When A Down Round Isn’t So Bad (Unless you are a VC)

All of us in the startup eco-system hear about the “evil” down round or “cramdown” financings that happen.  These days, the noise level around this financing dynamic is increasing, not decreasing.

While most entrepreneurs worry about down rounds, I’d argue that many times the entrepreneurs and employees are the ones that come out ahead.  In most cases, while the valuation is reset, the VCs funding the round don’t want to injure the current employee base by wiping out their equity holdings.  So what’s the answer?

VCs will look first to wipe out other VCs that are not participating in the round and give additional options to the employees.  Secondly, the VCs may consider wiping out their own previous equity to accomplish the same effect.

What I’ve seen over the past 10 years is that most (not all) times, the employees end up with roughly the same amount of equity while non-participating VCs are completely taken out and participating VCs being partially diluted.  Of course, ex-employees are wiped out as well.

There are plenty of examples of these types of transaction and there are plenty of examples of ultimate success stories with these companies.  My personal favorite is Stratify, but my friend Lorenzo Carver wrote a blog post about two recent examples: Open Table and SpringSource.  He points out that these are among the best exits of the year.  It’s an interesting read.

Bottom line, a down round / cramdown isn’t the end of the world for either the company or its employees.  While still stressful and painful, don’t get too out of shape.  All could turn out just fine.