If you're an employee at a startup with stock options, restricted stock units (RSUs), or other forms of equity, understanding what a "down round" means is crucial. It's not a topic that's often celebrated, but it's an important part of the startup ecosystem.
What is a Down Round?
In simple terms, a down round is a financing event where a startup raises money at a lower valuation than its previous funding round. This means that the price per share at which new investors buy into the company is less than what investors paid in the last round.
Think of it like this: a house was appraised at $500,000 last year, and this year, due to market conditions, its appraisal drops to $400,000. Similarly, a down round means the startup's perceived value has decreased.
Why Do Down Rounds Happen?
Several factors can contribute to a down round:
Economic Downturn: A broader economic recession or slowdown can affect investor sentiment, making them more cautious about valuations.
Missed Milestones: If the startup fails to meet key targets, such as revenue projections or user growth, its valuation might suffer.
Increased Competition: A more competitive landscape can force investors to re-evaluate the company's long-term potential.
Changes in Market Sentiment: Shifts in investor trends or the emergence of new technologies can impact the perception of a company's value.
Burn Rate: If a company is spending too much cash without generating sufficient revenue, investors may perceive it as higher risk, leading to a lower valuation.
Strategic Repositioning: Sometimes a company changes direction and needs new capital, but the new direction isn't yet reflected in value.
The Impact of a Down Round on Employee Equity
A down round can have a significant and often disheartening impact on employee equity. Here's how it plays out:
Reduced Paper Value:
Stock Options: Your stock options were granted with a specific exercise price (the price at which you can buy the shares). A down round typically leads to a lower current valuation. While your exercise price remains the same, the "paper" value of your option (current share value - exercise price) may decrease.
RSUs: RSUs are granted with a specific value based on the stock's price. If the company's value declines, the paper value of your RSUs also goes down.
Example: Let's say you have stock options with an exercise price of $5 per share. In the previous round, the company's share price was $10, giving your options a paper value of $5 per share. After a down round, the share price drops to $7. Now, your options' paper value is only $2 per share.
Potential for Underwater Options:
Stock Options: If the down round drives the share price below your exercise price, your options become "underwater." This means they have no current value because you would pay more to buy the shares than they are worth. You're not technically losing money, but your option is worth nothing for the time being.
Example: Continuing the example, if the share price drops to $4 after the down round, your options with a $5 exercise price are underwater. No one is going to pay $5 to buy a share that’s only worth $4.
When a company raises a new round of financing, it often issues new shares. These new shares can dilute the ownership of existing shareholders, including employees with equity. This means your percentage of the company's ownership is reduced. However, with the down round comes the need for the company to offer a significantly higher number of shares. This is often done through higher option grants. This could help to offset some of the dilution.
Example: Before the down round, you might have owned 0.1% of the company. After a down round with substantial dilution, you might own 0.08%.
Delayed or Reduced IPO Potential:
A down round can signal that a company is struggling, which can delay or diminish its chances of a successful IPO. This, in turn, impacts when or if your equity becomes truly liquid (convertible to cash).
Morale and Psychological Impact:
Down rounds can be demotivating for employees who have been working hard and believed in the company's growth. It can lead to questions about the company's future, causing some employees to seek other opportunities.
Key Considerations and Actions for Employees
While a down round is never ideal, here's what you should keep in mind and consider:
Understand Your Equity Package: Review the details of your stock options, RSUs, or other grants. Note your vesting schedule, exercise prices (if any), and any other relevant terms.
Communicate with Management: Don't hesitate to ask your manager or HR about the down round, its causes, and potential impact on employees. Transparency from the company can ease anxieties.
Do the Math: Understand the potential value of your options under different scenarios. Create hypothetical situations to evaluate your options.
Consider the Long-Term View: Startups can have ups and downs. Assess whether you still believe in the company's mission and team. If you do, focus on your role and the company’s recovery.
Look for Potential Refreshers: Companies in a down round may try to encourage key talent to stay by issuing new grants at more favorable prices. In some cases, the company will add a bonus of additional options in an effort to boost morale. This is not a guarantee, but ask your management for this.
Consult a Financial Advisor: If the situation is complex or you have significant equity holdings, consider seeking advice from a qualified financial professional.
Don't Panic Sell: If you have the option to sell your shares in a secondary market, it may be tempting to cut your losses. Carefully weigh your options, and don't act rashly.
Explore Secondary Market Options: In some cases, companies will set up a secondary market for their employees to get some liquidity. This is not always available, but worth exploring.
Down Rounds: A Normal Part of the Startup Journey
Down rounds are not a death knell for a startup. They can be a reset point, allowing the company to adjust its strategy, cut costs, and build a more sustainable business. Many successful startups have gone through down rounds. Navigating the world of startup equity is challenging, and down rounds can add another layer of complexity. By understanding what they are, why they happen, and how they impact your equity, you can make more informed decisions and manage your expectations. Stay informed, ask questions, and continue to evaluate your situation thoughtfully.
Important Note: This information is for general educational purposes and should not be considered financial or legal advice. Consult with qualified professionals for personalized guidance.