Beware the Down Round

Good comments here from Peter Rip about how the current bullish market in early-stage venture capital is likely to lead to a disproportionate number of down rounds, and commensurate founder dilution.

In English: Early-stage companies are putting too high a value on themselves, and the result will be subsequent venture investments at similar or lower values, which will mean that founders, who are now keeping more of the company, will eventually end up with less than would otherwise be the case.

Granted, sometimes this argument gets trotted out by venture investors as FUD to drive down valuations, but Peter makes a very fair point that is too often overlooked.


  1. Brent Buckner says:

    “Early stage companies are putting too high a value on themselves”
    The price is co-determined between “early stage companies” (e.g. founders) and VCs. I suspect that founders now place about the same value on their companies as founders did a couple of years back, they just get a higher price as a negotiation outcome. If there is a misallocation, blame the professional allocators of capital.
    I note that the lynchpin of the argument of the pain of down rounds for founders is that VCs suffer severely from the sunk cost fallacy (which venture capital as an institution may be picking up and magnifying from the end-clients, the LPs). Again, this would be something to denigrate VCs about, not to cast aspersions upon the prices that founders are getting in first rounds (or the values that they place upon their companies).

  2. I agree Brent, but it is a hell of a lot harder (and a couple of levels of causality removed) to solve the problem by a re-allocation of capital from pension funds. It is much easier to remind early-stage founders of the problem, and then let them decide how eagerly to play chicken with the “B” round valuation.

  3. Brent Buckner says:

    To me, the situation doesn’t require “reminding” founders of the problem (as most founders go into negotiation not ever having been aware of the problem). The situation requires educating them on just how far removed from economic rationality their counterparties are or may be.
    I’m sure it’s a hard sell to founders: “if you let the VC make the mistake of paying too much in the first round and letting you keep more of your company, the VC will see to it that in the next round conditions will be imposed such that you get paid less than you otherwise would subsequently and you’ll end up on net giving up more of your company.” Gruesome.
    I concur that there’s no near or mid-term prospect for pension funds to improve as investors, or for the institution of venture capital to mitigate those flaws. Founders will continue to face this dilemma.

  4. Paul:
    I think the readers are missing the main point. The main point is that a down round doesn’t just hurt VCs. We’re (in theory) sophisticated investors. If we made a mistake, shame on us.
    The collateral damage of perceived loss of momentum is significant with employees (existing and recruits) and with customers and potential partners.
    That’s why down rounds are bad, not just because of the effect on investors.

  5. Brent Buckner says:

    I’m commenting on Paul’s take rather than Peter’s original blog entry.
    As to why Peter’s readers have been missing his main point, it may be somewhat buried. I note that Peter’s blog entry begins its discussion of the problem of down rounds with: “This can get very arcane with all sorts of mechanisms (preferences, warrants, voting rights, management carve-outs) getting thrown into the mix, mostly to help the Old Money not feel so badly about its loss of value. Everyone knows these mechanisms distort valuation and corrupt the alignment of incentives.” [Aside: this discussion occurs ahead of the section labelled “The Down Round”.]