When A Down Round Isn’t So Bad (Unless you are a VC)

All of us in the startup eco-system hear about the “evil” down round or “cramdown” financings that happen.  These days, the noise level around this financing dynamic is increasing, not decreasing.

While most entrepreneurs worry about down rounds, I’d argue that many times the entrepreneurs and employees are the ones that come out ahead.  In most cases, while the valuation is reset, the VCs funding the round don’t want to injure the current employee base by wiping out their equity holdings.  So what’s the answer?

VCs will look first to wipe out other VCs that are not participating in the round and give additional options to the employees.  Secondly, the VCs may consider wiping out their own previous equity to accomplish the same effect.

What I’ve seen over the past 10 years is that most (not all) times, the employees end up with roughly the same amount of equity while non-participating VCs are completely taken out and participating VCs being partially diluted.  Of course, ex-employees are wiped out as well.

There are plenty of examples of these types of transaction and there are plenty of examples of ultimate success stories with these companies.  My personal favorite is Stratify, but my friend Lorenzo Carver wrote a blog post about two recent examples: Open Table and SpringSource.  He points out that these are among the best exits of the year.  It’s an interesting read.

Bottom line, a down round / cramdown isn’t the end of the world for either the company or its employees.  While still stressful and painful, don’t get too out of shape.  All could turn out just fine. 

  • Dave

    A cram-down is not the end of the world by any means. Employees may get new options, but typically have to vest once again so it is like signing up for a new 4 year run. It may be ok, but not without a cost. I appreciate the investors who actually have a full on down round and, if needed, a recapitalization complete with a forced conversion of non-participating preferred to common and 1,000:1 or greater stock split. It can be brutal, but is like taking your medicine. In those companies everyone knows where they stand and can move forward.

    The worst are the VC's that layer on a few rounds of financing that try to protect their valuation but just shaft the employees and make everything less transparent–multiple liquidation preferences, cumulative dividends, strange bridge loans, messing with conversinon ratios, etc.–all while creating a capital structure that is impossible for employees to understand. It is better to flush investments where an investment needs to be flushed, recapitalize and start anew. Not fun for VC's to explain to their LP's but the only way to really build a viable company, not one that hovers on the edge of the deadpool IMHO.

  • Jason, I appreciate the optimism, and totally agree that for most founders/CEOs it is much better to swallow a down-round vs. see your startup go under. However, downrounds can be pretty painful. The re-vesting issue that Dave mentions above is the most obvious one. If your VC is going to stick with their anti-dilution provisions, then that can end up being another hidden cost of a down-round (I recently posted on this on my blog: http://www.startable.com/2009/08/11/venture-capit
    However, since most VCs to try to get the "important" employees at the company back to equity ownership where they would have been if the round had been flatish, I hear your point. The thing that I think you are missing is that down-rounds is the obnoxious amount of management time + heartburn in pulling such a deal off – not to mention the crazy, crazy legal fees. When VCs are trying to wash each other out/play chicken with each other, is the management team who gets caught in the middle. This is not fun, really stressful and a huge time suck. Some day I'll probably do a blog post on "when VCs play chicken – and you and the board are the cars," since I saw that several times during my short time as a VC.
    You also might want to check out Marc MacLeod's take on how try to avoid a down-round (he's a tech CFO) http://www.startupcfo.ca/2009/08/down-round.html

    • I agree that the best idea is just to avoid one altogether.  Thanks for the thoughtful response.  I know that management team gets to play “middle man” which sucks, however I really do try to make sure they are happy at the end of the day.

      Good comment.

  • I know that management team gets to play “middle man” which sucks, however I really do try to make sure they are happy at the end of the day.

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