Down Rounds and Valuation

There is a small company here that has just relocated to be in Silicon Valley and it has a Term Sheet from a VC who effectively underwrote its financing on the presumption that the VCs would be able to secure a co-investor here in the Valley. The VCs now want to renege on the term sheet and change the raise and pre-$. Sounds like another "vulture capital" story doesn’t it? Well perhaps ... or perhaps not.

So one of the worst things that can happen to a company and the investors, is a "down round." It's one of the main reasons VCs push back on valuations. If the company cannot create enough value on a funding round to justify a larger pre-$ on the next round, everyone is in serious trouble. The VCs hate down rounds, not because it changes their ownership (this is a common misconception among entrepreneurs)--the VCs are naturally trying to own as much of the company as they reasonably can, but there are simple and reasonable limits to this, which if they are ignored by the VCs will be corrected by the market anyway.

In a down round, what the previous round holders lose they make up for on the next round--net net, they typically end up at the same place--no big deal. But the founders, ouch! The team is usually okay because the new investors boost the ESOP to incentivize the team, taking that boost out of the founders and the previous investors. What VCs hate about down rounds is having to tell their limited partners that they effectively lost money--the value they are carrying the investment at has gone down, and this is never a fun conversation ;-(

Now from the VC side, the company has missed some required accomplishments in order to attract a co-investor, like the new version of its product, which can be sold here vs. the old one which can’t, the building of a team, and others--but as in most cases, communication and misunderstanding are largely behind the issues, and the end result is ... do the VCs stick to the original deal which will almost certainly result in a down round, or do they work with the company to restructure? The company on the other hand, does it wheel out the lawyers and try to force the original deal, or does it have conversation(s)?

Back to my recurring theme of team, team, team--once the VCs have funded, even partially, they are in the same boat as the entrepreneurs, generally they don’t propose deal changes that don’t make sense from a shareholder’s perspective. For VCs deal terms get renegotiated by teams frequently--e.g., management carve out in acquisition overtakes liquidation preference, anti-dilution, and earn out rarely finds its way back to the investors but ends up in the pockets of the team, etc….

It will be interesting to revisit this case, and the urban myths it creates over the next several months, because it could go either way. Wheeling out the lawyers rarely works, because (in my experience) the only ones that win are the lawyers and litigation makes you a poor investment risk in the future regardless of whether you are successful or not. Unfortunately, the reality of most situations is that both sides are right, and ironically wrong at the same time. If the entrepreneurs cave, are they opening the door for future renegotiation? Should they argue the case of whether they delivered or not, whether it was miscommunication or not?

At the end of the day its largely irrelevant--it is what it is, deal with it! I suspect the right solution is for everyone to compromise--for the VCs to put up more cash to give the company more runway so it can have the best possible chance of delivering the up round needed (which goes against the post money problem by making it even higher), but at the same time give the VCs a claw back provision or warrants or some other mechanism to turn a Down Round (if there is one) into a flat round, so that everyone wins. For sure, while everyone is arguing the "he said she said," the chances of the company hitting its milestones are getting smaller, and that’s in nobody’s interest!