Venture capital funding continued its slump through the end of 2022, and there aren’t any real signs things are going to pick back up for a while. That means more doom and gloom ahead for startups looking to fundraise.
Many startups that tried to avoid raising a regular round in 2022 — or turned to an alternative to hold them over — will find themselves in a tough cash position this year and will have to try to raise.
In the process of securing the funds they need, they may have to raise a down round — which consists of raising at a lower valuation than their last — or take on a deal riddled with legal terms and structure meant to provide downside protection to investors.
A lot of startup founders won’t have a choice as to which deal they’d rather take, but some will, and there are some things to keep in mind when deciding which one might be the better fit.
Multiple investors have recently taken to Twitter and news outlets to express that companies are better off taking a down round and seeing their valuation cut than adding a bunch of structure and investor preferences to a deal. Although founders only get so much choice here.
While, of course, we aren’t looking to provide any actual legal advice here, this recent focus on down rounds did get me thinking: Is that better than a structured round every time? Also, even if investors are touting down rounds, is there any downside? I asked some lawyers to get a better idea.
“It’s a hard pill to swallow if you are a CEO,” Dane Patterson, a partner at Goodwin and Proctor, said in relation to making this choice. “Taking a round with structure, multiples on the liquidation preference, some weird things with warrants, that avoids having to roll the dice on, ‘We did a down round, are all my top employees going to leave? Are we not going to be able to recruit new awesome engineers?’”
For the most part, down rounds seem to be the option that creates fewer headaches down the road for startups, at least when it comes to their investors.
Melissa Marks, a partner at Gunderson Dettmer, agreed, adding that taking a down round could prove especially helpful for some early-stage companies because they get to reset the valuation they will base future raises on while they’re still young.
“A down round has the benefit of potentially making it easier to raise in the future because of the overall capital structure of the company,” she said, especially compared to taking a structure round early, which may complicate the cap table and deter later investors.
Raising a down round also can prevent the founder dilution that would typically come with a structured round, especially one that includes liquidation preferences.
“The top-tier VCs are going to much rather have clean terms and company-favorable terms with the compromise being on valuation,” Patterson said.
But a down round isn’t going to be right for every company. For example, if a company was doing well and maybe just got a little overvalued, it could take a serious reputation hit if the startup was, say, the first in a hot category to be marked down.
Yes, even as investors work to diminish some of the stigma that surrounds raising at a lower valuation, investors aren’t the only group startups need to consider in this decision. Being the first company to raise at a lower valuation may impact a startup’s customers and employees, too.
“It can also have consequences if not managed properly,” Marks said. “Employees could lose confidence or customers might switch to a competitor.”
Raising a down round also has a direct impact on how much employee stock options are worth, which, depending on what a company’s compensation package looks like, could be a big hit to employees and have an effect on future hiring.
But there are many potential downsides to raising a structured round, too. While some potential terms aren’t terribly unfriendly, many are. A warrant that gives an investor additional equity if the startup has a good exit is a reasonable term, for example. Investor downside protections, which commonly appear in structured rounds, can expire if the company does well. Both of those are fairly friendly terms for a founder facing the death of their startup.
But there are also unfavorable terms in structured rounds, too, which tend to come into play when the market isn’t doing so hot. This list includes liquidation preferences — which could make it so one investor gets more than 1x their capital back before anyone else gets anything, which can drastically reduce a founder’s equity stake — or terms that give an investor more control on how a company exits.
“The benefits of a structured round are likely most related to outward optics,” Marks said. “They enable a company to credibly say that its valuation has not dropped, which can be important in the public eye and can be important to their employees and their customers.”
Marks added that every company should look at the proposed terms or valuation cut and run multiple exit scenarios to see how the dilution will all play out. She said the better option sometimes isn’t what the company originally thought.
While the number of companies actually able to pick how they want their rounds to go in this economy will be few, it’s important to take everything into consideration and not just rely on what VCs say to do on Twitter — especially those who may not be following their own advice.
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