The Down Rounds are Coming

There is a serious funding crunch in the early stage start-up ecosystem. Therefore, founders should get prepared to deal with the prospect of a raising a flat round or in many cases, a down round. The reasons behind the funding crunch are clear but there is also a fair bit of profligacy in the valuations made by first-time founders’ in their PowerPoint business plans. I often notice that with start-ups that need a down round, the founder and/or funder has made an error in judgement of one or more of the following-

  • the size of the target market
  • the time and/or cost it would take to get a significant portion of the SOM
  • the time it would take to achieve positive unit economics
  • the costs it would take to achieve product-market fit

There are three things that a founder can do when facing a down-round situation (in order of increasing difficulty)

  1. Give the previous round’s investors more shares to preserve their percentage shareholding in the company i.e. invoking the anti-dilution clause
  2. Convince the investors to take a haircut on the paper value of their investments
  3. Extinguish all the stock of the investors that are not investing in the round including the shares held by founders, employees that are no longer involved in the business. Start the cap table afresh with a new round of funding i.e. recapping the cap table
  4. Shut down the business 

Being involved in a down-round is not the end of the world. I have been an investor in each of the situations above and have seen start-ups turn around after the painful experience. However, it takes a lot of courage & care for a founder to convey this painful reality to their investors and I pay close attention to the empathy with which they deliver the news in a such this situation. If their attitude is indifferent, it gets my alarm bells ringing but if the founder/founders are genuine and can clearly display how they went wrong and why things will be different next time, I’ll agree to do the down round, and invest more capital.

4/2019

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