What Are Down Rounds and Their Impact on Financing and Accounting?

Startups and private companies often raise money by selling shares to investors, but not every funding round increases a company’s valuation. When a company raises funds at a lower price per share than in previous rounds, it is called a down round. These events can signal financial struggles or market shifts, affecting both the company and its stakeholders.

Understanding how down rounds impact ownership, investor protections, and financial reporting is important for founders, employees, and investors alike.

Factors Affecting Share Price

Investor sentiment, market conditions, and company performance influence share prices. Economic downturns, rising interest rates, or industry-specific challenges can reduce investor confidence, leading to lower valuations. For example, in 2022 and 2023, technology startups saw declining valuations as higher borrowing costs made speculative investments less attractive. When capital becomes more expensive, investors demand stronger financial performance before committing funds.

A company’s financial health also plays a significant role. Slowing revenue growth, shrinking profit margins, or high burn rates can signal risk, prompting investors to reassess a company’s worth. Publicly traded companies provide financial statements under GAAP or IFRS, offering transparency, but private companies often lack this level of disclosure, making investor confidence more sensitive to perceived weaknesses.

Competitive pressures further shape valuations. If a company’s rivals secure funding at lower valuations or introduce superior products, investors may adjust expectations. This is particularly relevant in industries like biotech or artificial intelligence, where rapid advancements can shift market dynamics. If a direct competitor raises capital at a reduced valuation, it can set a precedent that affects the entire sector.

Financing Structures

Companies raising capital during a down round must carefully structure financing to balance investor demands with long-term sustainability. The type of securities issued—whether preferred stock, convertible notes, or structured equity—determines how ownership and financial obligations evolve.

Preferred stock is commonly used in venture financing, granting investors priority in liquidation or dividend payments. When valuations decline, investors may negotiate additional rights, such as seniority over previous investors or enhanced liquidation preferences, to mitigate risk.

Convertible notes and SAFE (Simple Agreement for Future Equity) instruments can complicate financing in a declining valuation environment. These instruments initially defer valuation discussions, but a down round can lead to higher dilution when conversion occurs. A convertible note with a valuation cap of $50 million that converts in a subsequent round at a $30 million valuation results in investors receiving more shares than originally anticipated. This can significantly impact existing shareholders, particularly employees holding common stock, as their ownership percentage decreases.

Debt financing becomes an alternative when equity dilution is a concern, but it introduces repayment obligations that can strain cash flow. Venture debt, often structured with warrants or equity kickers, allows companies to access capital without immediately reducing ownership stakes. However, lenders may impose financial covenants, such as minimum revenue thresholds or cash balance requirements, which can limit operational flexibility. If a company fails to meet these terms, it may trigger penalties or accelerate repayment obligations.

Anti-Dilution Clauses

When a company issues new shares at a lower price than in previous funding rounds, existing investors can see their ownership percentages shrink. To protect against this, many venture capital agreements include anti-dilution provisions, which adjust the conversion price of preferred shares to compensate for the reduced valuation.

The two main types of anti-dilution protection are full ratchet and weighted-average adjustments. Full ratchet provisions are the most aggressive, resetting the conversion price of existing preferred shares to match the new, lower price. If an investor originally purchased preferred shares at $10 per share and the company later raises a down round at $5 per share, their shares will be adjusted as if they had been bought at the new price. While this protects investors from dilution, it significantly impacts common shareholders by increasing the total number of shares outstanding.

Weighted-average anti-dilution clauses are more common and take into account both the number of new shares issued and the price at which they are sold. This approach softens the dilution impact compared to full ratchet adjustments. The broad-based version considers all outstanding shares when calculating the new conversion price, while the narrow-based method only includes preferred shares. If a company previously issued 1 million preferred shares at $8 each and then sells 500,000 new shares at $4, a broad-based weighted-average formula would adjust the conversion price to a figure between the two. This minimizes extreme shifts in ownership distribution while still offering protection to investors.

Capitalization Table Changes

A down round reshapes a company’s capitalization table, altering ownership percentages and shifting the relative influence of shareholders. New investors often negotiate preferential terms, which can significantly impact existing stakeholders. If a company issues additional preferred shares with enhanced voting rights or liquidation preferences, early investors and common shareholders may see their influence diminish. These structural changes can lead to conflicts, particularly if prior investors feel their interests are being diluted beyond what they anticipated.

Employee equity pools are another area affected by a revised cap table. As valuations decline, stock options granted at higher strike prices may become less attractive or even worthless, a scenario commonly referred to as being “underwater.” Companies facing this situation might implement option repricing or issue additional grants to retain key talent. While these adjustments help maintain employee motivation, they also increase the fully diluted share count, further impacting ownership distribution. Balancing these adjustments is necessary to prevent excessive dilution while maintaining workforce morale.

Accounting Treatment

Down rounds create complex accounting challenges, particularly in how companies recognize changes in equity, compensation expenses, and financial disclosures. The treatment depends on whether the company follows Generally Accepted Accounting Principles (GAAP) in the U.S. or International Financial Reporting Standards (IFRS), as both frameworks require adjustments to reflect the financial impact of issuing shares at a lower valuation.

One primary concern is the recognition of a “deemed dividend” under GAAP when anti-dilution provisions adjust the conversion price of preferred stock. This occurs because the additional value granted to investors is considered a transfer of equity rather than an expense, reducing retained earnings. Companies must disclose this impact in financial statements, which can affect earnings per share (EPS) calculations.

If stock-based compensation is tied to equity valuations, a down round may require companies to reassess the fair value of stock options under ASC 718. If options become significantly diluted or underwater, modifications such as repricing or issuing new grants must be accounted for as incremental compensation expense, increasing reported costs.

IFRS follows a similar approach but places greater emphasis on fair value measurement. IFRS 2 requires companies to reassess the fair value of share-based payments when modifications occur, ensuring that any changes in employee compensation are properly reflected. IFRS 9 mandates that financial instruments, including convertible notes or preferred shares with embedded derivatives, be reassessed for potential liability classification. If a down round triggers a revaluation of these instruments, companies may need to recognize gains or losses in their income statement. Proper disclosure of these adjustments is necessary to maintain investor confidence and regulatory compliance, particularly for companies preparing for public offerings or external audits.