As we ring in the lunar new year around the world, it is the year of the “rabbit” or of the “cat” depending on your version of the zodiac calendar. In Silicon Valley, it is going to be the year of the down round.
In 2023, founders are facing a funding environment that is much different than anything they have experienced since the great financial crisis. Tech spending is down, layoffs are tracked on climate, rising interest rates, and lower valuations have led to a significant slowdown in funding. This does not seem to be going away any time soon as global economic issues continue to boil over and cause disruption.
Coming off historically outlier years where capital was plenty, when interest in technology and healthcare was at a zenith, with valuations off the charts, the markets are navigating back to historical norms. Chances are, if you have previously raised capital, and are not yet cash flow break even and fully scaled, you are faced with the need to raise capital. The cost of debt capital has become nominally very expense, and the road to a higher equity valuation is cloudier. Indeed, if you need to raise equity capital, it could be at a lower valuation than your last round, and this despite measurable progress your company has made in operating metrics because of the lower multiples applied, and to lower levels of growth.
As we discussed in a blog post from July 2022, “What Every CEO Needs to Know About Down Rounds,” these kinds of conditions can impose harsh decisions on founders, from cutting spending, layoffs, debt and ultimately down rounds. In a down round, a startup’s valuation drops below the level of previous rounds, but the company still needs further investment to move forward. This means the company will sell shares of stock to new investors at a price that is lower than its previous round(s).
In the life of every startup, there will likely be multiple rounds of capital raised, and during periods where the company’s performance and the greater market environment can be working at cross purposes. If your company needs capital, this will likely be one of the toughest environments in which to do it in the life of your company.
While this might not sound ideal, especially because a startup’s valuation is an immense source of pride for its founders and employees, down rounds are not always negative. They can be a good way for a startup that truly needs to raise additional funds critical to their survival, and to reset on firmer ground. However, as with any funding decision, there are many points to consider before entering a down round, and there are alternatives.
First, is the funding absolutely necessary? Very often, founders will look to an influx of cash to fix problems before they look at alternative options. Look at what you can do internally without turning to outside sources of investment. This might mean taking a very close look at each of the projects that your employees are working on. Are they core to your mission? Is the return on time invested near-term? Do you need these employees? Are each of them needed? Are there some cuts that could be made immediately that would help with cash flow and help you become more efficient? It might also involve examining your operations and identifying areas where you could make improvements that would save time and money. If you are in scaling mode, should you accelerate spending to achieve a higher multiple of valuation, or go for a slower but more profitable pace of growth?
This is also the time to look at expansion vs. a refocus. If your current plans include a significant expansion into new markets or products, is this the best time for you to execute those plans? Or might it be time to refocus your efforts and double down on what you already have in place? Utilizing the cash on hand to improve on your current offerings as opposed to securing additional funding to move into new areas might be the smarter play right now.
After taking a close look internally and identifying any areas of improvement, founders still might find themselves in a place where funding is still necessary. There are numerous options available, including taking on debt, but down rounds might be a more attractive option for founders as we move forward.
It is a decision that is very specific to each startup and each situation, and founders must carefully consider each of their options. But make no mistake: this is the year of the down round, and there should be no stigma attached to this, and the sooner you put it behind you, the faster you will push forward. As we said in our previous down round post, it is critical for founders to fully understand the potential implications of a down round and how to best navigate through the process to bring in the funding they need, while optimizing the downside consequences.
To end on a positive note, the year of the rabbit brings us the highest amount of dry powder in history, with both financial and strategic investors very committed to venture and growth capital, in a time where technology innovation and regenerative health have the opportunity to drive the highest alpha.