The Gestalt of Down Rounds

or … if Occam had a razor, Gestalt had a scalpel.

Clearly a topic for the very few, but if you’ve had Investment ready training, and think you know the terms down round and anti-dilution … read on. Founders need to wrap their heads around these two concepts, with surgical precision rather than bumper sticker buzz-words.

Taking anti-dilution first, it’s probably best to describe this in terms of dilution … which (in the simplest of terms) is a reduction in the percentage ownership in a business as a result of subsequent investments.

That bad, right?

Well, as expressed, that’s a question that cannot be answered.

As a founder, you may own 100% of the equity in your startup. Perhaps you started your business with £100, meaning that your business is valued at £100.

Cap Table after Registration … Founder has 100%

After a while you create a demo, and have an attractive plan, so you think the business is worth £1,000. And a seed investor thinks the same, is excited at the opportunity offered and invests £500.

Let’s look at the moving parts here.

Before the investment, your business was worth £1,000. After an investment of £500, your business is now worth £1,500 (£1,000 + £500). 

The investment of £500 bought 33% of your business (£500/£1,500) and your ownership was diluted by 33% to 67%.

Cap Table after 1st Seed Round

Bad?  No – good – in fact GREAT.

Before the investment you owned 100% of a business worth £100, or £100. 

After the investment you own 67% of a business worth £1,500, or £1,000.

Come on down!!! The box on the right has £100, the box on the left has £1,000, but it is labelled “33% diluted”. Which one would you choose?

OK, so dilution is explained. It’s not bad, it’s just a number.

Then what is anti-dilution? Hold that question, we need to delve into down round first.

In the simple example above, the valuation of your business increased from £100 to £1,000 … i.e. it when UP, and after the investment it is £1,500.

Let’s say you are looking for another investment, but, for whatever reasons (and we’ll look at these later), the investor states that – in their opinion – your business is really only worth £1,250, i.e. it went DOWN (from £1,500).

Cap Table after 2nd Seed Round

And that’s a down round, right? When the VALUATION goes down? No, it’s a down round because the SHARE PRICE went down.

Let’s take a sidestep and look at one of the many differences between public and private companies. 

When investing in a private company, the investor negotiates the company valuation (with the founder) and that determines the share price. When investing in a public company, the investor negotiates the share price (through public exchanges) and that determines the market valuation.

As long as there is a linear, 1-1 relationship between share price and valuation, then it’s OK to consider a reduction in VALUATION as a “down round” – even though the concept is irrelevant for pubic companies. But, for a private company, the correct definition is … a down round is a reduction in the share price of a business as a result of subsequent investments.

OK, some astute [or smart arse] readers are thinking … but’s that just another way of saying that the valuation went down, right? WRONG.

For that to be true, the relationship between valuation and share price must be linear and 1-1 and – for private companies – there are a number of circumstances where that is NOT THE CASE.

In general terms, any time shares are issued at less than the determined share price, the relationship between share price and valuation is non-linear.

Eh??? When does THAT happen?

Well, for starters convertible loans? For ESOP allocations? Granted founder stock?

Head hurting yet? Good.

Here’s an example …

Cap Table after ESOP Allocation

In this case the VALUATION stayed the same, but the SHARE PRICE went down.

OK, now back to anti-dilution … almost.

The essence of a down round (but PLEASE use a reduction in SHARE PRICE as the definition – it works in every case) is that a previous investors value – in £ terms – decreases. This may be because:

  1. the previous investor was a poor negotiator
  2. the current investor is a great negotiator
  3. the potential exit valuation changed or (a) market reasons or (b) company performance reasons

Enter anti-dilution terms!!! A sneaky device, designed to either protect the early investors or (the cynical view) create more ways for a VC to get more of your business.

Anti-dilution is REALLY a misnomer anyway … its not dilution that it’s compensating for, its a decline in the value of shares owned. But we have to go with that term.

I first encountered this in 1985, but I believe it was conceived twenty years earlier. It also became commonplace in 1998 and 2008 and appears to be ubiquitous today.

The concept is generally the same … in the event of a down round (specified in the investment agreement as a drop in share price), the investors who own preferred shares (usually not the founders) get compensated with addition common stock to restore the value of their initial investment. The preferred shareholders get (in their minds) “made whole” whereas the founders and other common shareholders get screwed, err. diluted.

And it is extremely unlikely that anything can be done. Anti-dilution and liquidation presences are the two mechanisms that VCs use to increase their effective shareholding.

And most founders don’t understand the implications:

  • Whereas a down round may be temporary and the following round may be a BIG up round, there are no provisions to reverse the allocation of additional shares.
  • The shareholding is not impacted (other than for ESOP or convertibles), only the value of the holding at that time … so rather than focus on CURRENT value of investment, stay focused on returns from exit.
  • [Non-Unicorn] Founders are forced to concern themselves with this illusion rather than adjust to reality of valuations that go up and down. Although an imperfect analogy, APPL market cap (i.e. the valuation of a public company) has ranged – in the the past 15 years – between $3B and $1T. Investors still buy stock, even if the price goes down, and don’t expect to be issued more if they are hold a temporary capital loss.

What can you do? Nothing at all until you get past bumper sticker understanding … and even then, perhaps nothing.

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