies that track the startup world. Before you start your company you need to do a thorough web search for competitors. But that’s necessary, not sufficient. Monitoring competition has to be an ongoing task. The simplest way to do that is to set up Google alerts. In addition, success will attract copy cats. This is why investors are so fixated on sustainable competitive advantage and unique selling proposition. Be prepared for competition and be ready to explain why you will continue to grow due to your competitive advantages, be they patents, exclusive distribution agreements, large customer base, high switching cost for your customers, price advantage, superstar management team or any combination of advantages.
Previous rounds were overpriced
Investors hate to admit it, but they are like lemmings. They are eager to jump on the latest thing, be it crypto, block chain, deep learning, robotics or artificial meat. Flooding a sector with capital can result in valuations that were driven more by competition amongst VCs than true market value. While a rising tide raises all boats a falling tide can leave many boats stranded on dry land. “Market corrections” in your sector may cause your investors to stick to your previous valuation or even lower it as they come to their senses about whatever wave they thought you were riding.
Down rounds rarely make the news. But today’s article in The Wall Street Journal Genomics Startup Human Longevity’s Valuation Falls 80% sub-titled Fundraising round this week values company co-founded by genomics pioneer Craig Venter at about $310 million; aiming for a turnaround is the story of a down round. Genomics latest round represents an 80% decline from its previous valuation of $1.6 billion – that’s a real haircut!
But down rounds aren’t simply confined to a lower valuation, they also often come with harsh terms and conditions as well.
This round also includes onerous terms that promise priority payment in case the company shuts down or sells itself, and a so-called ratchet that would reset the share price investors in the new round paid if the company has to raise future capital at a lower price, according to the filing. Such terms are rare in venture-capital financing, and typically imposed on companies struggling to find new investors.
According to analysts at the law firm Fenwick & West, 9% of venture financing in the third quarter were down rounds, up rounds represented 78%. Simple math tells us that 13% of rounds were at the same valuation as the previous round – resulting in dilution for all involved unless they “buy up” to maintain their percentage ownership.
The genetics firm Human Longevity is a case study of the fallout from a down round:
As the company has continued to burn cash, its workforce has dropped to around 150 from roughly 300 people at the end of 2016, according to one of the people. And its chief executive officer, chief medical officer and chief operating officer all departed in 2017, according to their LinkedIn profiles.
Dr. Venter, who helped sequence the first human genome, relinquished the chief executive role at the beginning of 2017, resumed it in December, then stepped down again in May, according to company statements. He remains a shareholder.
So how can founders avoid down rounds? As mentioned above, you can start by not getting greedy on the valuation of the Series A round. But mainly by continuing to hit benchmarks and continuing to grow important metrics (versus vanity metrics like page views). Founders need to realize that they have stepped onto the hamster wheel of VC-backed companies: get big fast and then get acquired or go public. The pressure on the company will be unrelenting. So before you take VC money, which is the most expensive way to fund a startup, investigate your alternatives. The best use of professional investor funding is to scale your company, meaning you have nailed your target customer, your business model, your competitive advantage, and the ability of your infrastructure and cash on hand to keep up with the needs and demands of a rapidly growing customer base.
One of the failed initiatives of Human Longevity is a real red flag to founders who think that data is the new oil and they will get rich drilling for data.
But key facets of its business didn’t develop as planned, say people familiar with the company. It had hoped to sell analytics to pharmaceutical companies as they increasingly incorporated genetic sequencing into drug development, these people say. But drugmakers have been slow with the new technology and wary of sharing data, they said.
If you are counting on revenue from the data or analytics your company generates you need to be very sure that it really has value, and to whom. Too many founders I mentor seem to assume that all data has value – not true.
The old medical saw that An ounce of prevention is worth a pound of cure holds true for down rounds as well. The best way to avoid them is to carefully manage both your cash flow and be able to make accurate revenue projections. Your goal every day should be increasing the value of your venture, whether that’s by becoming more capital efficient, selling new products to old customers, raising prices or inventing new products.
Down rounds should be something you only read about, you never want to hear that phrase from the mouths of your CFO or your investors!
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