VCs regaining power triggers widespread down-round phenomenon in startup ecosystem
It appears that things are not going well for startups these days. Down rounds, or a funding round in which a startup raises capital at a lower valuation than its last investment, have become more common than the venture community has seen in nearly half a decade.
The Rise of Down Rounds
According to data from Carta, down rounds nearly quadrupled in number in Q1 2023 compared to a year earlier. This is a disturbing trend for startups, as down rounds can lead to outsized dilution, unhappy investors, employees fretting over the value of their equity, and other less-than-win situations.
The Impact on Startups
Down rounds are new to many startups and were quite rare during the most recent venture boom, when so many startups were raising multiple up-rounds in the same year that it became a mini-trend. It’s not shocking to see down rounds becoming more common, but it is somewhat surprising that they accounted for nearly one-fifth of all venture investments Carta saw in the first quarter.
The State of Venture Capital
Given the sheer number of unicorns with indefensible valuations that will have to raise capital before they can even hope to go public, we wouldn’t be shocked to see down rounds taking up more of the startup fundraising pie for a few quarters. Thinking out loud, if about 40% of Series A and B rounds in Q1 were bridge events and nearly 20% were down rounds in the first quarter, the number of venture funding events that we could call "wins" for startups may be in the minority of all deals.
The Silver Lining
For investors, however, there is a silver lining: it’s now much cheaper to buy equity in companies that look poised to weather the storm and end up being worth lots of money later. Investors can enforce more favorable terms in deals, too: Carta noted that in the first quarter, investor-friendly terms like "participating preferred stock and attractive liquidation preferences" spiked sharply in frequency when compared to both Q4 2022 and recent local minimums.
The Benefits for Investors
Getting into good companies’ cap tables at even an up-round valuation is likely cheaper than it has been in years. The maxim "great companies are built in hard times" may be true, but we should add a corollary: "outstanding venture returns are built when startups are having a hard time." This means that investors can buy equity at a lower price and still make a profit if the company succeeds.
The Challenges for Startups
For startups, however, down rounds are a sign of trouble. They indicate that a company is struggling to raise capital at its previous valuation and may be facing financial difficulties. This can lead to a vicious cycle of decreasing valuations, decreased investor confidence, and ultimately, the death of the startup.
The Future of Venture Capital
Given the current trends, it’s likely that down rounds will continue to be a common occurrence in the venture capital space. However, this may also present opportunities for investors who are willing to take on more risk and buy equity at lower prices. As always, the future of venture capital is uncertain, but one thing is clear: startups need to adapt quickly to changing market conditions if they want to survive.
The Conclusion
In conclusion, down rounds are becoming more common for startups, and this trend is likely to continue in the coming quarters. While there may be some benefits for investors, such as cheaper equity prices and more favorable terms, startups face significant challenges in navigating these difficult market conditions. As always, the future of venture capital is uncertain, but one thing is clear: only the strongest and most adaptable companies will survive.
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