News headlines have shifted from sharing tales of record-setting funding rounds and IPOs to tracking plummeting valuations. Founder and leadership conversations have changed from "How much can we raise?" to "Can we raise?"
Now, employees need to understand the ramifications a down round can have on their equity.
A down round is exactly what it sounds like: A fundraising round in which the share price is lower than that of the shares sold in the previous round (or rounds). In other words, company leaders are raising money based on a valuation that has decreased since the last fundraising round.
Examples of this have been all over the news, thanks to a mini tech bubble. After investors poured record-breaking amounts of money into tech companies in 2021, inflated valuations started bursting the following year, resulting in valuations and share prices dropping dramatically. Now that investors are holding tighter to their wallets, tech companies that need to raise are more likely to have to do so at a significantly lower share price than in the previous decade.
Speaking of bubbles, while raising a down round isn’t going to have founders and investors popping champagne, it’s not necessarily a cause for panic. Share prices go up and down, and one down round doesn’t mean shares will never regain their value. What’s important is that companies are transparent with employees about when they’ve gone through a down round and how this will impact their equity.
Here’s what you need to know about down rounds.
What happens to employee equity in a down round?
A down round usually impacts different types of shareholders in different ways. For employees, it can put your share options underwater, meaning that your strike price—the amount you will pay to exercise your options when they vest—is now higher than the fair market value (FMV) of the shares. This would leave you making a loss on your shares if you were to exercise them (which you most likely wouldn’t).
Being underwater isn’t ideal, but it’s not necessarily cause for alarm, especially if you have a very low strike price and/or your company is still in its early stages. If your strike price is low, you don’t have to rely on the share price jumping significantly to put you back “in the money”. And if your startup is still in one of its early fundraising rounds, you have a long time for the share price to recover before you go through a liquidity event and have the opportunity to sell your shares. If you monitor the value of your equity stake on the Ledgy dashboard, you’ll be able to see how the value changes over time.
Employees who are at risk of losing out from a down round include those who joined the company relatively recently, whose strike price is based on the FMV of the company at an inflated valuation. Once valuations drop, it can take a long time for the share price to rise above that artificially high strike price again.
Another scenario in which employees lose out in a down round is when their company is acquired based on the reduced valuation. In most cases, share options vest when a company is acquired. Employees then have a limited window (often just 90 days) in which to purchase their shares at the strike price. But if a low valuation puts your shares underwater during the exercise period, you either have to buy them for more than they’re worth (i.e. pay a strike price that is more than the current share price) or lose the value of your equity entirely.
There are things companies can do to mitigate the impact of a down round on their employees’ equity. Before we get to that, it helps to understand how investors are sometimes treated differently in a down round.
How investors are protected in a down round
Whereas employees earn shares at a reduced price through their work for their company, investors typically buy them outright at the FMV. To reflect the difference in price, employees receive common shares and investors receive preferred shares that come with certain protections. That often includes anti-dilution protections that are triggered in a down round.
Every fundraising round dilutes investors’ shares. The intention is that further investment will ultimately enable the company to make more money for everyone. Even though an individual investor’s shares now represent a smaller proportion of the overall value of the company, the value is higher, so their segment is worth more than it would be without the cash injection. Think about it like this: Would you rather have half a cupcake or quarter of a full-size birthday cake?
In a down round, though, not only are the incoming investors diluting the proportion of shares the existing investors hold, but the value of the company has also shrunk. And the newcomers are effectively getting the same shares at a discount.
How close the investor gets to that previous proportion depends on the type of anti-dilution provisions they negotiated. A full ratchet anti-dilution protection clause can convert previous round(s) investors’ shares to the new share class in an amount negating any loss of ownership. In other words, they get the right to acquire the number of shares necessary to take them back to their pre-down round ownership stake, at the new, lower share price. More commonly, investors have a broad-based weighted-average anti-dilution protection clause. This takes them close to their previous stake but still results in a slightly diluted ownership stake.
Many investor term sheets also include provisions that ensure they get priority in a liquidation event. Usually the most recent investor gets paid first—a concept known as “last in, first out”--since they are typically investing more money than earlier investors. Liquidation preference clauses dictate that investors get paid a multiple of their initial investment before common shareholders receive any cash. Typically this is 1x or 2x, but that’s significant when you’re talking about larger investments—and it can be much higher.
Say an investor invests £5 million pounds into a startup that has an employee equity scheme. The term sheet gives the investor a 1x liquidation preference. The startup eventually has to admit defeat and start liquidation procedures on its remaining assets, which are worth £6 million. The investor has the right to 1x £5 million, leaving only £1 million to split between all the other shareholders. As you can see, clauses like this can significantly impact the value holders of common shares can access.
A down round impacts all shareholders—but not equally. Common shareholders like employees have fewer protections. However, companies can take certain actions to soften the blow.
What companies should do to protect employees in a down round
As a leader, the first thing you should do is be transparent. If you have to raise in a down round, tell employees that’s what you’re doing and how it can affect their equity. As discussed, a down round can put employees’ options underwater, hopefully temporarily, so it’s important that they understand the implications.
Companies can also try to correct for the decrease in value of their employees’ equity stakes by issuing each employee additional options at a lower strike price, or by repricing options. In the latter case, the company effectively cancels existing options and reissues new options at a lower strike price.
Both of these approaches will probably involve negotiations with the board and investors, especially since re-evaluating the common stock price impacts every shareholder. Ledgy’s scenario modeling tool allows you to model the potential outcomes of lowering option prices. These processes also involve additional accounting, and when the options are exercised, the company will get a smaller cash injection than it would have based on the previous strike price.
Although there are potential obstacles, taking these steps proves to your employees that you take their equity seriously and want them to represent meaningful compensation. Cushioning the blow to employees’ equity can help maintain their trust in your company and the long-term value of their equity, enabling you to keep the kind of top talent that can get your company through difficult economic times.
Another step companies can take to help soften the blow of a down round is to extend the exercise window from 90 days to five or even 10 years. This gives share prices time to rise and get back into the money, so that employees are finally able to access that value. It’s particularly important in situations where people have been made redundant. It’s hard enough for people to lose their salary, but at least an extended exercise window means that if the company’s fortunes improve, they will still benefit from the equity they earned.
Companies don’t have to throw their hands up and shrug in the face of a down round. Those that prioritize employees’ needs can retain their people and come out of a tough economy fighting.
Don’t let down rounds get you down
For employees and companies, down rounds are just one aspect of operating in the challenging world of startups. They don’t have to be an apocalyptic event. If the company can use the new investment wisely, restructure the way existing options work to lessen the impact on employees, and come out the other side, the share price will gradually go back up. Your round may be down, but you’re not out.
For more essential information on the ins and outs of equity schemes, read more articles from Ledgy.
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