Avoiding the Hated Down Round

Struggling private companies are finding creative ways to raise cash without accepting a lower valuation

- Hema Parmar, with Loukia Gyftopoulou and Linly Lin

For startups that rode the tech boom to soaring valuations, few things are harder to swallow than the dreaded down round. It happens when backers throw fresh money at a fast-growing business and demand more equity than previous investors got for a similar amount of cash. The result is a decline in value-sometimes by an embarrassing amount.

It's such a badge of dishonor in Silicon Valley (not to mention alarming to employees with stock options) that private companies and investors are coming up with inventive workarounds. Private markets have few disclosure requirements, so most of the maneuvers aren't made public. "What they try to do is sort of defeat reality," Tom Slater, a Baillie Gifford fund manager whose firm buys stakes in private companies, said at a conference earlier this month. "Do you want to accept reality that your valuation has fallen by 50%? Because that's potentially quite disruptive internally."

Structuring deals with confidential perks, such as promising investors discounted shares in a potential public offering, is one way to avoid a down round, says Next Round Capital Partners founder Ken Smythe, who helps startups obtain financing. "Everyone is trying to avoid marking their company down," he says. "There are many flavors to these structured deals, but what's constant is that it's unpriced, so you're basically kicking the can down the road on the valuation."

Last year was especially tough on cash-starved startups. The amount of money invested in private companies in the first nine months of 2022 dropped 33% from the same period in 2021, according to GlobalData Plc. By the end of November, investors were getting shares of closely held companies in the secondary market at a record 50.5% median discount off the price set in the most recent funding round, says Forge Global Holdings Inc.