The Damaging Psychology of Down Rounds

Posted on May 5, 2013 | 35 comments


Yesterday I wrote a post about “proprietary dealflow for VCs.”

In the article I discussed the downside of raising capital at a too high of a price and referred people to a previous article I had written encouraging founders to raise “At the Top end of Normal” as opposed to stratospheric prices.

In the comments section Siqi Chen wrote a great question

“Whenever I hear advice about pricing a round too high for the next round, I can’t help but think: well, if the choice (ceteris paribus) is between

a) doing what is effectively a down round preemptively when I don’t have to, by underpricing my current round in this market vs

b) accepting the market price along with some risk of taking a down round in the future, if I don’t hit my milestones, why would I ever choose b)?”

Since it is a great question with a subjective answer I wanted to broaden the reach of my answer beyond the comments section. I would love it if other people would weigh in on the comments section below if you’ve had experiences with down rounds.

The Damaging Psychology of Down Rounds

There is an important psychology that exists in investments. I don’t make the rules so don’t shoot the messenger. But psychology DOES play a big role in investment decisions. Even when investors themselves might not realize it is at play.

The rule is, “Always be over-subscribed.”

What does that mean?

It’s far better to be raising $1.5 million and get $2 million in interest (or perceived interest) than to be raising $1.5 million and only manage to get $750,000.

“What’s wrong with them that they couldn’t raise their money?”

Damaging psychology. People want what they can’t have. They want what they must work to get. So if you’re not a sought-after commodity investors may avoid you.

I know it shouldn’t be like this. They should either believe in you and your business or not, but I promise you I’ve seen this type of behavior repeatedly over the past 15 years.

And what’s worse than being under-subscribed?

A down round. That’s why.

But why?

Well, a down round is even more complicated than having no demand for your investment round.

First, a down round sends a signal that something is wrong with your company. Something didn’t go to plan. And no amount of explanations, “we raised in a frothy market. We know that. You’re getting a great deal when we’ve made huge progress.” or whatever simply won’t erase the “something is wrong” psychology.

But here’s the kicker.

As has been pointed out by Dan Primack based on FLAG Capital data, there are fewer than 100 “real and active” tech VCs in the country. If we count seed funds and large angels maybe that number goes up by 2x?

Point is – it’s a small industry. Everybody knows everybody. And we think of it like a Prisoner’s Dilemma played in multiple games. Whatever I do now it going to affect my future deals.

Often that is a good incentive because it keeps VCs from screwing people over since a bad reputation or bad working relationships could cost you deals in the future.

But in this case it works against the founders. Many VCs would prefer to avoid having to cram down other VCs by investing at a lower price or even if it’s not a cram down they prefer not to invest in a down round that forces the VC to take a “write down” on their valuation sheets they should their LPs.

And most VCs are over-whelmed with deals. So given the choice of pissing off your VCs (and you) they simply give you a polite response and move on to the next deal (with less hair on it).

What can you do if you’re already in this situation?

I’ve written about this before. I always tell entrepreneurs, “Clean Your Own Shit Up First.” (before fund raising). It’s the one post where my wife actually complained I went too far in trying to come up with an authentic image to represent the post.

So what do others think? Have you been involved in companies with a down round? Has it been easier / harder than I describe?

Do you think there’s a case for not raising at too high of a crazy price either for psychology reasons or for restructuring reasons?

Love to debate in the comments.

Image courtesy of Daniel Moyle on Flickr.

  • http://jackdempsey.me Jack Dempsey

    “Do you think there’s a case for not raising at too high of a crazy price either for psychology reasons…”

    Given that valuations are a complicated mixture of 2 parts data, 2 parts gut, and X parts whatever the founders can earn via charm, reputation, etc…doesn’t it make more sense to be confident but humble, and go strongly at just inside the line of where people would want to go, rather than shooting far past it?

    It’s human nature to say “ok you know what, we’ll agree to X, but damned if that’s not greedy and you know it and you’re over-leveraging yourself here and frankly, I can’t help but remember this fact in the future.”

    Instead, wouldn’t it make more sense to say earn a “you know, you probably could have pushed for a little bit more, but I could tell you wanted everyone to feel great about the deal, it’s already a strong valuation, and I will remember the positive nature of optimizing for all rather than pushing past the point of what you really think it’s worth.”

    I hear numbers thrown around at times and my immediate thought is “no WAY the founders think they’re actually worth it, they’re just pulling that out of their ass”…that’s got to engender some (even subconscious) bad vibes?

    I often tell people when asking about freelancing rates to charge strongly, but charge what you’re worth. People can tell when they’re being squeezed and no one likes it, and often it’s a short term optimization that sacrifices real long term value.

  • Eli Colner

    Isn’t that same incentive to not “look bad to LPs in a prison style system” the same thing that will prop up your next round so that your VCs come up with creative solutions for the CEO as well as themselves (think 4square)?

  • http://www.hypedsound.com/ jonathanjaeger

    I don’t have any first-hand experience with this kind of thing, but my own opinion from all the stories and interviews I’ve heard: There are tons of companies who later become big hits that struggled to raise a round (perhaps because their idea was ahead of its time or no one “got it” until it gained traction). If I were a VC, there might be signaling problems with a company that tries to raise $1.5 million but can only raise $750K. But it’s still early on.

    I find the damaging psychology of downrounds is way worse when a company has already been in the market and can’t hit profitability and suddenly the press and VCs turn against them. They lost their momentum and their hype. Raising their Series A+ or Series B suddenly becomes a nightmare. I would much rather be in that seed stage or early A round zone still trying to prove a company’s worth than be a company that’s lost favor with its employees and the public at large.

  • http://bothsidesofthetable.com msuster

    I think the FourSquare financing is an outlier. AH & USV very supportive and believe in the long-term. Both hugely successful funds willing to take a bit of a creative risk. But this seems the exception not the rule.

  • http://bothsidesofthetable.com msuster

    “go strongly at just inside the line of where people would want to go, rather than shooting far past it?”

    Yes. Exactly what I referred to in raising “at the top end of normal”

  • http://www.mentortechventures.com Brett Topche

    I think what the commenter you referenced is missing is that sometimes markets get so out of control (or you find unsophisticated investors, even in a normal market) that you can get a valuation you can’t later justify even if you do hit your milestones. I’ve seen it happen and it’s ugly, especially because the investors who paid the high price are even less willing to accept a down round given that the milestones were reached.

  • http://bothsider.com/ Mark Gavagan

    Valuation is just one data point in a transaction with many important ones.

    Rather than the absolute maximum valuation, it’s definitely (IMHO) worth getting great quality investors who have exactly the experience and relationships you need, and perhaps also worth getting better terms on everything beyond valuation.

  • http://www.tatango.com Derek Johnson

    We thought we would have to do a down round a couple years ago, all because our first Angel round was valued way too high, and we didn’t grow into the valuation quick enough to outpace our burn. I feel the problem is that investors and entrepreneurs are raising based on their perceived value in 2-3 years, not what their value is now (I did this the first time). By raising like this, especially with Angel size investments, you’re just increasing the chance of a down round, which as you put it above is a downer for everyone involved.

    We didn’t have to raise the capital as we were able to lower our burn and all of the employees started doing side consulting gigs during that time to keep the burn low. We pulled through and I’m glad that we didn’t do that down round.

  • jlemkin

    Mark – maybe I can suggest a follow-on post. Maybe a lot of down rounds happen … I don’t see that many. Instead, what I see in Super High Valuations is … Shoot the Founders when Things Don’t Go Perfectly thereafter. Raise money at too high a valuation and miss your crazy plan … it’s the fastest ticket to bringing in the Guy Hanging Out at your lead VC Firm as Operating Partner / CEO-in-Residence / etc. as the new CEO. Then, if he needs a few more bucks, there’s a flat add-on round one way or another.

    I think Losing Control is the real #1 issue from an excessively high valuation.

  • https://www.pegu.me/ Trip Tate

    Mark, do you think there’s a stronger argument for managing your valuation in that there’s a direct (negative) correlation between the quality of investors joining the round and how far above “reasonable” they’re willing to go? As in, find the right people and find terms that work for both sides

    The “if you raise too high you might be facing a down round in the future” risk feels to me a bit hard to predict (how high is too high…you’d certainly know better than the entrepreneur who only gets to read about the big rounds in the press) and one of many, many risks you face as an entrepreneur when compared to the clear and present decision of choosing a quality partner to work with to build the business.

    I guess the point is the same either way, though.

  • Guest

    Hi Mark

  • https://bubbleideas.com/story Arvind Nigam

    Hi Mark, should an entrepreneur reveal a roadmap that says that their current round (could be series-A or even seed) is going to be the last lump they’re gonna pick up as outside investment? It could be that the startup knows how to make money, and wants to do just that. In such a case is down-round i.e. a certain degree of flexibility okay or it’d be a more complicated context for the incoming investor?

  • Michael Blend

    While I agree that a down round is a big negative, I think trying to manage your current valuation to try to avoid a future down round is a bad idea and overthinking the process. Startups take on a momentum of their own, both on the way up and on the way down. If you have positive momentum, you are almost certain to see up rounds. Conversely, on the way down you are going to have pain no matter how well you managed your previous round’s valuation. I would say that the amount you raise, rather than the valuation you raise it at, is a much more important thing to focus on.

  • http://twitter.com/klistwan Konrad Listwan

    Mark, you mention that it’s better to do be oversubscribed than to be under subscribed. At what point, is too much oversubscription a bad thing?

  • http://www.crunchbase.com/company/vumedi Roman Giverts

    I wonder if someone can comment on “down-acquisitions”. I’m thinking examples like:

    - slide – raised big round at 500m valuation acquired for ~180m
    - ning – raised big round at 500m valuation acquired for ~150m
    - meebo – raised 70M total, acquired for 100M

    It seems like any time a company is sold for that much money everyone SHOULD make a ton. But if there are liquidation preferences on those final large rounds, could it be that very few people actually made out well?

    Perhaps this is another argument against very large valuations. Large valuations require you to raise a lot of money because investors require certain % ownership. If you have liquidation preferences on all that money, it could severely impact what’s left over for the founders in the event of a “down-acquisition,” even a very large one.

    Are liquidation preferences more or less common with stratospheric valuation rounds? I would think more. Any thoughts?

  • http://www.facebook.com/yangeldotco Terrence Yang

    The whole downround problem is much more a reflection of a barrage of bad advisers and lemming-like investors, not founders. These not-so-competent “advisers” told founders to raise at the highest valuations in 2011 and 2012 and many investors just went along with it. Now the Series A crunch is biting about 90%+ of these founders in the derriere. And the advisers and investors whom the founders trusted one or two years ago are not helping. They’re not investing. They’re not fundraising. And they’re not helping the startups successfully figure out product-market fit or become truly cash flow positive. The other issue is that in the bizzarro world of startup-land, a good startup that is trading cheap is seen as a failure. This contrasts with the public markets, where if a publicly traded stock of a good company trades cheap, the Warren Buffetts of the world buy. Who are the Warren Buffetts in startup-land?

  • Eli Colner

    Oversubscription is a problem when you’re trying to fit people into a round. It just means stop shopping the round and close that thing down to get back to building. You’re going to want to be fair to your early commitments, and at the end of the day turn investors away and promise to keep in touch for future rounds, but there’s really no downside. Stay organized and keep your word to the dot.

  • laurayecies

    The psychology of down rounds is tough but generally speaking it is a paper loss and in the long term won’t matter if the team builds a great business. Look at Equalogic. I also think the psychology is affected by what else is going on in the market – e.g. 2009 more downrounds.

  • thatmtnman

    In my view this is an easy question to answer. Money in the bank trumps all. Who knows what the economy will be like when it comes time to raise again? I reduce everyone’s risk in all scenario’s save one. I’m raising, my deal is hot, and I’m not going to temper VC’s enthusiasm for the hard work, sacrifice, innovation and opportunity we’ve created. The answer to the question of the down round risk, is to over perform, to exceed expectations and to make the lucky VC’s who got to work with us look like and actually be ‘hero’s’ inside their organizations.

    At the end of the day, over pricing is ‘risk mitigation’.

  • http://www.vcexperts.com/ Michael Ostendorff

    Just look at Good Technology (https://vcexperts.com/vat/good-technology-inc#/vat/companies/7671/investment_history). This company has been around since `96, but has had multiple down-rounds. Just last week, round priced at $4.11/share while the October 2012 round priced at $4.84/share. Last week’s round was Participating Preferred while previous rounds were Conventional.

  • Rob

    I would add that not only will some VCs pass because they do not want to force a down round, some will not even look knowing that the last round was done at a very high level and therefore believe that they have already been priced out. It is really hard to raise at any price when VCs will not even look – right or wrong.

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  • Aaron Choi

    just wanted a clarification. when is a round classified as a down round (technically vs reality)?

    now i know that obviously if a new round is priced at a lower amount than the previous round, it is a down round.

    But what if it is a flat round? I’d believe that’s basically a down round since a startup is expected to grow, and it clearly hasn’t.

    And even if a round grows from one to the next, but not by much, it could be considered a down round if an investor’s total share value doesn’t grow because of dilution?

    And then a step further, if a company is expected to grow at a faster rate than it has and is priced at a lower valuation than expected, but still higher than the previous round?

    I see this as a massive exercise in managing expectations.

  • Ralph Mack

    Mark. From my experience, I always focus on pricing angel rounds at the right valuation to not only avoid a down round but to adequately compensate the early investors who are taking all the risk.

    The complicating factors in pricing seem to be the make-up of the investors, the area of the country where the capital is being raised, and the experience of the entrepreneurs. I have been in situations where an entrepreneur raises money from investors who may be very experienced in operating companies and would be great advisers but have no clue about valuation. My position in those cases is to pass and explain to the entrepreneur that 50% of the SUCCESSFUL companies exit at $20mm or less, 70% exit at $50mm or less, and 90% exit at $100mm or less. (Those numbers I believe are approximately correct). As such, pricing an angel round between $8 and $12mm doesn’t give investors good odds of reaping adequate returns. The exception I Might make is if in the initial round $2-3mm is raised and the company is given a long lead time to develop its product and gain market traction. Secondly, perhaps I don’t see enough deals but it seems to me that West Coast investors are more willing to invest at higher valuations. I like to refer to it as the Y Combinator Effect. As far as I can tell, there shouldn’t be much better results in Silicon Valley than, NY, Austin, or LA. The data would likely show that Silicon Valley has had many more billion dollar enterprises created and some may justify higher valuations for that reason but the data would also likely show that there are just as many failures. Finally, one could argue that serial entrepreneurs also have a tendency to shoot for high valuations. Participating in such a deal could also be risky as their is no guarantee they will be successful again and even if they are more likely to be successful, the time frame for success could take longer than expected. I like to invest with serial entrepreneurs but I also like to believe that I was very helpful in their past success if I invested with them or that I will be instrumental in their next company’s success. As such, I still want to be compensated for the risk.

    I have tried to give some justifications for pricing rounds at reasonable valuations but the underlying reason is to never have a down round. Having been part of a couple of down rounds, I can tell you it is never fun.

  • http://www.justanentrepreneur.com Philip Sugar

    That is truth. Perfectly said. As founder you are not going to do a down round. Somebody else might but not you.

  • http://www.justanentrepreneur.com Philip Sugar
  • http://nabeelhyatt.com nabeel

    Just as VCs have a hard time doing down rounds due to the psychology, also don’t forget the psychological impact on the team even if the deal does get done.

    If you’ve ever been part of a public company with a collapsing stock price you’ve got an idea of what that does…

    Actually this got me going so it turned into a full post: http://nabeelhyatt.com/post/49825262568/the-effect-of-a-down-round-on-your-team

  • http://www.linkedin.com/in/markpydynowski/ Mark C. Pydynowski

    FACTS
    We did a 92% down round. I was a co-founder and the down round was led by our lead VC, who was an insider. There was no new lead investor. The company missed its milestones.

    OPINIONS
    It was akin to the kiss of death for all momentum, confidence, and subsequent financings. This happened because we, as founders, created a scenario where it could happen – we did not deliver results and our lead VC was greedy. As CEO, I screwed-up by not finding a new lead investor to price the round.

    This put a bad taste in everyone’s mouth. The early angels were crushed, the strategic was livid, the founders (refreshed with options) were demoralized and the VC was frustrated. The bad taste never went away. The relationship with our VC was forever tense. Picking up the phone and talking to our early angels was never the same.

    Our lessons learned: (A.) the fallout from a massive down round is so damaging that it is unlikely to be worth the risk of “accepting the market price along with some risk of taking a down round in the future,” (B.) always have a new lead investor in the green room, (C.) choose your milestones wisely, and (D.) put on your big boy pants every morning and refuse to work with anyone that does not do the same.

  • http://www.sift.com Ben Heald

    Down rounds can be uncomfortable. Wipe-out rounds are out and out nasty, ruthless and brutal. If anyone hasn’t come across these, it’s when a down-round is done at zero value. My company Sift invested $0.6m in a Norwegian technology business for 25% of the equity in 2004 in order to give us (we hoped) a technology partner. Not only did we not get any technology benefits, two years later our stake was wiped out, when the 2 Norwegian VCs pushed through a Zero value round that we decided not to follow. Lots of learnings from this of course. The one that sticks in my throat still is that some of the round that we participated in went to one of the founders of the business to purchase some tax losses from which the Norwegian company hoped to benefit later on!

  • http://www.justanentrepreneur.com Philip Sugar

    It is good to have somebody share an actual experience. Having a new lead investor in the green room is easier said that done. Especially when you have had a really high raise with not much traction.

  • http://www.repeatablesale.com/ Scott Barnett

    Put another way…. with a down round, *somebody* is going to feel significant pain. Given that VC’s in general go very far out of their way to avoid pain, it’s typically gonna be the founder. But there are instances where the VC’s and founder share the pain. Rare, but it can happen.

  • Steve Lofotenoski

    I have raised VC funds in 2 companies. In the first company I raised about $10M and in the second, about $30M in 3 rounds. To the degree that my experience is representative, I would have to disagree with your assertion that most VCs do not like to cram down on others. From what I have seen of the California scene (Sand Hill Road, Palo Alto, San Francisco) in the Cleantech sector, when I had to do a down round in 2010, none of the incoming VCs had any compunction at all in cramming down the previous investors. In my case I was dealing with some pretty big and well know funds and the cramming was sizeable. The prevailing attitude of the incoming investors was “why should I be made to pay for the mistakes made by the previous investors?”

  • http://marcbarros.com/ Marc Barros

    Agreed. Even without a super high valuation, if things do go as expected in an investors mind this happens.

  • http://marcbarros.com/ Marc Barros

    Great post as usual.

    This is definitely a very real experience and agree with all the points that you made. The only slight addition is no one calculates the amount of time wasted on funding that doesn’t come through or negotiating down rounds, especially when they are internally lead. The value of the organization drops when the leadership team and investors spend hours negotiating against one another. You can’t see the cost on paper, when you look up six months later it’s very real.

    Equally fascinating is how the metrics of the business really go out the window. The price is what someone is willing to pay for your company so if the investors used metrics to value their original investment, those become irrelevant if they realize they are the only ones standing there with a check.

    Would love to see a follow on post that exposes this even more. It’s like failure, few people want to talk about it, but it’s an important discussion to be having.

  • http://www.facebook.com/fdemmler Frank Demmler

    An extreme case can occur when a “strategic partner” leads an investment round. I’ve had to deal with 3 separate situations in which the strategic partner significantly overprices a round, each with regrettable results.
    One case was as follows: my portfolio company had a very good working relationship with a strategic partner, development contracts in which the strategic partner would pay “my” company for services rendered; IP rights had been reasonably negotiated; and distribution agreements were in place. My company wanted to raise $6 million, $3 million of which would support delivery of the contracted work to the strategic partner and $3 million for business development activities that would protect the company on sole reliance on the strategic partner. The strategic partner offered to invest $3 million at a $21 million pre-. The “fair” valuation would have been around $12 million. That being the case, none of the institutional investors that had expressed interest in the company were willing to invest at the inflated valuation.
    So, I tried to convince the CEO that he should reduce the valuation to a point where he could secure an additional $3 million and protect the company. I was very persuasive as to why this was really the prudent thing to do, but here’s what the CEO heard: “I have a company for which I have secured an investment offer whereby I will sell 12.5% of the equity and have a company whose post-financing value is $24 million. This idiot VC is trying to convince me to take a $6 million investment in exchange for 33% of my company which would have a post-financing value of $18 million. Why would I ever do that?”
    Needles to say, “S–t happens.” The company was unable to untether itself from the strategic partner and we ended up selling the company for cents on the dollar.