The Case of the Downer Round

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HEIDI: Welcome to The Startup Solution, and “The Case of the Downer Round.”

Hello. I'm Heidi Roizen from Threshold Ventures. The Startup Solution is a podcast where we unpack the “oh shit” moments faced by entrepreneurs and then find the best ways to get through those moments alive — and with a little luck, maybe even better off.

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HEIDI: As a tech VC, I’m both a pragmatist and an optimist. As a pragmatist, I know that concepts sometimes don’t work, technologies don’t always come to fruition, and markets go through their ups and downs.

But, as an optimist, I also believe that new technologies are always enabling new company formation, regardless of where the NASDAQ closes on any given day.

So if you ask me, anytime can be a great time to be an entrepreneur.

Of course, I have the luxury of saying that because I’m not on the front lines of fundraising for a startup. For those of you who are, down markets can be a bitch, and they may hit right when you most need that new capital.

So I suspect some of you will relate to a call I recently received from someone out raising her series B.

As always, we protect entrepreneur identities and circumstances on The Startup Solution, so let’s refer to her as Ann.

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ANN: Hey, Heidi. It’s Ann. So … I got a term sheet for the B round. Honestly, I’m really bummed. It’s at a lower valuation than our last round, and I don’t even want to tell my team. We’ve worked for over a year since the last round, and now people think we’re worth even less? It’s an insult. Look, I know we need the money, and this is the only offer we’ve got, but it’s like I don’t want to even consider it. So I’m calling because I’m wondering if you have any ideas for how we can get the valuation up, like maybe putting some structure into the round? One of my entrepreneur friends got their valuation up by 20% in an exchange for some structure. Have you seen something like that? What can I do? Anyway, please give me a call, I really could use your advice. Thanks. 

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HEIDI: I’m calling this “The Case of the Downer Round,” because in VC talk, a down round is one that occurs at a lower valuation than the prior one — and most entrepreneurs consider that a real downer emotionally as well.

But contrary to Ann’s initial reaction, a down round is not actually the end of the world.

The first thing to realize is that if someone is offering to put more money into your company, they must think you’re doing something right!

That’s a win — so take a moment to feel good about it.

The next thing to realize is that valuations are not absolute; they are relative to markets. So a down round is often more of a reflection of market conditions, rather than a grade on your company’s performance.

For example, a pretty big component in coming up with any startup’s valuation depends on what’s happening in the broader markets, including the public markets.

And as you probably know, those public markets have had some rough sledding recently.

A case in point: The NASDAQ composite index lost over 30% of its value in one year, 2022, even though the underlying revenue for the companies in the index actually grew 16% during that same time.

So that lower valuation you just got offered is probably not a personal insult; it’s just a market reflection.

And not only that, most down rounds don’t actually have that great an impact on the ultimate outcome for the entrepreneur. The numbers may seem dramatic in the moment, but over the life-cycle of a company, the impact due to any one round tends to be fairly minor.

However, there is something else that can have a way bigger impact, and that is what I really want to dig into now.

When I first became a VC, another VC said to me, “Valuation is the grade at the top of the paper.” It’s what people boast about at cocktail parties. It’s the headline in the news release.

But truth is, it’s the terms you really need to pay attention to. In my experience, I’ve seen case after case where the terms ended up mattering way more than the valuation.

And those terms usually create the greatest delta in medium-success outcomes — which is where most liquidity events end up settling.

So, how do those terms come into the picture?

Well, what I’ve seen happen in downturns in the past is that some entrepreneurs feel demoralized by down rounds — even though, as I’ve explained, they’re often market driven. And so, to get that price back up, they agree to provide more investor-friendly terms in exchange.

Here’s how that might play out: The prospective new lead investor offers a valuation. The entrepreneur says it needs to be higher for them to move forward on the deal.

The investor doesn’t feel the higher valuation is merited, but they still want to do the deal. So in order to hit that headline number the entrepreneur wants, they negotiate for various forms of downside investor protection. This could mean making their round senior in preference, or putting a guaranteed multiple on their capital, or including a guaranteed annual percentage return — or a combination of these things.

Now I’m not saying any of these things are evil! They are all terms that have been agreed upon in the past to bridge the gap between what an investor wants and what an entrepreneur wants.

But, while they are not evil, they can become problematic — and very much so — in certain outcomes.

So, you, as the entrepreneur, should consider the actual cost/benefit of these tradeoffs before you ask for them.

Most entrepreneurs initially see these terms as “almost free giveaways” because they generally only matter in downside scenarios or modest outcomes — and what entrepreneur ever thinks that they are going to deliver anything less than a home run?

The truth is: home runs rarely happen, and most results end up more in the middle of the pack.

And it’s in that very range where the terms make the biggest difference on who walks away with what.

In order to understand how terms impact outcomes, it is necessary to create some spreadsheets that model how the terms being considered play out over various exit ranges.

Unfortunately, podcasts and spreadsheets don’t mix well. So, I’m going to talk through the results of the math here, but for those of you who want to dive into the details, go to threshold.vc/downer. I also have that link in the show notes.

The headline is this: if you trade downside protection for a higher valuation, you are usually committing to give more of the returns in a smaller outcome to the investors, in order for you to keep a larger percentage of the returns on a much bigger outcome.

To give you a solid example of this tradeoff math, let’s return to my original call from Ann.

ANN: So I’m calling because I’m wondering if you have any ideas for how we can get the valuation up.

HEIDI: Ann is out to close a B round. Prior to now, she did a $5 million seed round at a $30 million post-money valuation and then did a $15 million series A at a $75 million post-money valuation. Now she is in the market for a $25 million B round.

Unfortunately, the market is sucky, and even though her company has made progress against its business plan, Ann has just received a term sheet for a down round. It’s on the same terms as her prior rounds, but the valuation is 10% lower.

Ann really wants this to be an up round, so she goes back to the VC and suggests that she will trade downside protection for a higher valuation. She offers a 2x senior liquidation preference, double the 1x that the prior rounds had. What that means is: if the company is sold, and before any other shareholders participate in the proceeds, she will give this new investor not only their $25 million back but an additional $25 million as well.

The VC agrees that with this extra downside protection, they are now willing to offer this round at a valuation 10% above the last round.

So here’s the question: Is this a good trade for Ann to make?

Well, it depends on the ultimate outcome, which is of course unknowable today.

However, Ann can at least estimate the impact by choosing some potential outcomes and then modeling her return.

So let’s do that for Ann now:

The two options on the table are a 10% down round with standard terms or a 10% up round with a 2x senior liquidation preference.

Now let’s hypothetically sell Ann’s company for a range of outcomes and see what she and her fellow common shareholders would walk away with.

If she sells for 85 million dollars, in the 10% down round, she — along with the rest of the common shareholders — would get 43% of the proceeds.

But in the case of the 10% up with a 2x senior liquidation preference, the common would get only 18% of the proceeds. That’s less than half of what they would have gotten had they just taken the down round on simpler terms.

At a hundred million dollar sale, the down round would result in Ann and the common shareholders getting 46% of the proceeds, while the up with the 2x would get them only 29%.

At a 200 million dollar sale, common shareholders finally make out a little better with the 2x up round, getting them 48% versus 46% on the down round.

And at a billion dollars, the common gets 49% instead of 46%. That extra three percent is nice, but really, in a billion-dollar outcome, who’s counting?

Seriously, the key takeaway is this: If you trade a liquidation preference to get that higher valuation, your outcome will be diminished (and sometimes dramatically so) in what are still positive, preference-clearing sales in the lower to mid-range of potential outcomes.

So, when it comes to those more moderate and statistically more likely ranges, it will have been a bad tradeoff.

That’s the basic math. But there’s another potential problem in making these trade-offs, and it’s a more nuanced one.

When you give different investors different terms, this often creates different motivations about when they will want to compel you to sell. And that has the potential to cause some nightmare shareholder dynamics.

Consider Ann’s case, for example: if her last round was senior and had a 2x preference, those investors will double their money in any scenario that clears their own round of preferences — that is, any sale of over roughly $50 million. Meanwhile, the investors below them could walk away with nothing. And so could Ann.

And yes, these highly lopsided cap table sales are where everyone starts using blocking rights, legal threats, and other tactics to try to force moving the money around, or even to block a sale. It can get really ugly, and trust me, you do not want to end up there.

Again, my advice is not that you should never agree to any of these terms. I’m just recommending that you do an analysis of the terms you are considering, across the reasonable set of outcomes, to see what the impact might be. And you should consider the impact not only on you and the other common shareholders but also model it out for the various classes of preferred shareholders as well.

Because, not only can their outcomes be dramatically different depending on the terms of each round, but those shareholders often have voting rights that may affect your ability to get the sale over the finish line. And, not surprisingly, their potential outcomes will usually influence how they’ll vote.

I hope I’ve convinced you that down rounds don’t have to be downers. It’s capital, at market, that you need, and kudos to you for attracting it. Just be sure to do the math on that down round so you understand the implications, fight for terms you determine to be best for your situation — and toast your good fortune when that round closes! Nice work!

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And that concludes “The Case of the Downer Round.” For the record, this situation is real, but Ann is not. And no startups were exposed or harmed in the making of this podcast.

Thanks for listening to this episode of The Startup Solution, a podcast from the venture capital firm Threshold Ventures. We hope you've enjoyed this episode, and if you did, please leave a rating or review it in your favorite podcast app. I’m Heidi Roizen.

Further Reading

Here is Heidi’s blog post and spreadsheet referred to in the podcast

Connie Loizos of TechCrunch with a comprehensive article, “The case for down rounds” 

A fabulous article by Janelle Teng on down rounds versus structure, with excellent links embedded 

Down rounds are a “ticket to try again” (TechCrunch, subscription required)

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