Down Rounds 101

A guide for employees on why their company might need to take a down round, and how it'll affect them.
Down Rounds 101

So you joined a hot growth-stage startup a couple of years ago — things were scrappy, they were hiring rapidly, and everything was going up and to the right. Especially the value of your stock options.

Fast-forward to today’s uncertain markets, and the same scrappiness feels more panicked. The company’s always been loss-making, but people’s attitude towards profitability has suddenly shifted. And there are mutterings about public stocks being overvalued, and growth stage companies having to take “down rounds” (additional financing at a discount to the previous valuation) as a result.

There’s a great deal of scaremongering about what the tech downturn means for employees, but in moments of Current Thing-ness it’s hard to cut through the noise —

We’ve put together this simple explainer on down rounds, and an interactive calculator to work out how a down round might affect your finances as an employee.

How does 'growth equity' work?

Before the downturn in tech valuations, growth equity worked something like this…

Growth equity firms would approach a company 1-2 years from IPO, and offer 100s of millions, at very high valuations (like 100x revenue). The company would spend this money on things to grow the top line (often hiring a bunch of people). All the new hires would get granted option at the previous (very high) valuation. The growth round investors would push the company to grow as fast as it can, and they’d double revenue, albeit inefficiently, in a year.

Once the company IPO’ed, the public markets would buy the company at a similarly high multiple, and after a lock-up period, the growth equity firm would be able to cash out, having doubled their money in a couple of years, and then they’d rinse and repeat.

This was a neat strategy for a while at least. One of the earliest instantiations of growth equity was Softbank’s $100 million investment in Yahoo in 1996. Softbank’s growth stage investment made more money dollar-for-dollar than Sequoia did, despite the fact Sequoia had discovered the company, done the Series A, owned a third of the equity before the investment, and recruited the CEO. But the alpha in this model was eroded, especially in the last few years, as this model only scales on the supply of Yahoo-like successes (...and crucially not with the number of companies that growth investors try to crown as category winners!) 

It’s similar to a game of musical chairs: when the capital continues to flow, the music continues to play, so nobody gets exposed (and everyone looks smart). Only once the music gets stopped by the public markets refusing to buy companies at the same high valuations, does a cohort of companies get stuck in the middle. They’ve raised in the last few years at a high multiple and haven’t-yet gone public, and so they’re unable to raise again without accepting a big discount to their previous valuation. In particular, this leaves employees who joined the company after the growth round “underwater”, where the strike price of their options exceeds the value of stock they’d receive for exercising their options. (The previous fair market value of your options no longer seems very fair at all!) 

What happens to employees in a down round?

If your options are underwater, you can take partial relief in knowing that a lot of your colleagues will be in the same boat. As I’ve mentioned, growth rounds usually come with implicit strings-attached to Grow Very Quickly, which has been a corollary for Hire Very Quickly. Often, headcount increases 2x or more after a growth round, and so in a subsequent down round it’s possible that ~50% of the employees will have options underwater.

Because it’s true of so many employees, companies strongly want to rectify the situation. Hiring gets more difficult after a down round, because the perception of the company changes, and so employee retention is very important. (Retention simultaneously becomes difficult because total comp packages change quickly when options aren’t worth exercising.)

There’s a few ways companies might fix this:

  1. Swapping options for cash. This can be a good deal (of course, depending on the price) because it offers employees instant liquidity, when the company is unlikely to be able to go public, or provide another liquidity event for a while.
  2. Repricing the options. The company simply lowers the strike price on the options (i.e. the price to exercise) without changing any of the terms.
  3. Regranting options. The company cancels the existing underwater options, and gives new options, with a new strike price, and potentially different terms (like changing the vesting schedule).

Interactive Calculator: Employee Options

This is an interactive calculator built with Causal. How to use: 

  1. Select your company's stage using the 'Scenario' dropdown at the top. The default is for a Series B company.
  2. Customise the assumptions at the top to see whether your options will be still be profitable after a down round. You can find most of these numbers in Carta or the options paperwork that you signed when joining the company.

Keep an eye out for…

Some companies are using tricks to avoid the appearance of a down-round, where their down round investors will buy some of the preferred shares at the last round’s valuation, and then another tranche of shares are at a lower valuation, and so the headline is that the valuation has remained flat but it hasn’t actually. It’s worth keeping an eye on how the price per share for the class of shares you own has changed, to see how the fundraising affects you, not just the press release figure.

Whether or not your company makes the employees whole (i.e. not underwater) it’s helpful to understand the scenario if they don’t, to understand the value of their fix, and to help with negotiations. We’ve created a series of calculators, where you can plug in some basic assumptions, to help think through this situation. If you’re interested in building out more comprehensive models, you can check out Causal here

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So you joined a hot growth-stage startup a couple of years ago — things were scrappy, they were hiring rapidly, and everything was going up and to the right. Especially the value of your stock options.

Fast-forward to today’s uncertain markets, and the same scrappiness feels more panicked. The company’s always been loss-making, but people’s attitude towards profitability has suddenly shifted. And there are mutterings about public stocks being overvalued, and growth stage companies having to take “down rounds” (additional financing at a discount to the previous valuation) as a result.

There’s a great deal of scaremongering about what the tech downturn means for employees, but in moments of Current Thing-ness it’s hard to cut through the noise —

We’ve put together this simple explainer on down rounds, and an interactive calculator to work out how a down round might affect your finances as an employee.

How does 'growth equity' work?

Before the downturn in tech valuations, growth equity worked something like this…

Growth equity firms would approach a company 1-2 years from IPO, and offer 100s of millions, at very high valuations (like 100x revenue). The company would spend this money on things to grow the top line (often hiring a bunch of people). All the new hires would get granted option at the previous (very high) valuation. The growth round investors would push the company to grow as fast as it can, and they’d double revenue, albeit inefficiently, in a year.

Once the company IPO’ed, the public markets would buy the company at a similarly high multiple, and after a lock-up period, the growth equity firm would be able to cash out, having doubled their money in a couple of years, and then they’d rinse and repeat.

This was a neat strategy for a while at least. One of the earliest instantiations of growth equity was Softbank’s $100 million investment in Yahoo in 1996. Softbank’s growth stage investment made more money dollar-for-dollar than Sequoia did, despite the fact Sequoia had discovered the company, done the Series A, owned a third of the equity before the investment, and recruited the CEO. But the alpha in this model was eroded, especially in the last few years, as this model only scales on the supply of Yahoo-like successes (...and crucially not with the number of companies that growth investors try to crown as category winners!) 

It’s similar to a game of musical chairs: when the capital continues to flow, the music continues to play, so nobody gets exposed (and everyone looks smart). Only once the music gets stopped by the public markets refusing to buy companies at the same high valuations, does a cohort of companies get stuck in the middle. They’ve raised in the last few years at a high multiple and haven’t-yet gone public, and so they’re unable to raise again without accepting a big discount to their previous valuation. In particular, this leaves employees who joined the company after the growth round “underwater”, where the strike price of their options exceeds the value of stock they’d receive for exercising their options. (The previous fair market value of your options no longer seems very fair at all!) 

What happens to employees in a down round?

If your options are underwater, you can take partial relief in knowing that a lot of your colleagues will be in the same boat. As I’ve mentioned, growth rounds usually come with implicit strings-attached to Grow Very Quickly, which has been a corollary for Hire Very Quickly. Often, headcount increases 2x or more after a growth round, and so in a subsequent down round it’s possible that ~50% of the employees will have options underwater.

Because it’s true of so many employees, companies strongly want to rectify the situation. Hiring gets more difficult after a down round, because the perception of the company changes, and so employee retention is very important. (Retention simultaneously becomes difficult because total comp packages change quickly when options aren’t worth exercising.)

There’s a few ways companies might fix this:

  1. Swapping options for cash. This can be a good deal (of course, depending on the price) because it offers employees instant liquidity, when the company is unlikely to be able to go public, or provide another liquidity event for a while.
  2. Repricing the options. The company simply lowers the strike price on the options (i.e. the price to exercise) without changing any of the terms.
  3. Regranting options. The company cancels the existing underwater options, and gives new options, with a new strike price, and potentially different terms (like changing the vesting schedule).

Interactive Calculator: Employee Options

This is an interactive calculator built with Causal. How to use: 

  1. Select your company's stage using the 'Scenario' dropdown at the top. The default is for a Series B company.
  2. Customise the assumptions at the top to see whether your options will be still be profitable after a down round. You can find most of these numbers in Carta or the options paperwork that you signed when joining the company.

Keep an eye out for…

Some companies are using tricks to avoid the appearance of a down-round, where their down round investors will buy some of the preferred shares at the last round’s valuation, and then another tranche of shares are at a lower valuation, and so the headline is that the valuation has remained flat but it hasn’t actually. It’s worth keeping an eye on how the price per share for the class of shares you own has changed, to see how the fundraising affects you, not just the press release figure.

Whether or not your company makes the employees whole (i.e. not underwater) it’s helpful to understand the scenario if they don’t, to understand the value of their fix, and to help with negotiations. We’ve created a series of calculators, where you can plug in some basic assumptions, to help think through this situation. If you’re interested in building out more comprehensive models, you can check out Causal here

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Down Rounds 101

A guide for employees on why their company might need to take a down round, and how it'll affect them.