Venture Capital Nightmares: Down Rounds And Dilution
Summary
- Startups, particularly in technology, are raising incredible amounts of money, sometimes even before they gain traction or sales.
- But what happens when things go wrong? Investors in these early-stage innovators often dread two of the most common signs of startup failure - dilution and down rounds.
- This vicious cycle is the worst-case scenario for VCs.
Source: Pixabay
This article was originally published on MarketCurrents WealthNet
Venture capital, or the pursuit of startups, is probably the trendiest sector of the investment world at the moment. Startups, particularly in technology, are raising incredible amounts of money, sometimes even before they gain traction or sales. Nevertheless, successful upstarts can still deliver tremendous performance for their early backers and faithful investors.
But what happens when things go wrong? Investors in these early-stage innovators often dread two of the most common signs of startup failure - dilution and down rounds.
A down round refers to a private company offering additional shares for sale at a lower price than had been sold for in the previous financing round. These rounds often happen when the company fails to meet certain targets or expectations. They could also be the result of a shift in investor sentiment and a lack of liquidity in the startup world.
According to the Wall Street Journal, down rounds spiked in the second quarter of 2020 as investors and startups struggled with the ongoing pandemic. The most noteworthy example of a down round was Airbnb’s $1 billion round led by Silver Lake and Sixth Street Partners in April which reduced its valuation from $31 billion to $26 billion.
This means investors, founders and employees all face a destruction in wealth from a down round. Magnifying the pain further is the impact of dilution. To raise new funds, the company must create new shares which reduces the ownership percentage of existing shareholders. In up rounds, where the valuation is increasing, this is fine. But in down rounds, investors own a smaller piece of a company that is worth less than they originally paid for. A double whammy.
“Is equity dilution something to be avoided? Sure,” says Ben Horowitz in an interview posted on a16z’s website. VC’s like a16z can avoid dilution by placing anti-dilution protection clauses in their term sheets for startups. This mitigates the risk for the investor but heightens the risk for founders and the company itself.
This vicious cycle is why down rounds and dilution are the worst-case scenarios in startup investing.
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