Few things make an investor wince more than a down round. The central fear is that we could be throwing good money after bad. But if we step back from the initial alarm, is a down round really an omen of death?
So what are investors really facing, and why shouldn’t they be afraid? Yenyun Fu, a founding partner at London Bridge Ventures and a recent guest on Angel Insights, is keen to stress that a down round is not necessarily a bad thing.
Sometimes the ominous, looming figure turns out to be nothing more than some twisted branches, an old sheet, and some truly unfortunate lighting. In the same way, down rounds don’t necessarily reflect the quality of a company, but rather its environment.
‘Lending Club is a very good example,’ says Yenyun. ‘Lending Club started in the mid 2000s, just before the crash. After the crash, 2008 or 2009, they had to take a down round … They needed the money to scale; it was a down economy.’
It happens to the best of us
‘When entrepreneurs are starting companies, it’s quite easy to get seed money,’ says Yenyun. ‘Every successful company has been at it for eight to ten years. In the first two to five, they’ve had to pivot or suffer some drawbacks, or even take a down round.’
Looking at recent history, albeit in the case of larger, later-stage businesses, it all starts to sound familiar. Facebook was valued at $15 billion in 2007, falling to $10 billion by 2009. Now Zuckerberg’s leviathan is worth almost $300 billion. Similarly, Veracode and Bit9 both bit the down-round bullet, and both were recently reported to be applying for IPO.
It’s not over till it’s over
Valuations tend to jitter about in the early years, especially if the founders are still finding their feet. That’s natural. And while that may mean that the value of the shares drops, that’s just on paper. Only a liquidity event, anything from IPO to liquidation, will expose the true value of shares.
‘Really very early on, it’s not that relevant,’ says Yenyun. ‘If you’re arguing between three million and five million, or if it’s eight million and ten million, it doesn’t matter. It really matters at your exit point.’
Of course, it can be painful when shares get diluted. But Lending Club’s story shows that dilution doesn’t necessitate low returns. The company went on to IPO towards the end of 2014, offering 58,000,000 shares for $15 a share and giving the eight-year-old company a valuation of $5.4 billion.
‘The investors at the time suffered a price cut in their shares, but ultimately they became very successful,’ said Yenyun.
Conclusion: What doesn’t kill you…
Let’s say the valuation has taken a hefty drop. The entrepreneurs could have cut their losses. In bad cases, down rounds squeeze the founders’ shares so tightly that giving up would be less painful. But by raising more money, entrepreneurs have the tools and the opportunity to build the business into something more robust and to learn from their mistakes.
After all, persistence is the hallmark of a good entrepreneur – especially following a blow from the humility stick.