I had a chance to sift through Pitchbook’s U.S. VC Valuations Report for the first quarter of 2024.  The data point that really jumped out at me was the increase in down rounds.  The number of flat and down rounds as a proportion of all VC deals has been rising consistently since the first quarter of 2022, reaching 27.4% of all VC deals in Q1 2024, the highest level in ten years. 

Startling, but predictable.  Companies raised capital during the venture frenzy of 2020 and 2021 at high valuations.  Many startups that had since failed to reduce their cash burn when the fundraising market turned sour in mid-2022 are now facing the prospect of having to raise capital at a discount to their last valuation.

This trend has implications for founders, investors and companies, as down rounds can trigger anti-dilution provisions, dilute existing shareholders and create challenges for companies seeking to raise additional funding.  And there’s reason to believe the worst is not yet behind us.  The incidence of down rounds during historic bear markets indicates there is still plenty of room for valuations of venture-backed companies to fall further.  The rate of down rounds in the aftermath of the 2008 financial crisis rose to nearly 36% of venture deals, which was actually dwarfed by the 58% of deals during the dot-com bust.

Downside of Down Rounds

A down round occurs when a company raises capital at a lower valuation than the previous round.  Unlike the case with public company price dips which are mostly deemed to be buying opportunities, private company valuation declines are negatively perceived for a number of reasons.    

The first is psychological.  Investments in, and employment with, private startups is risky, which means it’s critical that these companies produce evidence of rapid growth to attract investors and talent.  A down round sends a signal of desperation that the company is willing to raise money at a lower valuation which tends to dampen employee morale and shake investor confidence.

The second relates to the VC business model.  VCs report the value of their portfolio to their limited partners on a periodic basis.  A down round means that the VC fund will need to write down the value of its portfolio, which in turn may negatively impact fundraising prospects as well as distributions and fees to the VC sponsor from the fund.

Finally, a down round almost always triggers conversion price adjustments under anti-dilution provisions from previous rounds, as a result of which the investors would be entitled to receive more shares upon conversion, resulting in significant percentage dilution to the founders and other common shareholders.

Alternatives to Down Rounds

As a practical matter, companies needing to raise capital while facing the specter of lower valuations do have alternatives to effecting a down round. The objective of these alternatives would be to avoid triggering anti-dilution provisions.

A company may try to negotiate a waiver from its existing investors of their antidilution rights.  One factor that may motivate existing investors to do so is if they believe the disproportionate dilution to founders and key employee shareholders that would otherwise be triggered by the antidilution adjustment would be so massive that they would no longer be sufficiently incentivized to remain with the company and work hard to help it grow and achieve a successful exit.  The consent mechanics may be such that some vote threshold would be enough to bind all preferred investors or all those in a particular series.

Another approach would be to negotiate away more favorable non-price terms in exchange for a higher valuation that avoids a down round.  Some examples would be a greater than 1x liquidation preference, participating preferred, redemption rights, accruing dividends and warrant coverage.  

A third approach would be foregoing a priced round altogether in favor of a bridge financing structured as either a convertible note or a SAFE where the instrument converts into the security issued in the next round at a discount.  Doing so would avoid having to agree to a lower valuation.  I would note the valuation issue is not avoided entirely if the conversion price of the convertible note or SAFE is determined at least in part by a valuation cap, which tends to be based on an approximation of the then current valuation; however, a valuation cap does not trigger conversion price adjustments under the terms of typical anti-dilution provisions.

So given these alternatives and the negative consequences of a down round, what should a company do in an unfavorable valuation environment?  Generally speaking, a bridge round in the form of convertible notes or SAFEs would be the best short-term approach, although this would likely only postpone the valuation problem rather than fix it.  If existing investors won’t consent to a bridge round (or it is not otherwise viable), and won’t agree to waive their antidilution rights, the company would need to evaluate the relative harm of the down round against that of the enhanced non-price terms the investors in the new round would demand in exchange for a higher valuation.  This would require careful analysis with the assistance of competent counsel.