Down Rounds and Secondary Sales: Managing Difficult Financing
Navigate down rounds, secondary transactions, and liquidity events
Understanding Down Rounds
A down round occurs when you raise capital at a lower valuation than your previous round. This is emotionally difficult for founders and can feel like a failure. However, in challenging market conditions, a down round may be the difference between survival and failure. The key is to focus on outcomes rather than ego. A smaller ownership slice of a surviving company is worth more than a large ownership slice of a company that runs out of money.
When a Down Round Makes Sense
A down round makes sense when the alternative is running out of capital. If your current investors will not participate and new investors are only willing to invest at a lower valuation, you have two choices: take the down round or face potential liquidation. In most cases, taking the down round is the better choice. The cost of a down round is dilution; the cost of running out of money is losing everything. Many successful companies have taken down rounds and recovered to achieve successful exits.
Employee Stock Options in Down Rounds
Down rounds significantly impact employee stock options. When valuation drops below the exercise price of options, all options become underwater—worthless on paper. This can devastate morale and retention. Consider repricing options to restore their value, though this requires board approval and may have tax implications. Alternatively, grant new options at the lower valuation to restore employee incentives. Communicate transparently with employees about the situation and your plans to address it.
Down Round Reality
Valuation in Difficult Markets
Valuation in difficult markets is more art than science. Focus on what your company is worth given current conditions, not historical valuations or founder ego. Consider: cash in bank (or lack thereof), revenue trajectory (growth vs. decline), customer concentration and retention, team strength and key person risk, intellectual property and defensibility, and market conditions in your sector. Be realistic in negotiations—buyers will do their own analysis and will not pay more than they believe the company is worth given current conditions.
Managing Investor Relationships Through Down Rounds
Down rounds can strain relationships with existing investors, especially those who invested at higher valuations. Be transparent with existing investors about why the down round is necessary. Give them the opportunity to participate if they want to maintain their ownership. Some investors will choose not to participate, which can create hard feelings. Handle these conversations with honesty and empathy. Remember that investors understand risk—they may be disappointed but they understand that sometimes companies face difficult situations.
Secondary Marketplaces
Several platforms now facilitate secondary transactions: Nasdaq Private Market, Forge, and others. These platforms provide liquidity for private company shares and handle much of the legal and administrative work. Using a marketplace can simplify the process but typically takes 4-8 weeks. Prices are determined by negotiation between buyers and sellers, often at a discount to the last round price.
Secondary Transactions
Secondary transactions allow existing shareholders to sell their shares to new buyers without raising new capital for the company. This provides liquidity without dilution. Secondary sales can be structured in various ways: direct sales between shareholders, facilitated secondary platforms, or tender offers. For founders and early employees, secondary sales can provide needed liquidity. For investors, they provide an exit without waiting for an IPO or acquisition.
Founder Liquidity
Founders often have most of their net worth tied up in company equity. During difficult times, consider your personal financial situation. While it is not ideal to sell at a down round, sometimes founders need liquidity for personal reasons. Secondary sales can provide this liquidity without forcing the company to raise capital. Some investors specialize in founder liquidity transactions. Be transparent with your co-founders and board about any personal liquidity needs.
Secondary Sale Considerations
Secondary sales have several considerations. First, they can signal to the market that insiders want to exit, which may concern potential buyers or investors. Second, there may be restrictions in your shareholder agreement that limit or require approval for secondary sales. Third, buyers in secondary transactions often demand discounts to current valuation due to illiquidity and risk. Fourth, secondary sales can create complexity for cap table management. Despite these challenges, secondaries can be valuable tools for providing liquidity and resolving shareholder disputes.
Liquidity Options for Employees
When primary fundraising is difficult, look for liquidity options for employees. A tender offer allows employees to sell a portion of their vested shares to investors or third parties. This can help retain key employees by providing some liquidity without requiring them to wait for an exit. Some investors specialize in buying employee shares in tender offers. While this dilutes employee ownership, it can be better than no liquidity at all and can help maintain morale during difficult times.
Alternatives to Traditional Financing
If traditional venture financing is not available, consider alternatives. Revenue-based financing provides capital in exchange for a percentage of revenue, without equity dilution. Debt financing may be available if you have assets or cash flow. Convertible notes with favorable terms can provide runway while delaying valuation discussions. Government grants and non-dilutive funding may be available depending on your industry. Explore all options before accepting a down round that significantly dilutes your team.
Key Takeaways
- •A down round may be better than running out of money—focus on survival, not ego
- •Many successful companies have taken down rounds and recovered
- •Be transparent with existing investors and give them participation opportunities
- •Secondary sales provide liquidity without dilution but can signal insider exit
- •Consider alternatives like revenue-based financing before accepting harsh terms
Navigate Difficult Financing
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This article is part of our When Your Startup Is Dying: Financial Turnaround Guide guide.