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A down round is when a startup raises money at a pre-money valuation that is lower than the post-money valuation of its previous round.
On July 11, 2022, with stock indexes firmly in bear market territory and the Federal Reserve pulling back on liquidity, fintech giant Klarna announced it had taken on a new financing round at a $6.7B valuation. This was notable as, just a little over a year prior, Klarna had raised funding at a $45.6B valuation—almost seven times higher.
In venture capital parlance, Klarna had undergone a down round—raising money at a lower valuation relative to its previous fundraising round. It’s a scenario nobody wants. But why are startup down rounds regarded so negatively? And what can be done to avoid them?
In this article, we’ll go over everything founders and investors need to know about down rounds. We’ll cover their technical definition, why down rounds happen, the implications of down rounds, as well as several alternatives.
Let’s say Startup X raised $5M for its Series A at a $15M post-money valuation. Now, it wants to raise $20M for its Series B. If investors offer that $20M at a $10M pre-money valuation—equating to a $30M post-money valuation—it is said to have undergone a down round because the pre-money valuation of its Series B ($10M) is less than the post-money valuation from its Series A ($15M).
So, in technical terms, a down round happens when the pre-money valuation of the current round is lower than the post-money valuation of the previous round. (If both of those valuations were equal, the round is a “flat round”).
Down rounds result in a loss in value for the existing shareholders. The table below shows how a hypothetical investor in Startup X that bought 20% of the company for $3M during that Series A round would have seen the value of their stake decrease as a result of the subsequent down round funding.
As you can see, there was a 33% drop (from $15M to $10M) from the post-money valuation of the Series A to the pre-money valuation of the Series B. As a result, the value of the investor’s stake also correspondingly fell by 33%, from $3M to $2M.
Down rounds can happen for any number of reasons, but some common causes are:
We saw how down rounds cause a loss of value for existing investors. For venture funds, this may require them to write down the value of their portfolio holdings—resulting in a drop in TVPI and IRR metrics.
Depending on the magnitude and reasons for the write down, down rounds can hamper the GP’s ability to raise future funds—or even make it difficult for them to call committed capital.
But for startups, down rounds can have serious and cascading effects, starting with:
In sum, a down round can be the start of a negative feedback loop for a startup. Investors lose confidence while employees—and even founders—are drained of morale, making it even more difficult to turn the ship around. And the triggering of negotiated anti-dilution provisions can accelerate this negative spiral.
That said, not all down rounds are created equal. For instance, if the down round was due to the broader macroeconomic environment and many other startups have also been forced to take down round funding, the perception will likely be less negative. Context always matters.
Still, it’s no surprise that founders (and investors) want to avoid down rounds as much as possible. So, the question is—how can they do that?
Because the reasons behind a startup’s troubles typically cannot be instantly fixed, there are no magic ways to avoid taking down round funding. There are only difficult choices, which include:
Just like bear markets, down rounds are a sometimes inescapable reality for startups. There are alternatives that could help the startup to avoid them, but there are no magic pills—every alternative comes with very real costs and may simply delay the timing of the down round. It is crucial for both startup founders and investors facing challenging situations to balance the negative implications of down rounds with these costs.