The Down-Round Dilemma

Once a rarity, down rounds are becoming the norm among firms lucky enough to get venture capital funding. But is topping off the tanks worth the drop in valuation?

1 | 2 NEXT

Case Study

Outside the sixth-story windows of CollabNet Inc.'s offices in Brisbane, Calif., palm trees swayed almost imperceptibly and the sun glistened off San Francisco Bay. But the serene vista contrasted sharply with the intense discussion going on in the company's conference room. It was a Monday in March 2002 -- time for the regular 10 a.m. meeting. CEO Bill Portelli sat down with seven of his top executives, including founder and CTO Brian Behlendorf, who had first conceived of CollabNet's Internet-based tools for collaborative software development.

Portelli called the meeting to discuss whether or not to seek new funding through what is called a "down round" -- a stage of venture capital financing that results in a lower company valuation. For the past decade, down rounds have been considered the funding of last resort, a sign of a failing company and poor management. But times have changed.

CollabNet's position was far different from the one it had enjoyed just a few years earlier, when the company was a darling of venture capital firms. Benchmark Capital, Hewlett-Packard, and Intel Capital, among others, sunk in $38 million from the company's founding in 1999 through 2000. Then the bubble burst, sending the stock market and IT spending plummeting. To survive, Portelli ditched research projects and product lines, and laid off about a third of his 120-person staff. He refocused his remaining resources on SourceCast, a software development tool for programmers.

Demand for SourceCast grew steadily. But while the company was close to surviving on cash flow, by early 2002 it had not yet turned a profit. Portelli worried that if the economy took another dive CollabNet would meet the same grim fate as many other tech companies. But maybe, he thought, he could "provide a cushion" for CollabNet -- one made of cash. Securing a new round of financing would be difficult. Venture money had been drying up, with $21.2 billion invested in 2002, compared with $106.6 billion in 2000. Still, Portelli figured that looking for funding when the company wasn't desperate for cash might allow him to negotiate better terms than if he waited.

But he also knew that a cash infusion through a down round can have unpleasant side effects. CollabNet had finished its second round of financing in 2000, near the height of the tech boom, with an extremely inflated valuation of about $70 million. After this third round of financing, the company could end up having a valuation closer to $20 million. (Portelli would not disclose precise valuation figures. These estimates are based on interviews with a key competitor and several financial experts.)

A down round would also dilute the equity stake of previous investors. CollabNet could sell 50% of its equity to new investors for $10 million, for example. But that would mean that second-round investors -- unless they chose to reinvest -- would end up having paid $35 million for half as much equity. "In a normal world, you invest in a company and then you invest a few years later and the valuation is higher," says Portelli. "That's what people are accustomed to."

Early stage investors occasionally sue companies over what they consider to be unfair terms in a down round. In fact, Benchmark, which could see its more than 20% stake in CollabNet decrease in value by millions of dollars, filed just such a suit against a Canadian bank last year. "Lawsuits are certainly a concern in a down round," says Barry Kramer, partner at Fenwick & West, a law firm that tracks down-round financings. "There haven't been a great deal of lawsuits, but there are certainly more than in the past, because the terms are very tough."

Founder Behlendorf recalls additional concerns expressed by some of the investors, "like 'Are you guys really going to make it fly with this new money? Will you refrain from the temptation to dive into the new pool of money too much?'" Portelli adds, "There were certainly those who thought that we could get to profitability without additional funding. There were those who thought we were strong enough that we didn't need it."

Portelli and his team had to weigh their personal ambitions, too. They always had the option of shopping CollabNet as an acquisition to corporations like Borland, Sun Microsystems, or Oracle. And Portelli says he had been courted by potential buyers. Selling the company would certainly provide early stage investors with liquidity. However, this option did not sit well with founder and CTO Behlendorf, who disliked the idea of handing over his baby to corporate overseers.

1 | 2 NEXT

Try a RISK-FREE Issue of Inc. Today!

Renew | Contact Us | Current Issue

Select Services