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The Down-Rounding Of Venture Capital And Speculative Private Tech Bubble: 5 Things To Know About ‘Valuation Spook’ Being Over

The Down-Rounding Of Venture Capital And Speculative Private Tech Bubble: 5 Things To Know About ‘Valuation Spook’ Being Over

down rounds

Photo: Penny Higgins, https://www.flickr.com/photos/paleololigo/ https://creativecommons.org/licenses/by-sa/2.0/

Sweden-based payments company Klarna Bank AB was Europe’s most valuable fintech startup in June when SoftBank’s Vision Fund 2 led an investment that valued it at $45.6 billion, making it more valuable than most large European banks.

Now the company wants to raise up to $1 billion from new and existing investors in a deal that could value it in the low $30-billion-range — a 30 percent drop.

It’s what’s known as a down round — when a company needs more capital but finds that the pre-money valuation of a subsequent round is lower than the post-money valuation of the previous round — and it’s bad news for founders and employees but friendlier for investors.

Venture capital-backed U.S. companies raised $329.9 billion in 2021 — almost double the record-breaking amount raised in 2020. This massive influx of funds sent startup valuations to the stratosphere in 2021, but now there are signs these sky-high valuations won’t last.

Private markets are known for following public markets and the speculative private tech bubble could be bursting.

“I’ve seen more term sheets pulled in the last month than in the last decade, Just saying,” tweeted Josh Kopelman, a partner at First Round, a venture capital firm that provides seed-stage funding to tech companies. 


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Here are five things to know about “valuation spook” — the era of unicorns on questionable scientific footing — being over, or not.

How bad are down rounds?

Down rounds are considered a very negative thing, depending on who’s talking. In a recent podcast, Motley Fool Money radio host Chris Hill summed it up like this: “A down round is…such a catastrophic sign….it’s the worst possible thing that can happen outside of a tragic accident of some sort.” 

Investor and serial entrepreneur McKeever Conwell II took a more glass-half-full approach.

“For VCs like myself who have never invested through an economic downturn before, then the next 3 years are going to be nothing like the last 3. BUT, some of the best companies of the next decade-plus and being started and ran now. This time is an opportunity, not an apocalypse,” Conwell tweeted.

Why they occur

Down rounds for private companies happen for the same reasons as for publicly traded companies, including:

  • Tightening of general funding conditions
  • Failure to meet investors’ earnings targets
  • Deteriorated competitive environment

A significant portion of the nearly $5.8 trillion in financial support that the Federal Reserve pumped into the U.S. economy from March 2020 to March 2021 was received by venture capitalists.

The Fed has started reducing its balance sheet, worrying some stakeholders. However, this doesn’t necessarily mean the money will disappear.

“Venture capital as an assets class has historically done better than stock markets,” wrote Sergey Gribov, a Partner at Flint Capital, an early-stage venture fund for Forbes. “With a turbulent time ahead predicted for stocks, it may be wise to park some money into VC funds to ‘jump’ over these bad times.”

Implications

Down rounds can cause a loss of confidence and trust in the company, lower motivation and control for founders and managers, and a loss of employee morale.

They can also trigger anti-dilution protection, meaning that when shares get sold at a lower price than an investor originally paid for them, the investor will be diluted less than the other parties.

Down rounds could rise fast

In the first quarter, only about 5 percent of all VC funding was down rounds, according to PitchBook. That’s lower than historical averages. But that number could rise fast, based on the jump in discount requests on the secondary market, Axios reported.

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“The proportion of down rounds could increase in coming quarters if market headwinds persist,” Priyamvada Mathur wrote for Pitchbook. “However, before there is a significant growth in down rounds, PitchBook analysts say the market will likely see a rebound of investor-friendly deal terms—a feature that has largely been absent from venture rounds in recent years.”

Jeff Richards, managing partner at GGVCapital, a $9 billion global venture capital firm, tweeted on March 22, “I get a weekly ‘Unicorn List’ email of secondary shares available in notable companies (via a broker). On 10/4/21 there were 32 names. Today there were 103 names… Probably nothing.”

Avoiding down rounds

The best way to avoid down rounds is to be strategic and prudent when raising funds, Natasha Ketabchi wrote for Toptal.

There’s a strong temptation for startups to raise as much money as possible, especially since capital raises and large valuations are celebrated as markers of success, Sam Altman wrote in a Y Combinator blog.

However, “it’s more effective to raise the cash needed to achieve realistic growth objectives and not be constantly fundraising, which is distracting and stressful,” Ketabchi wrote.

Photo: Penny Higgins, https://www.flickr.com/photos/paleololigo/
https://creativecommons.org/licenses/by-sa/2.0/