What is a Down Round and How Can Start-ups Avoid Them?

What is a Down Round and How Can Start-ups Avoid Them?

The most important part of any company is funding and resources. Without money, there are no opportunities for growth and expansion. This means you can’t employ new staff, diversify into different areas or increase spending budgets. These are just a few examples of what successful funding rounds can achieve for a start-up company. In your start-up journey however, there may come a time where you experience a down round. What is a down round, why are they so feared and lastly, how can you avoid one?

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Table of Contents

Understanding valuation

To understand what a down round is, first you need to learn about valuation. Start-up companies will often have funding rounds to expand their business operations. To do so, the company sells shares at a fixed price per share, which is agreed upon by the company and the investors. Usually there will be multiple funding rounds. If a company sells shares at a lower price than the last time they raised funds, then the company will be devalued – that is, the company is worth less than initially thought.

What is a down round and how are they triggered?

A down round happens when a company is devalued. To put it another way, if a start-up sells shares for less than the previous offering, then a down round has occurred. The importance in using the word ‘valuation’ is to do with the effects of a down round. Considering the company is now worth less, future investors may be weary to invest again. In fact, while not necessarily true, a down round is often an indicator of a company that is doing poorly and may not have achievable long-term business strategies in place. Investors may also begin to question whether the initial valuation was too expensive, and whether they were ‘short-changed’ in effect.

A down round or devaluation can happen for many reasons. They include when the company’s growth has slowed, market competitiveness has changed, the wider economy is performing badly, or the company was initially over-valued by investors.

How to avoid a down round

The best way to avoid a down round is to seek alternatives to external funding. If funding is urgently required, attempt to cut operating costs of the business first. This may be difficult if your company already runs on a tight budget.

Where possible, consider taking a loan from a financial institution instead of seeking funding. A loan, if repaid on time and with regular payments will have no negative effects on a company. A down round carries stigma around it and will be far more likely to harm your company’s future. See how a loan compares to other forms of funding here.

Another good way to prevent a down round is to avoid over-valuing the company at the first instance. An initial over-valuation leaves no room for improvement and growth, and if targets are not met, then a lower valuation at the next funding round is inevitable.

Bouncing back from a down round

It is important to note that a down round while heavily stigmatised, does not mean that a company is doomed to fail. Just like other forms of investment, an investor will always look to opportunities for growth. A down round is a chance to invest in a company, that with the right business strategy can excel in the future.

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