In the News

Irrational Fear of the Down Round and Long-Term Implications

MENLO PARK, CA – November 13, 2017 – The appreciation of valuations in the technology sector after the 2008 correction has resulted in the entry of new types of investors into the venture/growth category. For a few high-profile companies there seems to be unlimited amounts of capital available at attractive terms, which continue to drive up valuations and competition amongst more traditional growth equity investors. Despite this tremendous influx of capital into a small segment of the market, investors in general are increasingly focused on sound financial metrics (e.g., sustained growth, low dollar churn, healthy margin structure, etc.) when deploying capital. As a result, a greater number of companies have been exploring newer non-traditional financing sources. While some of these deals solve immediate cash needs, many fail to address the root cause of the problem and can impair a company’s ability to raise subsequent rounds or attract additional talent within the organization.

Technology companies fear the “down round,” a scenario where capital is invested at a valuation lower than a previous round. For later stage companies with lofty valuations and broader market awareness, a down round is public evidence that the business is not progressing as originally anticipated. While most investors are aware of the implications of down rounds, flat insider-led rounds have become a less obvious indicator of distress as companies fail to convince outside investors that the investment opportunity merits even a modest markup from the previous valuation. As a result, valuation sensitive companies in need of financing are increasingly considering non-traditional sources of capital that provide valuation flexibility in exchange for more onerous debt-like terms mainly to avoid the stigma of a down round.

The Risks of Non-Traditional Financing Alternatives

What many companies fail to recognize is that some non-traditional financing alternatives are purely risk-adjusted bets from investors that do not have the resources, expertise or patience traditionally indicative of the venture capital asset class. If growth does not continue as predicted, a downward spiral can be accelerated by a cap table with onerous quasi-debt terms and an investor that is not as willing or able to work through challenges with the management teams. At the first sign of weakness in a company, non-traditional investors often retain operating executives to “manage” the asset in order to maximize near term returns to the detriment of other shareholders. Furthermore, it is difficult in practice to refinance out non-traditional investors because new equity investors prefer funding growth vs. paying down debt.

While a down round is not ideal, it is sometimes necessary to reset expectations and create stronger alignment between investors and employees. It can also be in the best interest of the remaining management team to fix a broken cap structure to redistribute value to employees and in the process help attract new talent to the business. A dose of valuation reality combined with better alignment is not something that should be feared.

Capital comes in many forms, and it is paramount that teams and companies consider the long-term impact of additional financing that does not always address the greater need for realignment among stakeholders and an increased focus on fundamental financial metrics. If all the stakeholders in a company focus on running an operationally-healthy business that can control its own destiny, management teams will not have to rely on non-traditional sources of capital that do not provide value beyond the invested capital.

John Kim is a Co-Founder and Managing Partner of HighBar Partners, a private investment firm focused on enterprise and infrastructure software companies undergoing change or transition. HighBar provides patient, long-term capital and resources to fund growth and assist management teams with financial, strategic and operational execution.