What is a Down 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.

What is a Down Round?

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.

Why do Startup Down Rounds Happen?

Down rounds can happen for any number of reasons, but some common causes are:

• Consistently failing to meet growth targets. The playbook for many venture-backed startups centers around rapid growth. So, when a startup consistently fails to hit growth milestones, it can have a negative effect on valuations when the startup goes to raise its next round of funding.
• Loss of competitiveness. Many startups are operating in markets where a disproportionate amount of the rewards go to the dominant player. As such, falling behind their rivals can trigger investors to reassess a startup’s valuation.
• A shift in the broader macroeconomic environment. Interest rates, stock market performance, and general investor sentiment in the microenvironment can have a profound impact on valuations. In 2022, with the Federal Reserve aggressively raising interest rates to combat inflation, valuations for risk assets came down across the board. So, it’s no surprise it has extended to all manner of venture-backed startups as well. In 2022, we saw substantial down rounds in fintech (Klarna) and crypto (Blockfi). Meanwhile, other companies like Instacart and Stripe are slashing their internal 409A valuations. The AngelList 2022 State of Venture report also found there were a higher number of down rounds in 2022.

What are the Implications of a Down Round?

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:

• The triggering of anti-dilution provisions. Existing venture investors (who hold preferred shares) may have obtained anti-dilution provisions that would be triggered by the down round. Such provisions would allow investors to avoid some—if not all—of the loss in value created by the down round. However, this would come at the expense of the common shareholders, who would see the value of their shareholdings fall even further. For an in-depth explanation of how these provisions work, check out our guide on anti-dilution protection provisions.
• Loss in employee morale. A good chunk of startup employees’ compensation comes in the form of equity—typically employee stock options. A down round means the value of their equity has fallen. In certain cases, it can also make their stock options worthless. This naturally affects morale and can require the startup to reprice employee options or reevaluate compensation packages.
• Less motivated founders. If the drop in valuation is severe enough, the founders’ stakes might become so diluted that their founder shares are no longer motivating to them. This can be exacerbated by anti-dilution provisions.
• Falling investor confidence. Down rounds can create a negative perception about the startup, leading to falling investor confidence and increased difficulty raising future funding.

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?

Alternatives to Down Round Funding

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:

• Reducing the burn rate to delay the next funding round. If a startup can extend its runway by cutting costs, it might be able to avoid having to take a down round, at least for the time being. Of course, this is easier said than done, and can involve painful layoffs and other cost-cutting measures.
• Taking a bridge round via a SAFE or convertible note. Bridge rounds can help extend the startup’s runway a little longer and hopefully buy it enough time to avoid a down round (either by waiting out the macro environmental downturn or allowing it time to hit growth metrics). Using convertible notes or SAFEs may be a way to avoid the financing round being viewed as a down round as neither of those instruments require landing on a valuation.
• Raising debt instead of equity. Priced equity rounds require a valuation—raising via a debt instrument doesn’t. For example, debt financing is what fintech startup Railsr did in 2022, with its CEO noting that debt capital was more “reasonably priced” compared to equity capital in the current environment. Airbnb also did something similar in April 2020. ‍
• Offering more investor-friendly terms. Investors ask for a lower valuation because they perceive the risk of investing has increased. As such, it might be possible to avoid lowering the valuation by offering different investor-friendly terms instead. This can include greater liquidation preferences, redemption rights, or other protective provisions.

Down Round Funding—A Sometimes Inescapable Reality

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.