By Paul Jones
Like much of the rest of the economy, though even more so, the high risk/reward entrepreneurship and investing sector has been on a roll these past few years. The venture industry has been raising and investing record amounts of capital; valuations have skyrocketed; and deal-terms have been ever-more founder-friendly.
Well, those days are over, at least for now. Look for 2020 to see declines in venture capital raised and invested; valuations to fall; and deal terms to pivot back towards investors. The future is here, and its looking more like 2001, or 2009, than 2019.
For entrepreneurs, the outlook is grim, at least by comparison to recent years. Ditto for venture investors, although they at least have the silver linings of declining valuations and better deal terms. Those in both camps who have lived through a down-cycle can probably dust off and update old playbooks for the new realities. For less experienced folks, and particularly entrepreneurs, now would be a good time to start thinking about successfully navigating through a venture cycle trough. Which is to say, start thinking about … down rounds.
First, a clarification. By “down round” I mean a round at a meaningfully lower price than the preceding round. So, for example, a round of $0.75/share when the last round was at, say, $1.00/share. For my purposes, the term down round does not encompass “washout” or “cram down” rounds, where the price falls much more dramatically, say from $1.00 to $0.05. While both kinds of deals can and do happen in good markets and bad, down rounds are more of a cyclical phenomenon, and in all events much more common than washouts. The two animals share some features, but down rounds are to cramdowns what, say, bobcats are to tigers.
The Lay of the Land. The starting point for thinking about down rounds is the same as thinking about up rounds: get out your prior round documents and figure out what rights your prior investors, you, and your team have on paper. Still more important, start asking yourself what the realities on the ground – of your progress, the market, and the perceived performance of you and your team are – and how those factors will impact the legal positions of the various players.
This bears emphasis: In a down round, as in any round, the legal posture of the various parties is a starting point, not an end point, for figuring out who has what leverage across the moving parts of a financing round. It is like the proverbial plan for battle: It warrants serious study, but once the contest is joined it becomes a, not the, factor in how the battle plays out.
Ordinary Course Down Rounds. Once you’ve got the lay of the land, start thinking in terms of the players: who brings what to the table, in terms of promise and baggage. The simplest down round scenario – let’s call it the Ordinary Course scenario – is a pro rata capital injection by the current investors with no changes to the business team. Nothing really changes except the investors average down their price, and the team takes a dilution hit.
In the Ordinary Course scenario, the investors have a common perspective on the deal (as they are all participating, pro rata) and the team is stable, meaning, everyone is considered to have more or less the same relative value proposition as they did at the last round. It’s a common enough down round scenario when the company gets a bit behind schedule and needs a little more runway, which together might have made for a flat round or even extension of the prior round but for the dip in the market generally. It’s a scenario we are going to see play out a lot over the next year or so.
The Ordinary Course down round is straightforward, involving as it does a united investor group (looking for lower valuation and perhaps some modest goosing of other deal terms) and a united team (focused mostly on valuation but not disinterested in the other deal terms).
What makes this scenario more often than not benign is that the investors, while interested in averaging down their price, know that they can’t go so low as to not leave enough upside for the team, and the team knows that while they don’t want to give too much on valuation, a pro rata inside round in-the-hand is, like a bird in-the-hand, worth two modestly better deals in-the-bush. Life is too short, so to speak, for either side to play too hard to get.
Next up: The mother of ‘down rounds’: The Hard Times Round
Jones is a veteran venture-backed entrepreneur and investor. He is of counsel to the law firm of Michael Best. His previous columns can be read here.