Why are VCs pushing down rounds?
The startup funding market has changed dramatically in the last year or so and looks set to remain as such for a while.
VCs, in particular, are becoming increasingly vocal about the negative landscape. This sentiment is permeating down to Angels and other smaller investors.
What this means for Founders is any fundraising, at all levels, is harder than it was before. Valuations are being challenged and unfavourable terms such as 3X liquidation preferences are becoming more common.
Most people accept that the crazy valuation days of 2020 and 2021 were not sensible. A new “Web 3 Crypto AI” startup doing $50k in revenue with no path to profitability being valued at $500m was insane. Even so, the dramatic shift is so stark that it’s worth trying to understand why. There is always a reason.
VCs have to deploy capital and the hype of the last few years meant that if VCs wanted to participate they needed to accept crazy valuations. They are now facing a number of challenges as a result which potentially jeopardises the VC business model entirely.
It would have been unheard of 18 months ago but VCs today are actively advising Founders to take down rounds now but why?
A VCs main goal is to make money. It takes money from wealthy people and pension funds (LPs) with the goal of paying them back 3X or more 10 years later and also paying the VC partners (GPs) as well. Every few years a VC raises a new fund so needs to show a track record of success. The recent events of deploying money at high valuations means people are re-looking at VC as an asset class. All but the best ones are worried.
Usually, down rounds for a VC are bad. If a deal is marked down it usually has negative consequences for a VC. Therefore, it is a significant change to see so many pushing this "take a down round" path but why?
Firstly, a down round injects money which increases runway. This extra time means the startup has more probability of success. It also prevents the VC from having to write the investment off completely.
Secondly, even in a down round, the VC is protected. If a VC owns 20% of a company and the company takes a down round now, they will probably still own 20% or more due to their anti-dilution protections. If all goes well, at this reset valuation the VC has a chance of getting a return on their money.
If a company was valued at 100m then it needs to sell for 300m or higher for the VC to achieve its return. If the valuation is reset to 50m then it may only need to get to 150m. This is a big difference.
While this is fine for the VC, it is not great for everyone. In taking this down round, all the other ordinary shareholders, early investors, Founders and employees will be absolutely obliterated in terms of dilution.
The incentive for an employee to remain and work super hard after this is much lower, to the extent that the best ones will likely leave. They may have worthless share options. Even the Founders may not think the opportunity cost of staying is worth it given their dilution. It may be better to call it a day and start again.
The VC in this scenario has protected themselves in theory but in practice may have just totally killed their chances of making any return or even getting their money back.
The only saving grace here, and the bet the VC may be placing, is that given all the negative sentiment and the layoffs occurring more broadly, it may actually be possible to hire great new people, more cheaply, in a way that was hard before.
The company may not have the founding team or original employees but perhaps others can make it work. If it does, the VC makes money and can live another day.
It will be interesting to see how all this plays out and any unintended consequences.
I believe Founders may quit companies that could have been great but it will also kill bad companies quicker than before which is a good thing. Companies that are doing well with good growth opportunities ahead may no longer look to raise capital. Growth will slow.
The very best companies and the best Founders will still get funded with reasonable terms as they always have done. It will just be very difficult for others.
Perhaps this reset is a good thing. Only time will tell. I do think the VC landscape will change and consolidate. The newer, smaller funds without a massive track record will likely lose money and struggle to raise again. Investors will either look to the more established VCs or perhaps even other asset classes. The current interest rate environment means it’s possible to get a 5% return with almost zero risk. A couple of years ago it was under 1%.
All I hope is that things settle and good Founders are still incentivised to solve problems. The world needs them.