Making Money in a Downround

A down round occurs when investors, such as venture capital firms (VC’s) determine the valuation of a business to be less than a previous valuation. Those in the venture capital business have a great deal of power when it comes to investing, and more so when it comes to determining the value, or valuation, of individual businesses. For ease of understanding we will use a fake business name and give you an example of a down round.

Shaw, Inc. is a small business and is really just getting started. They are in need of some big investors in order to take the business where they want it to go. The CEO of Shaw, Inc., John, managed to attract the attention of some VC’s. After reviewing the business plan and annual report, the VC’s decided to invest. First they had to put a value on the business. This value or valuation is called a pre-money valuation because it is before the VC’s invest. The pre-money valuation was set at $50 million. The VC firm that agreed to invest put in $20 million. This caused the post money valuation to be $70 million. John was ecstatic because they now had the money to grow the business.

Two years later Shaw, Inc. found itself in the position of needing money again. The $20 million from the venture capital firm was spent. John went back to several VC firms and again found one that would at least consider investing. The VC firm looked through all the financials and the business plan and was impressed; but the true test came when the VC had to determine the valuation of Shaw, Inc. The valuation, pre-money, was only $30 million. This was less than the pre-money valuation of the first round of investing. Thus this round became a down round.

Understanding Angel Investors and How They Work

According to Entrepreneur.com, “Working with an angel capital investor or an angel investor network means acquiring venture capital from individual investors. These individuals look for companies that exhibit high-growth prospects, have a synergy with their own business or compete in an industry in which they have succeeded.” (http://www.entrepreneur.com/article/). Although they are called angel investors because they seem like a gift from above, that doesn’t mean they will invest unconditionally – in fact it is just the opposite. Angel investors are likely to cost at least 10 percent of a company’s equity, and sometimes, for young businesses, that can go as high as 50 percent. An angel investor network can help you when no one else will but it comes at a cost, sometimes an immense cost.

An angel capital investor frequently invests in brand new companies. Although the angel investor’s money does come with a cost, there are some advantages to using angel investors or angel investor groups. For instance, they don’t expect as high a rate of return as VC firms. Yet you should look around; there is more than one angel investor network and there are numerous private angel investors.

Down Rounds and the Dot Com Bust

Many dot coms were forced to close up shop during the dot com bust; however there were some that survived. Of those that survived, many did so by taking advantage of a down round. All companies that survived needed a lot of support and cash to weather the storm.

Most companies had been through at least two rounds of investing and some chose to go ahead and go through another round even though they knew it would be a down round. Let’s take Shaw, Inc. for example. Shaw, Inc. is an IT company and was just barely holding on during the bust. The CEO saw only one way out: and that was to go ahead with a down round.

A down round, although the valuation of a company has dropped, draws the attention of angel investors. These investors can come as a group or as an individual private angel investor. Even though the valuation of these companies was lower than their previous valuations, each angel capital investor paid a great deal of attention to the future of the company. The angel investor groups and maybe to an even greater extent the private angel investors, took into account not only the current valuation but the growth potential and the company’s plan for the future and how they would build their business.

Even though angel investors, whether in groups or just an individual, came with a huge cost, the dot comer’s that attracted these investors knew the only other option was to go out of business. With that in mind, it made the pill (cost) a little easier to swallow.

Internet Resources for Finding More Information

Here are links to some websites where you can find more information on down rounds:

http://www.inc.com/magazine

http://www.investopedia.com

http://www.earlystagevc.typepad.com

http://www.americanventuremagazine.com

http://www.altassets.net

http://www.vcintermediary.com

http://www.ventureworthy.com

http://nixonpeabody.com

http://www.abanet.org

http://www.infopoint.com

http://www.melonventures.com

http://www.vcexperts.com