Don't Build a Zombie
5 paths to explore when you're considering a down round
We all agree that valuations in 2020 and 2021 were… let’s say overly optimistic, right?
Interest rates were near 0%, the public markets were booming, and a naturally disruptive moment like COVID all came together to make investors willing to take risky bets early. It was more important for them to land the deal in that competitive landscape than to worry about the price.
Fast forward two years though and those same startups need to raise again but in a vastly different climate with lower valuations available, despite many not yet finding product-market fit or meaningful revenue.
This week I outlined the options founders have, and put them in order of when to explore each one.
Read time: 05 minutes
5 Paths For Startups Considering a Down Round
Founders in this position have 5 options:
Try to grow
Recapitalize the company
Build a zombie
Pursue an acquisition
Give the money back
Let’s break each one down…
Try to Grow
Your first option should be to just simply find ways to grow the company. You can either:
Make no major changes → If you’re nearing product-market fit then look for ways to get leaner. Reduce expenses where you can. Focus on the high leverage things only.
Lay the team off → If you’re not near PMF then you’ll need to make drastic cuts and hard decisions while finding ways to do more with less.
Go back to first principles → Grow the “company” doesn’t necessarily mean grow your existing product. Explore pivots.
Regardless, set a time-boxed milestone for yourself that you’ll take action if you don’t hit it. For example: “We will hit $1 million ARR within the next 6 months.” Set this based on your most realistic projection.
Then, if that doesn’t happen, you know when to start considering other options including shutting down the company.
If you go this route make sure you have a clear plan and that your investors are onboard with it. Even if they’ve already written off their investment you’ll be better positioned to raise successfully for a future startup if you maintain good relationships with them.
And whatever you do, don’t just burn all the money and let the business go to 0. There’s likely no reason to go down with the ship other than your ego.
Recapitalize the Company
Chances are you won’t be able to raise at a meaningfully higher valuation than you did in the bull market. In fact you may need to take a significant down round if you want to raise money at all.
This may cause concern among existing investors. Raising a down round introduces substantial dilution for all existing investors. Quick example:
If a venture firm invested $10 million at a $100 million post-money valuation then they own 10% of your startup. They expect this to go down over time as you raise more capital, but only as the valuation increases.
But if you then later raise another $10 million from other investors at a $50 million post-money valuation, the new investors get 20% of the company and the original venture firm is diluted down to 8% of a company that’s worth half as much — meaning their $10 million investment is worth only $4 million.
All of a sudden that original firm is below their ownership target for the startup at half the valuation they invested in.
This means they see the investment they made as considerably less likely to be able to return their fund eventually and that may translate into them being less excited about your startup.
With that said, a down round can be smart for the company if there’s a clear path to growing again.