You might've noticed a big shift in startup valuations lately: while just 8% of U.S. venture deals were down rounds in 2022, that number jumped to 23% by early 2024. It's a trend that's gotten a lot of financial advisors and investors worried about protecting their clients' interests.

Down round protection is an important tool that helps shield existing shareholders when companies need to raise money at lower valuations. And right now, with the market going through some major changes, it's really crucial to know how these protections work.

In this article we'll break down different types of down round protection and strategies and show you how they can help both founders and investors make better decisions. 

What's Really Going On With Down Rounds

One example of a dramatic shift in startup valuation is Stripe, a company that many investors had their eyes on. Their valuation dropped to $50 billion in 2023, which was quite a change from their previous $95 billion. But they're not alone in this. Klarna, another big name in fintech, saw an even bigger drop — their valuation fell by $85% in 2022, going from $45.6 billion to $6.7 billion.

A down round happens when a startup needs to raise money at a lower valuation than before. And right now, we're seeing this a lot more than usual. The numbers tell us why — startup investment in North America fell to $144.3 billion in 2023, which was 37% lower than the previous year. That's a big drop, and it's made things pretty tough for companies trying to raise money.

Why Down Rounds Are Happening?

Post-money valuations dropped by about 50% from 2022 to 2023, and IPOs? They hit their lowest point in a decade.

Add to that the Federal Reserve pushing interest rates up to 4.25-4.50% by 2025, and you've got a situation where investors are being really careful with their money. Companies that might've gotten great valuations a few years ago are finding it harder to justify those numbers now.

Impact on Growth and Funding

When a company goes through a down round, it changes a few different things:

• The company's value goes down on paper, which can make it harder to attract new investors for current and future rounds.

• The whole situation can shake up relationships with everyone involved — from employees to investors.

This is especially important if you're advising companies that are still trying to grow. They might need to adjust their plans and think differently about how they're going to get the money they need to keep going.

The Mechanisms of Down Round Protection

When a company's value goes down during a new funding round, some investors already have a safety net in place. It's called anti-dilution protection, and it's a pretty big deal in venture capital deals. You'll find two main types of these protections — full ratchet and weighted average adjustments. Let's break them down.

Full Ratchet: The Tough One

Full ratchet protection is a bit intense. Here's what happens: if the company raises money at a lower price than what an investor paid before, that investor gets to pretend they bought all their shares at the new, lower price.

That’s how this works with some real numbers. Say you invested when shares were $10 each. Then the company does a down round at $5 per share. With full ratchet protection, you get to act like you paid $5 for all your shares — which means you end up with twice as many shares as you had before. Just like that.

But those extra shares have to come from somewhere, and that usually means everyone else (like the founders and employees) gets a smaller piece of the pie. That's why full ratchet isn't super common. It can be pretty rough on the team actually building the company.

A Real Example: Square's IPO Story

Square had a really interesting situation with their IPO. Their late-stage investors had full ratchet protection, and it turned out to be a pretty big deal. When Square went public at $9 per share — way below the $15.46 their Series E investors had paid — something interesting happened.

Square had to give those investors $93 million worth of extra shares. Just free shares, because of that protection. And you can probably guess who that affected — yep, the founders, employees, and earlier investors all saw their ownership get smaller.

This is why a lot of founders try really hard to avoid full ratchet provisions. When things get tough, these protections can end up moving a lot of value from the people working in the company to just one group of investors. It's not great for team morale, and it can make future fundraising tricky.

Weighted Average: A Better Way to Handle Down Rounds

There's a different approach that most VCs and companies use — it's called weighted average anti-dilution. And it's pretty great because it works a bit more fairly for everyone involved.

Here's how it works: when the company's value decreases, earlier investors still get some extra shares, but the number depends on how big the down round is. If the company only sells a small number of shares at a lower price, investors get just a few extra shares. But if it's a big down round, they'll get more. It's all about balance, really.

Most VC deals use what they call "broad-based" weighted average. It's become kind of a standard thing because it protects investors without totally messing up the company's cap table. And that's important — you want to keep your team motivated and make sure future fundraising doesn't become impossible.

How Down Round Protection Affects Everyone Involved

Let's talk about what these protections really mean for different people in a company. When you're advising clients about startup investments, you'll want to know how all this plays out in real life.

What Founders and Common Shareholders Get

The good thing about down round protection is that it can help keep things stable when times get tough. Founders can tell their investors, "Hey, we've got these protections in place," and that usually makes raising more money a bit easier. Investors feel better about putting their money in when they know they've got some safety nets.

But there's always another side to the story.

The Tricky Parts

Here's what can happen when these protections kick in:

• The founders' piece of the company might get a lot smaller, really fast

• Decisions that used to be simple now need approval from more people

• It can be harder to get everyone to agree on where the company should go next

And that's just the start. The founders might find themselves with less say in their own company — that's pretty tough when you're the one who built it from the ground up. You might have investors who want quick returns while you're trying to build something that'll last.

Long-Term Effects

This situation can really change how a company runs. When you need to get a bunch of people to agree on every big decision, things can slow down. And while investors usually want to see returns quickly, founders are often thinking about where the company will be in five or ten years.

If you're working with startup founders, it's good to help them think about all these angles before they agree to any protections. Sure, these tools can help keep investors happy, but they've got to work for everyone. It's like a balancing act — you need enough protection to make investors feel good, but not so much that the founders can't run their company anymore.

How Down Rounds Play Out for Investors

When a down round happens, investors split into two different groups — those who put in more money and those who don't. And the difference between these two can be significant.

Investors Who Jump In

If you've got clients who are active investors, they'll probably want to know about this part. Investors who put in more money during a down round usually try to get better terms. They might:

• Keep their ownership share (or maybe even get more)

• Push for "pay-to-play" rules that give them extra benefits

• Get first dibs on getting their money back through something called liquidation preferences

And here's something interesting — these liquidation preferences are getting more common. The latest numbers show that 8% of deals now include them, which is the highest it's been in ten years.

Investors Who Stay Put

But what about investors who don't (or can't) put in more money? Well, they might have a bit of a rough time. Even with some protection from anti-dilution rules, they could:

• See their ownership get smaller

• Lose some of their special rights if there's a pay-to-play rule

• End up behind new investors when it comes to getting money back

The New Investors' Game

New investors coming in during a down round? They've got a pretty strong position. The company needs money, and these investors know it. So they often ask for better deals — like getting 1.5× or 2× their money back before anyone else gets paid.

This can be tough for everyone else involved, but from the new investors' view, they're just trying to protect themselves. After all, they're putting money into a company that's having some trouble. And if you're helping clients invest in these situations, it's good to know that these terms are quite standard now.

For the VCs and other big investors, there's another angle too. They need to show their own investors (called limited partners) that they're making smart moves with the money. So they might structure the deal in a way that looks good on paper, even if it means asking for stricter terms.

How Down Rounds Affect Company Culture

A down round does more than just change numbers on paper — it can really shake up how people feel about working at a company. When employee stock options suddenly look less valuable, it's tough on everyone. And that's something you'll want to think about if you're advising companies going through this.

What Happens to Employee Stock

Here's a common situation: An employee has stock options they can buy at $5 per share. Then the company does a down round, and now each share is worth $3. Those options? They're basically underwater now. That's pretty rough for someone who's been working hard, thinking those options would be worth something someday.

But some companies are finding good ways to handle this. When Instacart had to cut their valuation in 2022, they gave employees more equity to make up for it. And Ramp did something really different — they let employees sell some of their shares during their down round.

How It Changes Things Day-to-Day

The situation can affect a company in a few different ways:

• When founders lose control, it can change how decisions get made

• Employees might start worrying about their jobs

• The whole vibe of the company can shift if people aren't sure about its future

So what can companies do about all this? Being really open about what's happening with the company and making sure people know their work still matters. 

It's not easy to keep everyone motivated when the company's going through tough times. But being straight with people and showing them you've got a plan? That can go a long way.

Smart Ways to Handle Down Round Negotiations

The game has really changed in 2023 and 2024. According to Carta's analysis, investors have a lot more power now, and they're getting better terms than we've seen in years. But that doesn't mean companies are out of options.

Getting Creative with Anti-Dilution Rights

Here's something that might surprise you — investors don't always stick to their anti-dilution rights. Sometimes they'll actually agree to reduce them or let them go completely. Why would they do that? Well, they know that if they push too hard, they might end up hurting the company they invested in. After all, if the founders and team get diluted too much, they might just walk away.

Making Everyone Play Along

A pretty common strategy is called "pay-to-play." It's a bit like telling investors, "If you want to keep your special rights, you've got to put in more money." If they don't join the new round, their preferred shares turn into common shares. That's a big deal because they lose some benefits, e.g., liquidation preferences and anti-dilution rights.

Working Out the Valuation

The valuation is always tricky in a down round. Companies try to keep it as high as they can, while new investors want it lower. But there are some creative ways around this. Sometimes they'll keep the same valuation on paper but give investors other benefits, like warrants or special preferences. These are called "dirty term" deals — they're not technically down rounds, but they give investors some extra protection.

Keeping Things Legal

And hey, there's more to think about than just the money. Companies need to be really careful about how they handle these deals. If board members have conflicts, they might need to step back from certain decisions. And it's usually a good idea to show that you looked for other options before taking a down round.

Right now, investors can ask for more because they know companies need the money. But you can still negotiate things like liquidation preferences or who's going to lead the round. The key is keeping things as simple as possible — the more complicated the deal gets, the harder it'll be to raise money in the future.

Getting the Right Help for Down Rounds

Venture capital deals can get pretty complicated, and that's why it's really important to have good lawyers on your side. If you're advising clients who are dealing with down rounds, they'll definitely want someone who knows these deals inside and out.

What Legal Teams Do

Good lawyers do more than just read through documents. They'll help write those anti-dilution clauses so they're totally clear and work the way they're supposed to. They'll also make sure everything follows the rules — that's important because you don't want any legal problems popping up later.

And when it comes to negotiations? Having someone who's done this before can be a game-changer. They know what's normal in these deals and what's asking too much.

Working with the right professionals can make a big difference. They'll help founders keep as much control as they can while still getting the money they need. And that's essential when you're trying to keep your company growing.

Final Thoughts

Down rounds are getting more common, and the deals are getting more complex. Between all the different protections, negotiations, and ways to structure these deals, there's a lot to think about — whether you're investing in startups or running one.

Having someone who knows the ins and outs of these situations can help you see angles you might miss on your own. If you're working with startup investments or advising clients who do, you might want to talk with a financial advisor who specializes in this area.

Modern technology has made it easier than ever to find advisors who get the complexities of venture capital and down rounds. Through platforms like FINNY, you can connect with financial advisors who might offer guidance specific to your venture capital and startup investment questions.

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