Down Round

What is a down round?

Down Round (German: Abwertungsrunde; also called down round financing or down round funding) is a funding round in which a company issues new shares at a lower price per share than in the previous round. In a funding round, investors pay money into the company and receive newly created shares in return. With an unchanged number of shares, a lower price also means that the new pre-money valuation lies below the post-money valuation of the previous round. The pre-money valuation is the value of all shares before the new round, the post-money valuation the value immediately after a round.

A property developer who sells the last plots of a new development area at a lower price per square metre than the first sets a new benchmark for the plots already sold as well. The early buyers have paid more than their plot is worth at the most recent price.

Down rounds arise when a company has developed more slowly than planned or when valuations in the capital market as a whole have fallen. A further cause is a previous round at a price that the later key figures do not support. All parties are affected. Founders and investors from earlier rounds (existing investors) are diluted: their percentage falls, and their shares are worth less at the new price. At the same time, contractual protective rights of the existing investors are triggered, and the employee participation loses value. The consequences are governed by the participation agreement and shareholders' agreement of the earlier rounds and by the documents of the new round.

When a down round exists: the price per share

Whether a round is valued upwards or downwards is shown solely by comparing the prices per share. If the new price is above that of the previous round, it is called an up round; at the same price, a flat round; at a lower price, a down round.

Formula: Price per share = pre-money valuation ÷ number of shares before the round

The count is usually fully diluted, that is, as if promised options and conversion rights were already shares, often including the pool for employee participation.

The headline of a round can be misleading. If considerably more capital is raised in the new round, the post-money valuation can be above that of the previous round even though the price per share has fallen. Conversely, a round at an unchanged price remains formally a flat round even if structured terms move it economically close to a down round. Structured terms are additional rights of the new investors, for example increased priority in the sale proceeds.

Consequences of a down round for shareholders and employees

Anti-dilution protection

Investors from earlier rounds have often negotiated anti-dilution protection. In a down round, it entitles them to additional shares, as if they had subscribed at a lower price. In a GmbH (German limited liability company), the protected investors take further shares in the capital increase at nominal value, the euro amount on which a share is denominated, usually EUR 1. The other shareholders waive their subscription right to that extent, that is, their right to take new shares in proportion to their percentage.

With a full ratchet, the entry price is reduced completely to the new price. With the widespread weighted average (Weighted Average), it falls only proportionately, depending on how many shares are issued at the lower price.

Pay-to-play and liquidation preferences

In a down round, new investors often demand that existing investors take part pro rata. Under a pay-to-play rule, existing investors who do not follow lose their preferential rights in whole or in part. At the same time, the ranking of the liquidation preferences is renegotiated, that is, the investors' priority claims to part of the sale proceeds. What is demanded is, for example, priority of the new round over all earlier ones or a preference above the simple amount of the capital invested. Such rules only take effect at the exit, that is, on the sale of the company or an IPO. Then, however, they determine how much of the proceeds reaches the founders.

Employee participation

Virtual shares and options usually have a base price that is deducted from the later payout or paid on exercise. If it is based on the price of the previous round, it lies above the new price per share after a down round. For the employees, the promises thus lose value, and their retention effect declines. Companies respond by reducing the base prices, where the participation plan permits it, or with new allocations from an enlarged pool. Both cause additional dilution, which belongs in the negotiation of the round.

Signalling effect

In itself, a down round is not a warning signal if the key figures are developing soundly and the previous round took place in a market environment with generally higher valuations. What is decisive for the effect on employees, customers and future investors is whether the round secures the financing up to the next milestone.

Implementing a down round in a GmbH

Legally, a down round is an ordinary capital increase, that is, the issue of new shares against a contribution. It requires a notarised resolution to amend the articles of association with three quarters of the votes cast (Section 53 of the German Limited Liability Companies Act (GmbHG)) and the taking up of the new shares by the investors (Section 55 GmbHG). It takes effect on entry in the commercial register (Handelsregister). The nominal amount of the new shares is usually EUR 1; the part of the price above that flows into the capital reserve as a premium.

Contractual hurdles are added. Shareholders' agreements often contain a catalogue of consent matters under which capital increases and the admission of new investors require the consent of certain investor groups. Existing investors with a blocking minority (more than a quarter of the votes cast) or a consent right can therefore prevent a down round or make it subject to conditions. According to the prevailing view, shareholders also have a subscription right to new shares, the exclusion of which requires objective justification; in practice, the shareholders who do not take part expressly waive it.

Alternatives to a down round

• Interim round via a convertible loan: A bridge round (Bridge Round) by the existing investors, usually via a convertible loan, postpones the price question to the next round, in which the company is expected to show better key figures. The price for this is usually a discount on the price of the next round on conversion and a valuation cap. If this cap is below the price per share of the previous round, the bridge round also acts economically like a down round.
• Structured terms: The nominal price per share remains stable, but the new investors receive a higher liquidation preference, additional shares if targets are missed or a minimum return at exit. The dilution is thus not avoided but postponed to the exit and is then often higher than with an openly lower price.
• Cost reduction and debt capital: Lower ongoing expenditure or venture debt (growth loans for venture-financed companies) extend the runway, that is, the time for which the existing money lasts. The aim is to hold out until the key figures support a higher valuation. The precondition is that growth does not suffer so much that the later round becomes more difficult.

Worked example: down round with full ratchet and weighted average

Before the new round, the founders hold 70,000 and Investor A 30,000 shares. A paid EUR 100 per share in the previous round, EUR 3 million in total; the post-money valuation of the previous round was 100,000 × EUR 100 = EUR 10 million. In the new round, Investor B invests EUR 2.1 million at EUR 70 per share.

• Pre-money valuation of the new round: 100,000 × EUR 70 = EUR 7 million, that is, EUR 3 million below the post-money valuation of the previous round
• New shares for B: EUR 2.1 million / EUR 70 = 30,000; post-money valuation 130,000 × EUR 70 = EUR 9.1 million
• Without anti-dilution protection: founders 70,000 / 130,000 = 53.8%, A and B each 30,000 / 130,000 = 23.1%. Before the round, the founders held 70% and A 30%
• Full ratchet: A is treated as if the shares had been subscribed at EUR 70, EUR 3 million / EUR 70 = 42,857 shares (rounded down), so 12,857 compensation shares at nominal value
• Percentages afterwards with 142,857 shares: founders 49.0%, A 30.0%, B 21.0%
• Broad-based weighted average: adjusted price EUR 100 × (100,000 + 21,000) / (100,000 + 30,000) = about EUR 93.08. Here 21,000 are the shares that B would have received at the old price of EUR 100, and 30,000 the new shares actually issued
• A receives EUR 3 million / EUR 93.0769 (unrounded price) = 32,231 shares (rounded down), so 2,231 compensation shares; percentages with 132,231 shares: founders 52.9%, A 24.4%, B 22.7%

The full ratchet keeps A's percentage stable despite the new capital; the burden is borne by the founders and B. New investors therefore often demand that compensation shares already be included in the pre-money valuation. The same valuation is then spread across more shares, and the price per share falls further. For the founders, the clause decides on the majority here: with a full ratchet they fall below 50%; with the weighted average they keep slightly more than half. Had B invested EUR 4.2 million instead of EUR 2.1 million, the post-money valuation without compensation shares would be 160,000 × EUR 70 = EUR 11.2 million and thus above the previous round. It would still be a down round, because the price per share has fallen from EUR 100 to EUR 70.

Distinctions: down round, flat round, up round and cramdown

• Flat round and up round: rounds at the same or a higher price per share. Anti-dilution protection is generally not triggered in them.
• Cramdown: a down round with a sharply reduced price whose terms are largely dictated by the new investors. Existing shareholders who do not follow are heavily diluted.
• Recapitalisation: a comprehensive reorganisation of the capital structure, often with conversion of preferential rights or waivers by creditors. A down round can be part of it.

Common mistakes

• Headline instead of price per share. A higher post-money valuation is presented as a success even though the price per share has fallen and protective rights apply.
• Protective rights not calculated in advance. Anyone who determines the effect of anti-dilution protection and preferences only during the negotiation cannot assess offers.
• Process started too late. With a runway of a few months, there is hardly any time to examine alternatives, and the company's negotiating position dwindles.
• Structured terms underestimated. A higher preference or a guaranteed minimum return can cost more at exit than a lower price today.
• Employees forgotten. Without adjusting the participation programme, the company loses precisely the people whose commitment is meant to carry the recovery.

Frequently asked questions

Is a down round the end of a company?

No. Many companies continue their development after a down round if the new round brings sufficient capital and the key figures rise again afterwards. Financing that is too tight is generally more critical than the valuation.

Can existing investors prevent a down round?

Yes, provided they hold more than a quarter of the votes cast or a contractual consent right. In practice, their consent is often obtained with concessions, for example participation in the new round on the same terms.

Does the conversion of a convertible loan with a discount trigger anti-dilution protection?

Not automatically. Many anti-dilution provisions expressly exclude the conversion of existing instruments and issues to the employee pool. The definition in the shareholders' agreement is decisive.

Who bears the cost of anti-dilution protection?

The shareholders without protective rights, usually the founders, and, depending on the agreement, the new investors. The company itself receives only the nominal amount for the compensation shares.

The Roemer Capital view

If it becomes apparent that a round will be below the price of the previous round, Roemer Capital calculates all protective rights before the first investor conversation. These include the compensation shares under the agreed anti-dilution protection, the preferences in the exit scenario and the consequences for the participation programme. On this basis, Roemer Capital compares a lower price with structured alternatives and a bridge round.

Because the negotiating position dwindles with the runway, Roemer Capital recommends starting a round with 12 to 18 months of runway. Existing investors are involved early, since their consent is required anyway. The corporate-law implementation lies with the client's law firm.