Valuation decline (down-round): Creative designs for obfuscation

A down-round is a funding round that occurs at a lower valuation than the previous funding round(s). For investors, such a drop in valuations is almost always disappointing, because young growth companies naturally want them to grow and their valuations to rise - and ultimately to leave the loss zone and generate the first stable profits.

A down-round is almost always a sign that targets have been missed and startup development is worse than hoped. In rare cases, I think it makes sense to invest heavily in a down-round in order to buy shares cheaply. Here it is important for me to get a clear picture in advance of whether the startup is still on the right track and whether I believe that the sustainable positive development will take place. The danger is throwing new money at your startup to salvage your previous investment. So the most important question is, is there anything left to save? In some cases, I make additional investments for strong founding teams.

I was interested in recently found ways to avoid a down-round on paper. Here's what I noticed:

  • follow-up financing of MATE.BIKE: The financing round takes place at the same valuation as the last financing round, valuation €64.1MM. However, the shares in the new round, the C shares, have strong preferential rights, specifically a "3x non-participating preference". This means that in the event of an exit or liquidation, the C-Class shareholders receive either a) first triple their investment back or b) they will proportionally a share of the proceeds if this results in them more than triple get back the investment.
  • New propeller air Convertible: This is the first convertible that catches my eye in the one Redemption Premium is agreed. The share price is capped (i.e. as a cap for the highest possible share price) at the price of the last previous round. In addition, there is the Redemption Premium for all investors: Depending on when the convertible is later converted into real shares, investors receive another 25-100% of the investment amount as shares or payment. Effectively a bonus that mathematically lowers the average share price.

From my point of view, both of the above constructs were deliberately chosen to avoid a down-round in which the share price falls, but the investors in the new round actually have a clear advantage over old investors. Ultimately, both are, in my opinion, a hidden down-round. I myself understand these constructs, just like an actual down-round with a falling share price, as a warning sign that requires careful consideration of whether further money is invested in this startup. First I would want to find out 1) what is currently going worse than planned, 2) how much worse it is going, 3) how management intends to ensure that the new money can now be used to regain its former strength and 4) whether I really believe in management trust to implement the new plan solidly.

Philip

I have been investing in startups since 2014. In recent years, my portfolio has grown to over 150 investments of various sizes. On my blog I regularly report about crowd investing and my investments.

This Post Has One Comment

  1. Florin

    Interesting article Philip, thank you. Both cases are indeed interesting ways to frame a raise as "same price but better terms".

Leave a Reply