VC downrounds: ‘Everyone is afraid of the falling knife’

The huge valuation drop reflects a wider slump in the tech market, which has lost much of its momentum in recent months as investors take stock after gorging on deals last year. 

But as the bull run grinds to a halt, startups that still need more cash face a tougher fundraising environment.

Firms are bracing for a wave of so-called downrounds, which take place when a company sells shares at a price below its previous round’s valuation.

Venture capital houses are at odds over whether these downrounds are a blessing or a curse.

While some investors view them as an opportunity to snap up stakes in fast-growing businesses at a bargain price, others see these funding rounds as a sign of more trouble to come.

“Downrounds are a company killer,” argues Activant Capital founder Steve Sarracino, whose investments have included ride hailing app Bolt. “The question is: how many multi-billion-dollar public companies do we know of who have done a downround? I can’t think of a single one. It’s really hard to recover from it and build momentum.”

He adds: “You’ll see people who are excited about getting in a downround, looking at what people paid two years ago. But the price people paid two years ago doesn’t matter. Assets don’t have memories. The pricing in the past is irrelevant.”

Sceptics such as Sarracino argue that downrounds can also prompt “a talent death spiral”.

Early-stage venture businesses often hand out a share of the ownership to employees and management to attract people into the company as they look to grow.

But if the valuation of the company slumps and the stock options lose their worth, employees sometimes jump ship.

Despite these concerns, one VC investor who sees opportunities amid the uncertainty is Mark Peter Davis, managing partner of US-based VC firm Interplay Ventures.

“We’re seeing a lot of buying opportunities for companies where the operating fundamentals are still excellent and they’re really being affected by the broader market dynamic,” he says.

“People are so quick to say the phrase ‘buy low, sell high,’ but when it’s time to buy low, you have to be a contrarian. You have to buy when no one else is buying, or you’re not buying low.”

He adds: “It’s really an opportunity to put more capital into companies that are as good today as they were yesterday at the same or a better price.”

As the need for new cash intensifies, investors are driving harder terms in their fundraising deals with startups. 

Enhanced liquidity preferences, redemption rights, protective provisions and cumulative dividend rights are all terms that become more frequently demanded by VC houses during a downturn.

Michael Preston of law firm Cleary Gottlieb says: “Some investors are really looking at the distress and thinking it’s a great time to get in and put in place far more enhanced protective rights. So we are seeing governance packages agreed with much more enhanced controls over the company’s ability to do things operationally.”

He adds: “There is a lot to be said for looking hard at downrounds. There could be some phenomenal opportunities and in 12 months, a lot of investors will probably be kicking themselves that they didn’t get in when they had these opportunities.”

“That said, everyone is afraid of the falling knife.”

As the downturn deepens and the knives begin to fall, VC investors will be hoping they don’t get hurt in the process.

To contact the author of this story with feedback or news, email Sebastian McCarthy