It almost doesn't feel right, in this funding climate, to bring up the subject of down rounds. An abundance of capital is available to startups, thanks in part to the rise of mega funding rounds of $100 million or more, fronted by Softbank's $100 billion Vision Fund and others, as well as increased activity from corporate venture funds. In the first six months of the year, 35 companies saw their valuations soar to $1 billion or more--more than double the number of unicorns minted during the same period in 2018, according to the latest MoneyTree report by CB Insights and PricewaterhouseCoopers.
What's more, down rounds, or funding rounds where companies raise money at a lower valuation than in a previous round, are at their lowest point in more than a decade, according to data from research firm PitchBook.
But here's the thing: The sky-high valuations probably won't last. If you dig into the data, it's clear that while there is more money available, it is flowing through fewer deals. And in some cases, bidding wars among VCs artificially prop up valuations. According to PitchBook's Venture Monitor report, startup valuations are starting to flatten in the later stages, which is not completely unexpected after about a decade of increases. To be sure, no one is yet ringing alarm bells--though the trend could indicate a significant shift coming in investor sentiment, the report explains. The performance of unicorn darlings like Lyft and Uber, which are both trading below their IPO valuation, could also bring about a trickle-down effect to the private market.
"We are possibly going to see some more down rounds coming down the pipe for the next 12 months," says Justin Byers, chief data officer for the Prime Unicorn Index, which tracks the share price performance of privately funded U.S. companies. "If a few more of these [unicorns] do get 'corrected' in the market, then you've got to think that private investors are going to take another look when future rounds come to them and reevaluate the valuation."
So what exactly is a company to do if and when it can't hit its metrics and must raise funding at a lower valuation?
Down rounds are uncomfortable subjects in the startup community. They signal that something went wrong--either in your planning or in your business. They don't discriminate against industries: As has been widely reported, fantasy sports startup DraftKings, consumer goods business the Honest Company, and even mobile payments firm Square have all taken a down round in recent years. They are dreaded so much that founders and investors often argue over the very definition of a down round. In some cases, they'll claim that if your overall valuation is higher than in your previous raise--even if you sold shares at a lower price this time around--then technically it was not a down round. Examples include DoorDash, which disputed a Wall Street Journal report in 2016 that said the company sold shares at a 16 percent discount in its Series C round; and SoFi, which told Inc. recently that it raised a flat round based on the company's valuation, despite the lower share price for its last funding round in May.
"From the entrepreneur standpoint, the perception of taking a down round can be very, very difficult," says Seth Beers, partner at VC firm Harbinger Ventures. As Inc. learned in the reporting of this story, even when their companies have gone on to thrive, and it's been years since their down round, most entrepreneurs are reluctant to speak about the experience publicly.
"You try to preserve the narrative," says the founder of a New York City-based tech company that went through a down round after its fast growth slowed to a halt several years ago. "You don't want to admit that you have to do it," adds the founder, who requested anonymity to speak candidly about the down round.
A big part of the problem is that for current and future customers, as well as potential investors, a startup's valuation is the easiest thing to measure and thus it dictates the perception. A more complicated story about what's happening inside a startup's business isn't very marketable. "It's much harder to talk about the per-share price, or about dilution, or about a founding CEO leaving," says the co-founder of a California-based analytics venture that went through a down round after its founding CEO left the company with a big chunk of equity. "The more complex the story, the less willing you are to talk about it because it's harder to get across.
"Future investors need reassurance that your momentum won't fade," adds the California-based founder, whose company was acquired a year after its down round.
Still, founders who refuse to let go of their valuations have found the alternatives can be much more damaging in the long term. Some companies, to avoid a down round, will accept terms with liquidation multiples that promise to double or triple investors' returns. Even with a big exit, such onerous terms could mean you run out of money before your employees see any gains from their shares.
"That's not the right way to do it," says the New York City-based founder. "The right way to do it is to just suck it up. Yeah, valuation takes a hit, and everyone gets back to work."
The founders who have survived down rounds say it's crucial in such a moment to focus on the things you can control--your mission and the fundamentals of the business. And don't forget to keep your employees in the loop on all necessary information.
How will the down round affect the company? What does it mean for current and future employees' equity? How exactly is the business going to move forward? All these questions need to be answered truthfully, the New York-based founder says. "Honesty inspires confidence in the leadership and confidence in the company's ability to execute."
Another thing to keep in mind: A down round is just a financing with terms, and in three months or in three years-time things may be different, adds the founder in New York. "We're probably valued more now than we were ever valued before. Because we're a real business generating real dollars."