By Steven Lord & Marc Zablatsky
Capital is the lifeblood of any business. It’s the golden rule, the foundation upon which everything else is built. Without it, there is almost certainly no product, no employees, and no revenue. The best ideas in the world, the most compelling business plans, and the most promising discoveries will all wither in the wind without sufficient capital.
For startups, in particular, this rule is etched in stone. And for most contemporary startup founders, capital has been both cheap and available for much of their adult lives. Growth was all that mattered – scale quickly enough, and venture capital would flow your way at ever-higher valuations. This macroeconomic dynamic, in place since the global financial crisis in 2009 and only briefly interrupted by the pandemic, compensated for dilution, unsustainable burn rates, and operational inefficiencies along the way.
The tide has turned, at least for the foreseeable future. U.S. venture funding was down nearly 40% in Q4/22 (h/t CB Insights), and valuations across the board have tumbled along with the public equity markets. Access to capital is much more difficult, expensive, and time-consuming. VC-backed companies have been told to extend runways by any means necessary, and talk of 2023 being the year of the dreaded “down round” has founders panicked.
It shouldn’t. Down rounds need to be considered as a practical option for long-term viability.
A down round, i.e., raising additional capital for your startup at a valuation lower than the previous round, is a complicated, messy, emotional, and difficult process. No one, including your investors, WANTS to do a down round. For obvious reasons, founders and current investors will do everything in their power to avoid one. Extensions or flat rounds are preferred options and fairly common at the moment, as is taking on debt. Less palatable choices include shelving products, delaying launches, eliminating personnel, etc. – whatever it takes to extend the runway.
But… a down round may be the best viable strategy
Sometimes, however, those steps are neither sufficient nor very prudent. For instance, high-growth venture-backed startups are often understaffed and over-tasked to begin with; laying off half the company might be enough to hit a runway target, but it eviscerates the business in the process. Plus, squeezing too hard on headcount – which, for most startups, accounts for 60-70% of expenses and 100% of growth – almost certainly jeopardizes the company’s ability to a) hit critical milestones b) rebound quickly once the all-clear sounds, or c) pivot quickly if need be.
This is where the stigma against down rounds can become problematic. The need to finance your business through a downturn is more important than the need to keep your valuation high. Living to fight another day is what matters. The idea of selling equity at a valuation recalibrated to reflect current economic conditions should not be such a four-letter word for founders. Is it ideal? Of course not. Is it fatal? No. Would you rather have 30% of a business with two years of runway or 40% of one running on fumes?
Would you rather have 30% of a business with two years of runway or 40% of one running on fumes?
Said another way, a long runway at a lower valuation is probably preferable to a short runway at a higher one. All else being equal, a down round may be the proverbial least dirty shirt in the closet for many companies this year, and astute founders should not reject the concept out of hand. Of course, optics matter, particularly with employees who see their options are worth less, but doing a down round at a time when venture investors are universally driving very hard bargains and a recession looms is a fundamentally different (and more understandable) proposition than doing one when everything is rosy. Founders would do well to remember there is safety in numbers.
No one likes down rounds. New money on the scene will drive difficult conversations about valuation and conversion rights, and current shareholders will obviously take a hit. But when viewed unemotionally and with the company’s strategic best interests in mind, a down round may turn out to be the most attractive way to get fresh capital in the door.