Andreas Wilhelmsson never expected to be raising a downround.
As founder of Swedish vertical farming startup Ljusgårda, he believed that his company’s rare traction within a sector he describes as a “shitstorm” would keep investors hungry for more — especially given the company’s lettuce was the cheapest in Swedish supermarkets, according to Wilhelmsson.
But fundraising was an uphill battle. Wilhelmsson was cautiously optimistic, expecting that in the absence of an up round — where a company raises at a higher valuation than it did at its previous priced round — Ljusgårda would at least raise money on similar terms as before. Instead, it raised money at half its previous valuation, from SEK1bn (€85m) to SEK437m (€37m).
It is a pivot that will be familiar to many founders right now. Fewer companies are raising up rounds and instead have to settle for rounds with a less favourable reputation, like a bridge, flat or downround.
But what do these rounds really mean for founders, and are they as damaging to a startup as pessimists would have us believe?
Up rounds on the downturn
Up rounds continued to make up the majority of deals in Q2 of 2023, according to a recent report by PitchBook.
But the proportion of up rounds among the total number of deals was at its lowest since PitchBook began recording them in Q1 of 2018, dipping below 70% for the first time, to 68.4% of deals.
Meanwhile, down or flat rounds — where a valuation or price per share decreases or stays the same, respectively — are becoming more common. Downrounds in Q2 2023 accounted for 26.3% of all European VC deal count, up from 19.8% in Q1 2023, according to PitchBook. Flat rounds made up 5.4% of deals, compared to 8.7% in Q1. That was more than the same period last year when 4.3% of deals were flat rounds.
Right now “flat or downrounds are often the only option for companies who need cash”, says Mike Turner, partner at VC-advising legal firm Latham & Watkins.
For companies that want to sidestep the potential valuation hit of a priced round, bridge rounds are also an option, where startups tap into existing investors for more cash instead of finding new backers. Shing Lo, partner at Latham & Watkins says that the firm has seen “a huge number of extensions” in the past year and a half.
Bridge rounds don’t come with a valuation, and Lo says that they’re often given in the form of convertible loan notes or advance subscription agreements (where investors “pre-pay” for shares), which “typically convert at a discount to the price of the next equity round for the investors involved”.
Tough times bring tough decisions
Harri Myllylä, founder of Finland-based startup Book Salon, which offers digital tools for hair, beauty and wellness SMEs, initially wanted to raise a €10m Series A round led by a US investor. But just two months on from setting that initial goal, had to pivot to raising a €2m bridge round instead.
The startup’s investors actually foresaw the difficult environment ahead of time and suggested the team raise a bridge round earlier in 2022, says Myllylä, but the “management team and working shareholders still saw rounds happening, so we didn’t want to move back down from our initial aggressive growth plans”.
Wilhelmsson went through the same internal turmoil — and while the reality was hard to accept, he realised that stepping into the shoes of the company’s shareholders made the reasoning a lot clearer.
He says that while founders tend to be quite narrow-focused on the details of their own company, they “need to [...] look from the investor’s point of view” and acknowledge that the risk factors of the sector and markets they’re operating in will cloud decisions.
Rather than succumb to self-pity, Wilhelmsson and his cofounder decided they would participate in the round themselves as a sign of the confidence they had in its success: with the alternative being a significant dilution of their stakes, they decided that “we wouldn’t accept being diluted when we are killing it out there”, and slightly increased their equity stake.
Ultimately, says Suranga Chandratillake, partner at VC firm Balderton, there’s no guarantee that raising an up round leads to a positive outcome. He adds that Balderton always advises companies to only raise money if they actually need to, as even in good market conditions, it can be a distracting process. “Higher valuations for the sake of them can be unhelpful,” he says.
Is anything other than an up round bad for startups?
Bridge rounds, says Lo, are often “used to avoid having to agree on a valuation”, which is ideal for startups that don’t want to risk a downround or can’t drum up the investor cash they want for a full round — but it’s not necessarily a sign of struggle, as Lo adds they see them in both good times and bad.
Far from sinking Book Salon’s reputation, Myllylä says that the company’s bridge round has been a “huge blessing”: the company has seen faster growth than he anticipated when it raised back in Q2, and hasn’t had to make any layoffs.
By contrast, “downrounds can give rise to negative publicity, founder and employee dilution and alienation of other early-stage investors,” says Turner. They can also mean that companies are compromised on the terms they can ask for in the next equity fundraising round.
Any share options recently granted as employee options could be underwater — Lo says that founders “will need to consider whether to issue new options at the new price to retain and attract employees”. Employees that joined when the valuation was higher would have to accept less favourable terms than they were initially incentivised with; their options could be diluted when reissued at a lower price, which could then mean that the strike price — the price they can buy those shares at in the event of an exit — is hiked up.
But despite the stigma some may attribute to a downround, it’s far from the end of the world, Wilhelmsson says.
“When you’re in the middle of it, it’s never fun [and] you react as a founder first so you don’t like it,” he admits. Once the money was secured to fund the company’s next steps, though, he felt confident in the investors who joined and was happy with the result overall. The company plans to use the cash to fund the building of a new facility to expand its operations.
Listen to advisors
Ultimately, says Myllylä, “founders should be focused on securing the future of your company in one way or another”; “be honest with yourself on what your real options are.” He echoes Wilhelmsson’s advice to listen to experienced investors and board members who may notice wider market conditions quicker than a more narrow-focused founder.
Chandratillake also believes that these rounds aren’t a sign of a bad business. “We have seen some flat or down rounds — but that is the case even in the best of markets,” he says. He adds that, in most cases, the resulting valuation has been fair, based on factors like being in a sector where other companies are struggling or the individual performance of companies.
In fact, he says that sometimes investors will actually prefer these rounds: “a well-handled down or flat round is almost always preferable to a highly structured round that creates cap-table opacity in the interest of maintaining a theoretical valuation.”
