The term “down round” is used to refer to a scenario where the value of a business at a time of investment is below the value of the same business during a previous period or financing round.
Normally during a down round, investors purchase equity in the business at a lower price, in comparison to previous investors. The same applies to convertible bonds. Down rounds can occur due to various reasons; however, common reasons include increased competition in the market, general economic or stock market declines, or the altered perception of investors on what they believe is the value of the business during the financing round.
During a down round, it is discovered that a business may require more capital than initially projected, and the business realizes that its value is less than it may have been during the previous funding round. Such a realization results in the sale of the business’ capital equity or shares at a lesser price per share.
Summary
Down round refers to a scenario where the value of a business at a time of investment is below the value of the same business during a previous period or financing round.
Normally during a down round, investors purchase equity in the business at a lower price, in comparison to previous investors.
Down rounds are common when the milestones set forth by the business are not met. The milestones can include the product or service development, revenue generation and profitability milestones, production output, hiring of key personnel, etc.
Understanding Down Rounds
A round is used to refer to a funding phase. Common for start-up companies, funds for the business are raised from investors via what is referred to as a series of funding phases. The image below provides an overview of the start-up financing cycle or what is also referred to as investment stages:
The growth of a business is typically accompanied by an increase in the valuation of the respective company. It allows the company an opportunity to get its stock or share prices increase in conjunction with the higher valuation. In contrast, during a down round, investors tend to value the business at a lower amount. It results in the shares and/or stocks of the business being sold at a lower price in conjunction with the decrease in the business valuation.
During fundraising, companies establish some milestones or benchmarks that are used by investors to evaluate the performance of the company and derive a value for the business. Down rounds are common when the milestones set forth by the business are not met. The milestones can include the product or service development, revenue generation and profitability milestones, production output, hiring of key personnel, etc.
Although it may be more challenging to value a start-up, investors are typically able to evaluate the performance of the business during the next round of funding, and they tend to make use of the milestones initially set forth by the business. Should a business fail to meet some of the milestones, investors in preceding rounds can make use of the drawback to lower the share prices and overall business valuation.
New entrants in a market introduce new competitors, and it can, at times, result in a down round. It may be challenging for businesses to convince investors of their value when they face steep competition. In a scenario where there is competition present in the market, investors tend to lower the value of the share prices to accommodate for the risk associated with the investments.
In other words, the lowered share price, and lowered business valuation by investors, serves as a hedging tool for them. In addition, investors tend to study certain elements of the competitors to determine the fair value of the company for upcoming funding rounds.
Furthermore, down rounds can also be attributed to investors lowering the value of a business to accommodate or account for risk management, and down rounds often mean that a business or company may need to sell a larger number of shares to meet its capital requirements. Such a scenario can result in the dilution of current shareholders, thereby lowering ownership proportions.
Finally, down rounds may result in the loss of confidence that investors, or the market at large, have in the business. The dilution of ownership, loss of confidence of investors and the market, and decreased company and employee morale resulting from a down round may make the business unattractive to a certain extent. Down rounds are usually viewed as a company’s attempt to stay afloat.
A few alternatives to down rounds are sourcing bridge or short-term financing, renegotiating terms with existing shareholders, significantly lowering the company’s current burn rate, or shutting the business down.
More Resources
CFI offers the Financial Modeling & Valuation Analyst (FMVA®) certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:
CFI is a global provider of financial modeling courses and of the FMVA Certification. CFI’s mission is to help all professionals improve their technical skills. If you are a student or looking for a career change, the CFI website has many free resources to help you jumpstart your Career in Finance. If you are seeking to improve your technical skills, check out some of our most popular courses. Below are some additional resources for you to further explore:
CFI is a global provider of financial modeling courses and of the FMVA Certification. CFI’s mission is to help all professionals improve their technical skills. If you are a student or looking for a career change, the CFI website has many free resources to help you jumpstart your Career in Finance. If you are seeking to improve your technical skills, check out some of our most popular courses. Below are some additional resources for you to further explore:
Below is a break down of subject weightings in the FMVA® financial analyst program. As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy.
A well rounded financial analyst possesses all of the above skills!
Additional Questions & Answers
CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation. CFI is on a mission to enable anyone to be a great financial analyst and have a great career path. In order to help you advance your career, CFI has compiled many resources to assist you along the path.
In order to become a great financial analyst, here are some more questions and answers for you to discover:
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