The Valuation Trap – Part 3, Downround (by Ondrej Fryc)

Reflex CapitalBlogThe Valuation Trap – Part 3, Downround (by Ondrej Fryc)

5. 2. 2019

Imagine: You have a really good company, an investor agrees to invest $5m at a wow valuation of $25m pre-money ($30m post-money) and everyone is happy. Happy … until it turns out that things are more complicated, that more money will be needed, and that no-one is now available to invest at $30m+ valuation. Yet you only need an additional $1m!

From your point of view, not such a big deal. Your stake is now 83.3% and the investor’s 16.7%. So, the hell with it, you raise at $20m, nobody dies… But it sucks. What looks like a no-brainer for you, that with such a small investment, dilution of shares is not so drastic and so let’s do it, has huge consequences. The situation described above is called a “downround,” and here’s what’s wrong with it:

The smallest problem is psychology, disturbing the valuation story. In the future, when you raise more money or sell your business, everyone will want to see the cap table, who owns what, who, when, and for how much people invested. Everyone wants to see an uncomplicated curve up. And sure we want the buyer in the mood to imagine how much higher the curve will be in a few years of his ownership. But instead of dreaming high, he would be now focusing on problems: “hey, what happened two years ago? Can not it happen again?”. It may hit the spell-binding moment hard.

Another issue is that the $1m will probably cost you much more than you imagined. Your first investor may have had some sort of “anti-dilution protection” in his legal documents. There are basically two types, weighted average, and the dreaded full ratchet. With that, the original investor will get additional preference shares issued as if he originally invested at $21m post-money valuation, i.e. his shareholding goes up from 16.7% to 23.8% … and you just lost 4.8% for the new investor + 7.1% for the previous one, so you sacrificed 11.9% of your company for $1m. By the way, it is the same as if you were raising at not $20m, but at $7.4m pre-money valuation (!).

Another reason why all investors hate downrounds and sometimes even block it with their veto-rights is their own accounting. If the investor does not enjoy a super anti dilution provision, the downround means a huge blow to his own profit and loss statement. In most cases, the investor would account its portfolio on so called “mark to market” value, so typically with startups, on valuations priced by a third party in arm’s length transaction. So, in our example above, you raise $1m, and it will create a whopping $1.5m loss for your previous investor (!). And some investors, as we already know, are somewhat corporate mannered and now it’s not the right time to report a loss …

And then the most important thing:

Nobody likes downrounds. Not even a new investor.

Okay, your company is still great, but not that great to support the higher valuation. You start fundraising and go on a roadshow. But now it’s very different from the last time, when you talked about the bright future, all the fabulous metrics, the potential etc. Now everyone is focused on problems. You will be defensive all the time. You will talk about what is wrong, why, what the original investor says about it, if it can happen again… everything wrong! Spirit is lost. Yet your company is still awesome! But no-one cares. You have a downround. You may think you offer a great deal for the new investor, that you offer a discounted valuation… but in reality, you present a problem. In such an atmosphere it is almost impossible to excite someone.

Not so long ago I met a company that was exactly in this position. Super product, people, industry, all good … to the point that their original investor a bit overshoot the valuation at the beginning and set the bar too high. It ended so we did not even give them a term sheet. Because giving a termsheet should always be an exciting moment, and you just simply cannot submit an exciting downround termsheet.

Investors do not want to buy companies that are not doing well. Investors want to be on the hockey stick curve. And no valuation discount will solve it.

To summarise: If you excite the first investor too much with your great projection and he gives you too high of a valuation, it’s a short-sighted victory. In the long run, you made a mistake, which can even be fatal.

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