In the last two years, many startups have faced difficulties, especially when they needed more funding despite not being profitable or struggling with uncertain future prospects. In fact, the number of startups shutting down increased significantly from 467 in 2022 to 770 in 2023.
Several challenges have caused this trend, including fewer seed investments and a rise in “down rounds” (when companies raise capital at a lower valuation than before). In Q1 2024, the share of down rounds was the highest in five years at 23%. This means that companies are struggling to raise money at their previous valuations.
Startups might see down rounds as a necessary evil, but there are ways to avoid or manage these situations. For example, in Q1 2024, more seed-stage investments showed slight improvements, suggesting that there’s still hope for some startups to succeed, especially if they are confident about long-term growth.
Alternatives to Down Rounds
Cutting Costs: The simplest approach is to reduce unnecessary expenses. While this can improve a company’s financial position in the short term, it doesn’t always solve the larger problem of needing to raise more cash.
Flat Round: A “flat round” is a financing round where the company’s valuation stays the same as the previous round, so investors don’t lose much value. This helps companies raise capital without the significant risks of down rounds. It might involve incentives for current investors to keep them on board.
Bridge Financing: Companies can raise funds through loans or short-term financing (like promissory notes) to bridge the gap before they can raise more money at a better valuation in the future. This option can be less dilutive to existing investors than a down round.
SAFE Notes (Simple Agreements for Future Equity): SAFE notes are another alternative financing option. They allow startups to raise money without setting a valuation immediately. Instead, investors give money in exchange for the right to convert their investment into equity in a future financing round (typically when the company raises more money at a higher valuation). SAFE notes are simpler and faster than traditional equity financing, and they don’t require immediate valuation negotiations, which can be beneficial in down rounds where the company’s valuation is uncertain. Investors in SAFE notes are often willing to accept a future conversion at a discounted valuation or with other favorable terms (such as valuation caps), which can reduce dilution compared to a down round.
These strategies are most effective when companies and investors believe that the downturn in the company’s valuation is temporary.
How to Handle a Down Round Properly
If a down round is unavoidable, companies need to be careful about how they implement it. There are legal responsibilities to existing investors, and the company must be transparent about its situation. Directors must be informed and careful about their decisions, ensuring that they’re acting in the best interests of the company and its shareholders.
It’s also crucial to consult with legal and financial advisors to comply with fiduciary duties, market checks, and approvals that may be required by investors. In some cases, recruiting an unbiased lead investor or forming a committee of independent directors can help ensure fairness.
Recapitalization (Recap) and “Pay-to-Play” Rounds
In some situations, companies may restructure their ownership through a recapitalization. This can be an opportunity to reset valuations, payment priorities, and other terms to make the company more attractive to new investors.
A “pay-to-play” round is a type of recap where investors must continue investing in the company at a new, lower valuation to maintain their rights. This ensures that only those who believe in the company’s long-term potential are involved, while discouraging investors who might abandon the company at a loss.
While down rounds are not ideal, they can be a strategic tool for startups in tough times. Done properly, they can bring in investors who are committed to the company’s future, allowing it to recover and succeed later on. The key is to make informed decisions, consult with experts, and carefully manage both the financial and emotional aspects of the situation.
Need Expert Financial Guidance? We Can Help.
At Accavallo & Company, LLC, we specialize in helping startups and businesses navigate financial challenges, optimize tax strategies, and secure sustainable growth. Whether you’re considering alternative funding options, structuring a down round, or need financial planning guidance, our team of experienced CPAs can provide personalized solutions tailored to your needs.
Contact us today at www.aco.cpa or call our office to schedule a consultation. Let’s work together to keep your business moving forward!
