A down round financing (or a “down round”) is a financing in which the company’s pre-money valuation is lower than the post-money valuation from its prior financing round. As a result, in a down round a company usually sells shares at an effective price per share that is lower than the price per share paid by investors in its prior financing round.
A company may conduct a down round for a variety of reasons, including:
- The fundraising environment is challenging — During times of economic turmoil or volatile world events (such as pandemics or geopolitical unrest) investors may slow down their investments or only be willing to invest in deals with investor-favorable terms. As a result, companies in need of financing for survival may have no choice but to accept lower valuations in order to incentivize reluctant investors.
- The company has underperformed or the market is fluctuating — If a company has underperformed investor expectations, the only way to obtain a financing may be for that company to accept a down round. In other cases, the company may be performing as expected, but acceptable valuations have decreased due to market or industry conditions.
- The company is pivoting (including new management) — If a company decides to change directions or undergoes a significant change in management, investors may view the company as a more risky investment, and thus the company may be forced to accept a lower valuation.
- The simplest down round structure consists of a new class of preferred stock issued at a lower price per share than the prior round, but with all other rights and preferences being the same.
- Down rounds may also be structured with the new class of preferred stock issued at the same price as the last round (often referred to as a flat price), coupled with warrants (with the exercise price of the warrants varying by deal).
- Lastly, a down round may be structured with the new class of preferred stock issued at a flat price, but with a more senior liquidation preference to all other preferred and/or special anti-dilution rights.
Many down rounds also include “pay to play” provisions, which are much less common in up round financings. For more information on pay-to-play provisions, see What Startups Need to Know About “Pay to Play” Provisions.
If a company decides that a down round financing is the only way for it to get the cash needed to survive, choosing the right structure will be very important. Down round financings present many potential corporate governance challenges and pitfalls for startups that must be carefully navigated. See 12 Questions Startups Should Consider for Bridge Financings and Down Rounds for more information on a board’s fiduciary duties and responsibilities in this context.