A “Winter of Investment Discontent”

By: Entrepreneurship & Innovation Clinic Student

A cold air mass has been moving slowly across the United States, from the Silicon Valley all the way to Boston, Massachusetts. As it passes from state to state, the skies darken, a strong northwest wind picks up speed, and temperatures quickly drop, indicating an impending polar destruction. In its wake are thousands of little crops, barely matured from their seed stage, dead and covered in frost. Only the most cold-tolerant, the mostly matured plants, survive. Farmers who once had high aspirations for budding, plentiful crops that would feed their families for years to come, are left in despair with little direction for what to do next. This cold air mass is called “winter” and it is predicted to cause a national freeze that will last the next twelve to eighteen months.

“Winter,” more commonly known as the dreaded “down round” in the investment finance world, has left its killer frost on even the most innovative startup companies. A “down round” is a “financing in which a company sells shares of its capital stock at a price per share that is less than the price per share it sold shares for in an earlier financing.” Private startup companies (companies that have yet to go public on the market—most early-staged startup companies—also called “venture-backed companies”) in particular dread “down rounds” for several reasons:

(i)                 A round at $0.10 per share lower than a prior round carries much more baggage than a $0.10 up round carries goodwill;

(ii)               “Down rounds” are detrimental to employee morale because in order to continue to attract investment to retain capital and talent, evidence of rapid growth in a company is often required—a “down round” is evidence of the opposite;

(iii)             Following a “down round,” investors who hold preferred stock with anti-dilution protection (protection from dilution when shares of stock are sold at a price per share less than the price per share paid by prior investors) will sometimes look to renegotiate the price of the prior round to more closely reflect the valuation of the company, which has a negative impact on, and actually magnifies, the dilution to common stockholders from the financing, resulting in a smaller percentage of ownership for the common stockholders; and

(iv)             Investors in a startup company that has experienced a serious “down round” are often forced to “write down” the value of their other existing holdings in their financial statements, which can have a negative effect on the fund’s ability to continue fundraising for the startup company.

Ultimately, the goal of most startup companies is to go public in order to expand the growth of the company in their specific market; this goal cannot be attained if the company stops receiving, or receives significant less financing from venture capitalists. A “down round” makes going public incredibly difficult; the ability of a startup company to continue producing returns after a “down round” is significantly hindered.

In the second quarter of 2016, the market saw a spike in “down rounds” from the previous quarters. According to a report issued by Cooley LLP, seventeen percent of the financing rounds in that quarter were “down rounds.” This is compared to the mere three percent experienced in the second quarter of 2015. Of the 154 deals that Cooley analyzed from the second quarter, twenty-one percent were “down rounds,” which is triple the number when compared to previous quarters. Other law firms experienced similar trends in the second quarter, with most reporting that the number of “down rounds” from the first quarter of 2016 to the second, increased by at least four percent. Moreover, firms have reported that invested capital in the second quarter decreased by an overall fifty-seven percent from the prior quarter, indicating a major cooling in the venture capital market. Industries that experienced the worst “frost bite” included life sciences and software startup companies—companies that had experienced a boom in the market in previous years.

This harrowing trend in the venture capital market suggests that entrepreneurs are no longer commanding significant valuations like they had in prior quarters, and investors who backed these private startup companies are reevaluating their market expectations. Market analyzers have concluded a few reasons for the rise in the dreaded “down round.” One reason is that in previous quarters, investors were valuing startup companies at such high levels, that the companies could not match valuation upon their next round of financing. Over-valuation is a significant problem for many startup companies who must prove their worth to investors in order to continue receiving funding. Companies that fail to meet valuation are not as lucrative to investors, and as discussed above, can cause serious headache to the venture capitalists. Market analyzers have also pointed to the demise of the “unicorns” as a potential reason for the rise in “down rounds.” Unicorns are private companies with valuations of $1 billion or more. In the past, venture capitalists threw massive dollars at these companies, but as of late, the valuation of the unicorns has fallen significantly.

Venture capitalists are now predicting that “‘the true day of reckoning lies ahead’ for overvalued startup companies and ‘will hit home in the next several quarters’.” To be exact, this “winter of investment discontent” is predicted to last twelve to eighteen months, and to impact seed-staged startup companies the most. Whereas seed-staged startups are experiencing a freeze in investment, middle-staged “mature” startup companies are experiencing a steady stream of cash flow. In part, this is because these mature companies have already proven their worth, and are a safer bet for investors to receive anticipated returns.


So what can seed-staged startup companies do to receive venture capitalist funding? During an interview with Cooley LLP, Felicis Ventures’ founder and managing director Aydin Senkut, indicated that “the best way to counter [down rounds] is for companies to be a lot more hawkish on cash management.”   Felicis Ventures recommends to all of their companies not to set maturity dates below nine to twelve months, and to take sixth months as the absolute minimum time to be able to manage a funding round. Other investors, such as Seattle angel investor Jon Staenberg, recommend that seed-staged startups figure out ways to avoid raising money to get profitability. If companies don’t need venture financing, then they can avoid the dreaded “down round” that other startup companies have experienced. Investors also recommend that founders look at the industries that haven’t been as effected by the market freeze—namely, the food technology industry—and try to fit their products in that “hot” market.

Whereas larger startup markets, including the United States and China, have experienced, and are predicted to continue experiencing a “winter” of investment for months to come, other markets such as India have continued to flourish. “India is one of the highest growth businesses we have anywhere in the world. It has strong double-digit growth,” reported John Flannery of GE Healthcare. Because of India’s strong business growth, major investors in the United States are looking to India for future, more reliable investment options. Investors find Indian business’ focus on cost, quality and outcomes particularly attractive. In the past few years, investment in India has spiked, and analysts predict Indian markets to continue to grow despite other markets experiencing “global economic uncertainty.” So perhaps American seed-staged startup companies should pack their bags and take a twelve to eighteen-month vacation to warmer weather. I hear India is pretty nice this time of year.