Dear SaaStr: Why Is a “Downround” So Bad?

Down-rounds shouldn’t be such a big deal — if the private stock markets worked more like the public ones.

Public stock prices go up and down, after all.

It wouldn’t be the end of the world if private ones did, too. At least, in theory.

The real problem is how venture capital works in practice — the nichey, quirky way private financings and investing works:

  • VC investment is high-ish risk and you need to know when to just walk away.  A lower price doesn’t make a bad deal into a good one. VC-backed start-ups generally require additional capital infusions (unlike most public companies) with only a relatively small number of players out there that can provide those infusions. There aren’t that many VC firms, not really, and it’s all a bit of a confidence game until the start-up is so big it doesn’t need VC capital anymore.
  • When a start-up is hot, it’s insanely easy to raise more money. But when you’re not — it’s extremely, extremely hard.  Only a handful of investments really make VCs big money.  Often, only 1 or 2 per fund.  So when you can see it’s not going to be one of those 1 or 2, even a price change doesn’t help make the deal more attractive.
  • VCs also have to decide when to walk away from their investments — which is tough not just financially, but also in terms of partnership dynamics. The more money in you are, the harder it is to walk away. When you sell GOOG, you just get some % of your money back. When you walk away from a venture investment, you often lose it all.

Then there’s the job. What is a VC supposed to be doing? There’s a basic assumption that the better companies in the portfolio will at least double in paper value every 18-24 months, sometimes faster.

So a downround:

  • Creates large internal stress at a VC firm when you have to go ask your partners for another check at a lower price than last time. It makes you look dumb, or at least, like your were dumb this time. This isn’t the way it should go. Sometimes it does go this way. But it shouldn’t. The best companies don’t really go through down rounds, not usually.
  • Creates even more internal stress when that “down round” check approaches, or exceeds, the maximum targeted reserves for that investment, i.e., the total modelled allocation for that investment.  Or goes past that amount.
  • By contrast, an “up round” is the easiest thing in the world to write a second check into. No one challenges you, or really, seriously discusses it. Even if there’s no practical justification for the increase in price. Even if it’s like 2x what you just paid 90 days ago.

A downround then doesn’t just show a normal fluctuation in value like it might at Zoom or HubSpot or Salesforce, but it strongly suggests no one else, no other investor, believes the check you wrote the last time was “correct”.

Even best case, it makes you look like a bit of a poor picker. Pick poorly too many times as a VC — and you’re out of a job.

Having said all that, times are different right now.  Growth investors are OK doing downrounds if they company has still done well, just raise its last round at a crazy price.  That is different from prior times.  So when you do raise another round, if you raised at a crazy valuation — just make sure you tell new potential investors upfront you are OK with a market price.

downround image from here

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