What the @#$ Is a “Down Round”?

The year is 1999. The economy is hot and full of excitements and opportunities. Promising dot-coms are popping up in the blink of an eye. The startup your buddy Ken invested in quickly attracted venture capital and on it went to the IPO wonderland. Ken is handing out cigars and telling you his success stories. “I’d be crazy if I don’t get in the game now,” you thought. So you decided to play angel and throw some seed money at a sexy dot-com set up by some pretty bright college kids. You’re ready to fly.

Your initial investment:

The founders hold a total of 700,000 shares of the company. You’re eager to play so you offer $300,000 for a 30% stake* on the spot. In other words, you’re offering to buy 300,000 new shares at $1 per share.

* Obviously just an example.

A year later, the dot-com bubble bursts and your startup is no longer sexy. Luckily for you, it’s at least meeting milestones and generating a little revenue. But cash is tight and it needs to raise additional capital to survive – and it needs it fast. So you make a few calls to Ken, who later agrees to inject some cash into the startup, but at a lower valuation than what you’ve originally paid.

Follow-on investment:

Ken offers to invest $500,000 in exchange for 50% for the company. This works out to 1,000,000 new shares at $0.5 ($500,000/1,000,000 shares) per share. Since the price per share has dropped from $1 to $0.5, your 300,000 shares now only worth $150,000 ($0.5/share x 300,000 shares) rather than $300,000.

This is called a “down round.” Stocks worth less now and your initial investment has become less valuable. But neither of you has a choice – it’s either down round or down six feet under. Yea, you guys are feeling pretty down, too.