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As a startup trying to grow by raising new rounds of financing from investors, it is important to show investors that the company has strong growth potential and continued momentum. A down round financing can be a gloomy proposition for a startup. A down round financing refers to a financing in which a company sells shares of its capital stock at a lower price per share than in a previous round.

Subsequent financing rounds are typically up-rounds, in which the pre-money valuation of a subsequent round is higher than the post-money valuation of a prior financing round. There is also the concept of a flat round, in which a startup raises financing at the same valuation as their previous financing round.

Down round financings are relatively uncommon, but can have a severe impact on a startup’s future prospects. It can be a negative signal to existing and potential investors. Down rounds can also lower employee morale and cause a loss of confidence in the founders and management.

Startups should attempt to avoid down rounds to the extent possible. A combination of proper planning and being strategic in the timing of raising new funds from investors can help avert a down round.

Mechanics of Down Round Financings

Each time a company engages investors to raise new financing, it agrees to a pre-money valuation and a post-money valuation with its investors. In a typical financing round, in which the valuation increases in the next round, both the founders and old investors experience some dilution of their ownership stake. However, the new capital infusion and higher company valuation more than compensate for this dilution. In a down round, a company must make adjustments to prevent dilution.

Anti-Dilution Protection

Investors in venture capital financing rounds typically receive preferred shares. This is because startups are inherently risky. Preferred stock comes with certain special rights and protections. One such feature of preferred stock is anti-dilution protection.

One of the main consequences of a down round is the triggering of anti-dilution protection. In the event of a down round, the preferred stock may be adjusted to increase the conversion ratio into common stock. For instance, if the preferred stock could originally convert into one share of common stock, upon triggering of the anti-dilution provision it may be adjusted to be convertible into 1.2 shares of common stock. This results in an increase in the “liquidation preference” of the preferred stock.

Anti-dilution protection works by increasing the preferred stockholders’ percentage interest in the company in a down round scenario. The mechanism results in the issuance of additional shares of common stock. However, the number of shares of preferred stock remains the same. As a result, the venture capital and other early-stage investors holding preferred stock will be entitled to receive a larger percentage of proceeds of the startup later on due to the increase in the liquidation preference.

Two Types of Anti-Dilution Protection

There are two main types of anti-dilution protection: full ratchet and broad-based weighted average anti-dilution protection. The latter is significantly more common. Both types of anti-dilution provisions protect existing investors holding preferred stock, but involve different adjustments to the conversion ratio.

Full-ratchet anti-dilution protection is more investor-friendly. However, it can be potentially dangerous to the startup. It gives investors holding preferred stock the right to convert their preferred stock into a number of shares of common stock equal to the total amount invested in preferred stock divided by the price per share of the current financing round.

Under a full-ratchet anti-dilution mechanism, early investors do not face dilution in subsequent financing rounds. Preferred stockholders can take advantage of the lower price per share in the current round. This action ensures against diminishment of their ownership. However, the founders must compensate the preferred stockholders by reducing the conversion price of their shares. These adjustments can result in startup founders finding their ownership stake rapidly diminished.

Broad-based weighted average anti-dilution protection is more commonly seen, and is arguably a fairer approach. While this form of anti-dilution protection also results in shares of preferred stock being convertible into additional shares of common stock, the adjustment is smaller and does not diminish the founders’ ownership stake as significantly.

Under the broad-based weighted average anti-dilution mechanism, the company adjusts the value of the preferred stock to a new weighted average price. The calculation takes into consideration all equity previously issued and currently being issued. The formula also takes into account convertible securities such as options and warrants.

Effects of Down Round on Employee Morale

Beyond the financial impact on outside investors, a down round can cause employees to lose confidence in the management team. Employees usually hold options on common stock. If the startup’s valuation declines, those options may be worth substantially less.

This has implications for the retention of valuable talent. The founding team and key employees are amongst the most important assets for an early-stage startup. Losing key employees can be disruptive and send negative signals to other employees.

Flat Rounds

One example of a flat round is Buzzfeed’s 2016 Series G financing round. Buzzfeed, the internet media and entertainment company, authorized a $200 million flat round in 2016. The $45.04 share price was identical to the share price in its previous Series F round in 2015. This caused worries within the company, and Buzzfeed took action to improve their performance and avoid a down round.