What is a “Downround” and why does it suck?
When you start capital raising, especially very early on, you need to figure out what valuation to use.
Too high, and everyone will laugh at you. Too low, and you’ll give away too much early on, creating other problems.
At the moment, people are getting incredible valuations for their early stage rounds. Given there’s often an idea and maybe a minimum viable product, why is this?
In the last couple of years, there’s been a lot of cash returned to VC’s in, based on a series of successful exits. This includes the Facebook IPO, Linkedin, the $6 billion that was part of the Whatsapp deal and a series of other high profile transactions.
Couple that with some deeply disruptive business models from AirBNB and Uber, and the sky seems to be the limit. Everyone now wants in!
There’s a golden rule in valuations:
“It’s worth what someone’s prepared to pay for it”
At the moment, if you can demonstrate you have the potential for a “unicorn” business ($1B+ valuation) because of some innovative code, global reach and a great viral marketing campaign, then at the moment, they’re throwing money at you.
What happens when the bubble bursts? History does repeat itself – it will burst at some point.
If you’ve raised $200K at a valuation of $8m from a bunch of people, who may not be so experienced in how tech sector valuations work, it sounds great! You’ve just raised $200K and only given away 2.5% of your company. Bargain!!
What happens when you’re raising $1m? By this time you’re talking to people who are far more experienced in valuing tech companies. They may only give you a $4m pre money valuation. For their $1m, they get 20% of the company.
What happens then?
All of a sudden, for your original investors, the $200K they put in is now only worth $100K.
They still only dilute 20% to a 2% stake, so it may not have a massive impact if the eventual exit is $500m, however it tends to leave a very sour taste in their mouth.
Your early stage investors will be with you for a long, long time. You need them to support you all the way through. Downrounds are a really bad idea.
4 METRICS THAT MATTER
Pre money value this round?
Expected valuation next funding round?
Amount of equity sold this round?
Amount of time between this round and the next round?