The Down Round

Yesterday I interacted with Mike Moyer’s class at Chicago Booth.  It was a lot of fun.  There were lots of questions, but one of the questions was on valuation.  How does anyone go about valuing a startup company?

It’s a hard question to answer because early stage valuations are mostly determined via heuristics.

Charlie O’ Donnell ran the numbers and found if you invest at seed over an $8M pre-money valuation, the expected IRR of the investment drops from roughly 40% to 20%.  That means there is a big economic incentive for seed investors to be below $8M pre-money.

Valuation is essentially a negotiation.  It’s all about supply and demand.  If there are a lot of people competing to get into the deal, the valuation goes up.  If there aren’t, it’s going to be hard to get a big valuation.  Last year, there were a lot of warnings that it was “winter” in VC land and valuations would take a hit.  For some companies, they certainly did.  For others, not so much.

The really hard question for entrepreneurs and existing investors is what to do when the company needs more cash, is showing promise, but the demand isn’t there.  It frustrates entrepreneurs for a lot of reasons beyond the money.  For investors, it pains them in the pocketbook.

Fred Wilson says, “This is so true. I have sat in and on countless meetings and phone calls with leaders who are afraid that the whole thing that they just spent three, four, five years (or more) building will come crashing down because they take a down round. I have been through dozens of down rounds in my career. At least thirty and maybe fifty if I really took the time to count them all. They are no different than a public company’s stock price taking a big hit. It is painful to be sure. Some people will leave but they are either weak in the knees or were half way out the door anyway. But I have never seen a down round destroy a company. And I have seen many down rounds save a company.”

VC’s don’t generally like to talk about down rounds because they are so painful.  The corollary is owning stock.  If you own a stock at $XX price, and now the stock is trading at .5($XX), do you buy more?  Do you hold?  Do you sell?  CB Insights has a down round tracker.  You can go read all the blood and gore there.

Behavioral economics has proven that no one likes losses and they weigh heavily on your psyche.  They also are twice as painful as the joy you feel over gains.  Recognizing this might not take away the pain, but at least mentally you will be able rationalize your internal feelings.

The next step is to determine if the strategy the company is planning to execute going forward is going to work.  The analysis on this is really not that much different than when the company first started out.  Perhaps the company is pivoting, or abandoning it’s initial strategy for something else.  Or, perhaps they are going to attack the market using a different way because the original way didn’t work as planned.  It doesn’t matter why, as an investor if you don’t have confidence that the new strategy can work, you can’t write a check.  If you don’t have confidence the current management team can execute, you can’t write a check.

The next part of it gets tricky.  Why?  Because you need to know the terms of the new financing. Cooley has a good blog post here illustrating many of the legal terms/issues.  Many times new financings will wash out a cap table and dilute the original investors to a point where they are guaranteed to lose money no matter what.  Are there any liquidation preferences, pay to play terms, or participating preferred terms that dilute your initial shares more than just a simple drop in valuation?  That lets you know where you stand.

Sometimes, the reason for the down round is totally out of both the investor and the startup’s control.  If worldwide markets are melting down like they did in 2008, the fear will permeate the funding environment.

On the other hand, all previous investments are sunk costs.  The down round should be approached like a new round of capital.  Decisions on investing should be made independent of previous investment.  VC Funds have different incentives than angel investors when it comes to these sorts of things because of terms and valuation.

  • awaldstein

    Good post.

    I assure you from the entrepreneur’s perspective, the logic you articulate will not be present through the emotion of the situation.

    Investors doing many investments and its a portfolio management system.

    For entrepreneurs it’s pretty well everything they are.

    Investors who show an understanding of this stand out.

    • I totally agree. I think that investors have a dual role. Fight for their LPs while at the same time fighting for the entrepreneurs that trust them enough to allow them the privilege of investing in their company. As long as investors treat it as a privilege, and remember that, then they will fight side by side an entrepreneur in the trenches. At the same time, it’s the responsibility of the investor to sometimes give an entrepreneur tough news that they don’t want to hear.

      • awaldstein

        Agree and I bet your investments appreciate having you on their team.

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