What Is a Downround: Causes, Effects, and Implications

A downround occurs in company fundraising when new capital is raised at a lower valuation per share than in a previous financing round. While often viewed negatively, a downround represents a recalibration of a company’s market worth and has implications for all involved.

Fundamentals of Funding Rounds and Valuation

Companies typically raise capital through a series of equity funding rounds to fuel their growth. These rounds progress from initial “seed” funding, often from individual angel investors, to structured “Series A,” “Series B,” and “Series C” rounds, which commonly involve venture capital firms and institutional investors. Each funding stage is designed to provide capital for specific growth milestones, with increasing scrutiny and larger investment amounts in later rounds.

A company’s valuation is determined at each funding round, distinguishing between “pre-money valuation” and “post-money valuation.” Pre-money valuation represents the company’s worth immediately before a new investment. Post-money valuation is the pre-money valuation plus the new investment amount, reflecting the company’s value after the capital injection. For instance, if a company has an $8 million pre-money valuation and raises $2 million, its post-money valuation becomes $10 million.

The per-share price for a funding round is calculated by dividing the pre-money valuation by the total number of shares outstanding before the investment, often including shares reserved for employee incentive plans. For example, if a company has a $10 million pre-money valuation and 10 million pre-money shares, the per-share price would be $1.00. A downround occurs when the per-share price of the current funding round is lower than the preceding round’s per-share price, meaning the current pre-money valuation is lower than the prior round’s post-money valuation.

Factors Leading to a Downround

Several factors can lead a company to raise capital at a lower valuation. Broader market conditions, such as economic downturns or shifts in investor sentiment, can impact valuations across various industries. A general tightening of funding conditions can decrease investor appetite for private company equity, leading to a downward adjustment in valuations.

Internal company performance issues also contribute to downrounds. Failing to meet previously set growth targets, slower-than-expected revenue generation, or an increased rate of cash expenditure (burn rate) can signal to investors that the company’s trajectory is not as initially projected. Competitive pressures or a loss of market position can also necessitate a reevaluation of the company’s prospects, leading to a lower valuation.

Investor appetite and due diligence processes play a role in determining valuation. A more cautious investment landscape might prompt investors to conduct deeper due diligence, which could uncover information that leads to a lower valuation offer.

A company’s urgent need for capital can weaken its negotiating position. If a company is running low on funds and requires immediate cash to continue operations or pursue growth initiatives, it may be compelled to accept a lower valuation to secure the necessary investment. This urgency can limit the company’s ability to negotiate more favorable terms, making a downround a necessary step for survival.

Implications for Equity and Ownership

A downround directly impacts the equity structure and ownership stakes of a company’s various stakeholders. For existing shareholders, including founders and early investors, a downround results in dilution. Since the company raises capital at a lower valuation, it must issue more shares to new investors to secure the same amount of funding, which reduces the ownership percentage and theoretical value of existing shareholders’ holdings.

Employee stock options and restricted stock units (RSUs) are also affected. When a downround occurs, the strike price of previously granted stock options might become higher than the current fair market value of the shares, rendering them “underwater.” This can impact morale and retention. Companies may consider repricing options or issuing additional grants to address this issue and maintain employee motivation.

Many preferred shareholders, particularly early investors, hold anti-dilution provisions designed to protect their investment from the negative effects of a downround. These provisions typically adjust the number of shares or the conversion price of their preferred stock, allowing them to maintain their ownership percentage or receive more common shares upon conversion. While protecting preferred shareholders, these adjustments often lead to further dilution for common shareholders, including founders and employees, who typically do not have such protections.

A downround can also influence a company’s future fundraising landscape. The market may perceive a downround as a signal that the company is underperforming or was previously overvalued. This perception can erode investor confidence and make it more challenging to attract new investors or raise subsequent funding rounds on favorable terms, potentially requiring operational improvements to regain market trust.