Small Business

"Down Round" Financing: Go Figure


By Gabor Garai The latest statistics about venture-capital investing suggest that the sharp dropoff in activity is at last easing after a three-year slide. The third quarter of this year showed the smallest decline on a year-to-year quarterly basis in both the number of deals and the amount invested since 2000, according to the PricewaterhouseCooper/Moneytree survey -- from 680 deals yielding $4.4 billion in last year's third quarter to 667 deals worth $4.2 billion this year.

What these statistics and my own observations suggest is that the survivors of the dot-com bust are finally able to bring in new rounds of financing with new investors, after a long drought during which most got by in a hand-to-mouth fashion. These survivors not only stretched their cash, but, in many cases, obtained bridge loans to tide them over the toughest times.

CHALLENGING INCENTIVE. The founders of these cash-starved companies now reaching the promised land of renewed venture-capital interest are discovering, often as not, a surprise when they go to drink from the capital pool: Their companies are being accorded significantly lower valuations than three or four years ago.

One of the unwritten rules of venture-capital financing is that each successive round of financing comes in at a higher valuation than the one immediately prior. This progression enables the early stage venture funders to show progress to their own backers and provides ever-growing incentives for the entrepreneur founders.

Traditionally, the opposite situation -- a so-called "down round" -- has been the exception, the unfortunate outcome for a company that failed to meet financial and other goals, but was deemed still promising enough to be advanced additional funds. But over the last couple of years, down-rounds have become much more common. A recent survey by VentureOne, a research firm, found that during 2002 and the first four months of 2003, 42% of respondents experienced a down-round, versus 41% completing up-rounds.

PERVERSE PLEASURE. On its face, a down-round would seem to be an unpleasant experience for both founding entrepreneurs and previous investors. Let's say a startup four years ago raised $20 million, in exchange for 25% of the outfit. This implied a total value of $80 million. Let's also assume the outfit required $4 million of bridge loans to stay alive during the intervening four years. Now, it is seeking $6 million of new cash, and venture capitalists are ready to invest.

The deal: $6 million in exchange for 25% of the company, meaning the implied valuation is $24 million. But don't forget, the company owes $4 million of bridge loans, so it will need $10 million of financing to obtain the $6 million of cash it requires. At a $24 million valuation, $10 million will cost 40%-plus of the company -- on top of the original 25% given up four years earlier. Suddenly, the founding entrepreneurs are feeling very much a minority -- and a squeezed minority at that. And the original investors can't feel too proud that the early-stage company they appraised at $80 million is now deemed to be worth a bit more than one-fourth of that.

Surprisingly, many entrepreneurs and early stage investors actually welcome the down-round. Like wanderers in the desert, they see the oasis as wondrous, even if the water is a bit sandy and the fruit tart. Entrepreneurs are typically thrilled to be raising new money, since it gives their startups new life. In bridge-loan-mode, they were likely pedaling to stay in place. Now, they can move on to the next stage of product and/or market development. Attracting talented new executives and employees becomes much easier. Plus, the appearance of new investors suggests fresh blood and new enthusiasm where the original investors might well have been showing signs of weariness.

INESCAPABLE LOGIC. The original investors gain validation that the company is still viable. Even though the new valuation is lower than they might like, at least there is a valuation that can be reported to backers of the venture capitalists. The main challenge of down rounds is ensuring that enough stock remains available to keep the management team motivated. The new investors, if they are smart, will ensure that enough stock is available so that the key people necessary to get to the next stage are adequately motivated. In some cases, this may mean more stock to new executives and little or none to the founders.

Generally speaking, everyone remaining after the down round understands that it's better to have a smaller slice of a potentially larger pie. Gabor Garai is a partner in the Boston office of the national law firm Epstein Becker & Green, specializing in the financing and growth requirements of small and midsize companies.


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