Strategies for Founders Facing A Down Round

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A problem many companies are facing today is last-round valuation, and more specifically, the case where their last-round valuation was way ahead of where the market is today. Understandably, this is the kind of problem that gets founders worried as they face the prospect of a down round.

Conventional wisdom says there are few things worse than a down round.  But the truth is, particularly in this current environment, you shouldn’t fear a down round. While it’s not a scenario most founders dream of, neither is it the worst thing that can happen nor a certain kiss of death for a company that’s otherwise in good health. Let’s consider why this is the case, and what you can do to turn this financial lemon into lemonade.

The Current Environment

If you believe you’re headed for a down round, then you’re not alone. According to Cooley, the percentage of down rounds increased to 27 percent of deals for Q3 2023—the highest percentage of down rounds since the company started its reporting in 2014. Your investors, if not directly, as part of their partnership have by the statistics already had to manage through this in their portfolio. In addition, the number of flat rounds increased to 9 percent in Q3 2023, while the number of up rounds declined to only 64 percent—the lowest number ever reported by Cooley.[1]

There are a few reasons we are in this current environment of compressed valuations.

1. Historically, if you were trying to raise a Series B or a Series C, and your company had doubled from the previous year, the kinds of multiples that people were paying were somewhere from 10 to 15 times one-year forward ARR. However, during the COVID phase—throughout 2021 and into early 2022—the tech public markets paid abnormally high premiums for growth. It was not uncommon for companies to get rounds done at 50 times, and sometimes even 100 times forward ARR. So, in these cases, rounds were done at very high valuations. While there’s still a premium for growth in the public markets today, the multiples have now settled back down to the historical norm.

2. The other thing is that during COVID, there was a runup in spending on software and applications, especially for enterprise, remote, collaboration, sales, and related products. That surge has faded, and the growth rates of these companies, which were in some cases doubling or even tripling, are now considered to be good at 50 to 70 percent. On the commercial side of things, people are prioritizing their spend in the most important categories and shrinking down the portfolio of software that they’ve bought.

These factors have put companies in a bind. While they may have had a high valuation in their last round, they are now faced with compressed valuations and slowed market demand. And if that’s where you are, you know it’s an uncomfortable place to be.

As a founder who’s contemplating a down round, you might be feeling like it’s an indictment of your performance, and it might be. But it’s also very possible that you are a victim of changing circumstances—your company may still be growing nicely, but your multiples have simply contracted more than you grew. You may have done a good job but still find yourself in a tricky situation. Fortunately, there are some things you can do to make the most of a down round.

Carefully Consider Your Options

The first thing to consider as you approach a down round is whether you should take another path altogether.

If you are fortunate enough to have raised a good chunk of money in your last round, you may be able to chart a path that maintains your product development and keeps you ahead of the competition at a moderate growth rate that’s not doubling or tripling, but a little bit less than that. And if you can accomplish that and hit cash flow positive or close to cash flow positive at a future time, you probably don’t need to raise right now. This path puts you in control of your destiny, and it may well be the best outcome for you. You can always come back and do a raise later to accelerate growth.

If you do decide to go for a down round, you have the power to minimize any negative impacts. First, do the groundwork to set up everything in advance. Get all the stakeholders around the table as early as you can, including your leadership team, your fellow co-founders, and your existing investors——each of whom might have different rights and expectations based on when they came in. Have a framework and a model that makes it easy for a new investor who is excited about the company, with valuation being the only thing that’s not right.  

Finally, get yourself in the best headspace possible as you work through a down round. You are going to be making trade-offs and having hard conversations, and people will propose things that might make no sense for you. And it’s hard to resist making proposals that make no sense for them and make sense for you. Try to get to a place of, “What I need to do is work this out in the most logical way.” Remove yourself from both the emotions and the self-interest you may be feeling for a moment. Maintaining a bit of distance as you go through a down round can be very helpful to the ultimate outcome.

It’s normal to get emotional along the way, and this is perhaps the hardest part for founders. But as a leader, you can say, “I made lots of commitments to a lot of people. Of course, I want a good outcome for myself, but I also want to be the kind of leader who will continue to inspire and bring my team members, my customers, and my investors along with me because we want to keep this venture going.” Ultimately, that’s the goal you should be focused on, whatever path you take.

Conclusion

In a nutshell, although a down round is a difficult experience, it is not the end of the world for a well-run company. It provides an opportunity for founders to realign their goals and pursue sustainable growth. Key steps include evaluating options such as delaying fundraising for cash flow stability or intentionally laying the groundwork for new investors to enter in a down round. Transparency with stakeholders and maintaining a collaborative approach are essential. Founders must continue to inspire their teams with the goal of emerging more resilient and better positioned after the down round.