What to do as an employee if your company raises a down round?

In the coming years (2023++), tech employees should be prepared for the possibility of their company raising what’s called a “down round.”

A down round is when a company raises a round of venture capital (VC) at a lower valuation than the previous round.

Here’s an example of a down round:

You work for a startup that previously raised at a $1 billion post-money valuation. This is the preferred valuation (separate from the 409A valuation). If you do not know the preferred valuation—think about the tech crunch sticker price you saw published. That is probably the preferred valuation. Now, fast forward, and the company is raising at a $750 million valuation. This “lower valuation round” is known as a “down round.” (Aside, if you raise at the same valuation as your previous valuation—that is what is known as a “flat round.”)

Compared to highs of 2020 and 2021, the market (in 2023) has slowed dramatically. You are seeing far less activity in the private markets, especially for late stage private companies. This is at least partially because public comps for tech companies have dropped considerably (i.e. the stock price of public tech companies has dropped considerably). As a result, we are seeing companies trying to hold off raising new capital because investor expectations have changed, too, and the resulting cost of capital has materially increased. In other words—it’s becoming harder to raise at large valuations and therefore companies are trying not to raise now until the market rebounds and/or their metrics materially improve.

Some, really most all, high growth startups will not be able to wait forever to raise. They may have some “runway” but inevitably they will need to find more capital to fuel their business. After all, they are trying to scale quickly and have high expenses (largely headcount and software costs).

They will eventually be forced to:

• Cut costs materially and optimize for profitability
• Shut down their business
• Raise a flat or “down round”

Many businesses will choose one of the first two options, but we will see a large percentage opt for trying to raise more money by raising a flat or down round.

Not all businesses will even be able to do that, but some will, and they will figure out how to take on capital to improve their short and long term business outcome.

As an employee—with some form of equity like stock options, grants, or common shares—here is how this down round may impact you:

We will start by saying what needs to be said: raising a flat or down round—in this market—is not the end of the world nor necessarily a terrible thing for your business. If the alternative is shutting down (which may actually be a good alternative for a variety of reasons depending on the stage and prospects of the startup), and you want to keep going, then raising a down or flat round may actually give you the fuel you need to take things to the next level.

It is a bit of an odd phenomenon that people in private markets have this picture of going up and to the right in terms of valuation until a company arbitrarily “goes public.” At which point, as a public company, there is no example in the history of financial markets where there was a company that was purely up and to the right. All public stocks deal with volatility—they move up one day and down another. This goes on for decades. So why do we expect such a different type of journey in private markets? This is probably worthy of another essay or two, so you can ignore the rhetorical question, but we do want to make it clear that having ups and downs is part of startups, and taking a step backwards in terms of valuation to hopefully propel yourself forwards does not mean that you should give up on your business.

It is also worth recognizing that founders are trying—or at least should be—trying their best to maximize the long term value of the business. How they get there may involve some ups and downs, but that is the nature of capital markets.

Rather than paying so much attention to valuation, what you should really ask yourself, as a shareholder or potential shareholder, is whether or not your business is building long term compounding value?

You should be asking this question regardless of market conditions. In the same way it may be hard to figure out this answer now, it is also hard in bull markets where there’s a lot of motion but perhaps even less progress.

Pay attention to momentum. Pay attention to network effects. Pay attention to assets that drive recurring value for customers. These are pieces that hold long term value.

If you can stay focused during this time—when most others are freaking out about the markets—you may stand out and build something truly legendary.

Pre-amble aside, here are some tactical things to think about as a down round is announced:

What this means for you:

Dilution:

You can think of your percentage ownership of your company as your total number of shares divided by the fully diluted shares outstanding (FDSO). The denominator—the FDSO—is the total number of shares (or even stock options that give you the right to purchase shares or even convertible notes that represent the right to have shares) that your company has outstanding. Whenever your company raises money, at any valuation, it means you will be diluted by some percentage.

Dilution means that your equity ownership percentage in the company decreases. You are being diluted because as a mechanism for fundraising, your company is creating new shares and selling them to investors. When your company raises money at a very high valuation, it means your dilution will be lower. When your company raises money at a lower valuation, it means your dilution will be higher. Dilution is not necessarily a bad thing—what you should really pay attention to is the value of your equity.

Valuing your equity:

‍There is no one way to value your equity, but there are a few key indicators you can look at:

• Preferred price: A lower preferred price and 409A valuation per share may mean the value of your equity and net worth will be lower than you previously estimated. As a result, it may impact your expectations around your ability to achieve your future financial goals (e.g. the size of the house you want to buy on what time horizon or capacity to pay off debt).

• 409A valuation/share: Stock options are taxed upon their bargain element, which is the difference between your strike price and the latest 409A valuation. As a result, a lower 409A valuation may reduce your taxable obligation if you were to exercise your stock options right now (compared to exercising when the 409A is higher).
• Secondary market trading: Anecdotally (not statistically significant data): most companies (in early 2023) are trading down from 50% of their peaks on the secondary market. The secondary market is far from efficient, and remember that startups are built over time, but this may give you an idea as to what you can expect for the value of your equity.

When you raise a flat or down round, it is likely that all of the above benchmarks will be impacted. And by impacted, we mean decrease.

• If the strike price of your stock options is now less than the latest preferred price, it means your options are underwater and/or out of the money. Out of the money just means that exercising them, generally speaking, would not make a whole lot of sense because they are worth less than the price you are paying for them. You would likely be better off holding onto your options until you have more value in sight. That being said, options are taxed on their bargain element (which is the difference between your strike price and the latest 409A valuation. If that difference is zero or even negative, it means you will be limiting your tax exposure, so in theory it could be a good time to exercise so long as you are very bullish on the company).

• Given the above context, you will want to make a decision about exercising your stock options (reminder that doing nothing is a decision). Here is a guide that explores that question more deeply.

• Your company may—and this does not always happen—re-issue your stock options at a lower price, perhaps at the latest 409A valuation, such that your equity can have more potential value and upside.

As mentioned, there are many financial and tax implications to consider when managing your equity. Reach out to us at Compound if we can be helpful.