A Down Round Is Not an End Point: What Founders Should Do Next

Down Round Valuations: Causes and Solutions

The venture funding environment has changed. After years of sustained growth, market data from 2023-2024 shows that venture funding cycles have tightened, forcing many founders to consider a funding round that once seemed unthinkable: the down round. Raising capital at a lower valuation than your previous round introduces a unique set of challenges that go far beyond the numbers in a spreadsheet. It impacts your relationship with early investors, the motivation of your team, and the market's perception of your company's trajectory. Successfully navigating this period requires a strategic approach to managing your cap table, rallying your employees, and controlling your company’s narrative. This is not about rescue, but about recalibration for the next stage of growth.

First, Understand the Mechanics of a Down Round

A down round is simply the sale of new shares at a lower price per share than in a previous financing round. This typically happens when a company's valuation drops due to challenging market conditions, missed operational milestones, or a necessary shift in business strategy. The immediate financial implication is dilution for all existing shareholders, but the complexity lies in how that dilution is distributed across the cap table. Early investors are often protected by anti-dilution provisions, which are clauses in investment agreements designed to protect their ownership percentage if the company raises money at a lower price in the future.

Understanding these provisions is the first critical step for any founder. There are two primary types you will encounter. The most severe is “Full Ratchet” anti-dilution, which reprices all of the earlier investors’ shares to the new, lower price. This mechanism provides maximum protection for the investor but can be devastating for founders and employees. A more common and founder-friendly version is “Broad-Based Weighted Average” (BBWA) anti-dilution, which adjusts the conversion price based on a formula that considers the number of new shares being issued and their price. The reality for most Seed to Series B startups is more pragmatic: you will need to model these scenarios in a spreadsheet to see the real impact on your cap table before starting any investor conversations.

How to Handle Down Rounds as a Startup: Managing Your Cap Table

Your first challenge in a down round is managing the cap table and the expectations of your existing investors. The specific type of anti-dilution protection they have will dictate the starting point for your negotiations and determine the severity of the dilution to your own stake and the employee option pool.

Understanding Anti-Dilution Protection Mechanisms

Full Ratchet provisions are extremely punitive to founders and employees. By resetting the conversion price of all previous preferred shares to the new, lower price, it massively increases the share count of protected investors. This concentrates the dilutive impact almost entirely on common shareholders, which includes founders and employees. While highly investor-friendly, this approach is less common today because it can cripple a company's future financing options and destroy team morale.

Broad-Based Weighted Average (BBWA) is a more moderate and widely accepted method. It adjusts the conversion price using a formula that accounts for all outstanding shares, effectively spreading the dilutive impact more evenly. While it still results in significant dilution for founders, it is far less destructive than a full ratchet. It is considered a more equitable solution that protects early investors without jeopardizing the company's long-term health.

Proactive Investor Negotiation Strategies

What founders find actually works is proactively modeling both scenarios and approaching investors with a clear, well-reasoned plan. Your primary goal should be to negotiate a waiver or an amendment to the existing anti-dilution terms, especially if you are facing a Full Ratchet provision. You can argue that a less punitive structure is better for the long-term health of the company and, therefore, all shareholders. A healthy cap table and a motivated team are essential for generating a return for anyone.

When opening this conversation, be prepared. Here is a brief example of a negotiation script for requesting an anti-dilution waiver:

"We’ve modeled the impact of the current anti-dilution terms, and a Full Ratchet would significantly harm the employee option pool and our ability to attract future investors. We believe a shift to a Broad-Based Weighted Average formula, or a complete waiver for this round, allows us to bring in the necessary capital while keeping the team motivated and the company structured for a future exit that benefits everyone. We’re asking our partners to invest in the long-term health of the cap table."

Another powerful tool to consider is a “Pay-to-Play” provision. This requires existing investors to participate in the down round to retain their anti-dilution rights and other preferential terms. This aligns interests by encouraging those who believe in the company's future to contribute new capital. It effectively prevents passive investors from benefiting from protections without sharing in the new risk, ensuring that only committed partners influence the company's direction.

Retaining Talent After a Down Round: Addressing Employee Equity Dilution

One of the most difficult parts of how to handle down rounds as a startup is managing team morale. A lower valuation means many employee stock options are now “underwater,” a term used when the option's exercise price is higher than the current fair market value of the shares. When this happens, these options lose their power as a retention and motivation tool, creating a significant risk to the business.

To address this, companies generally have two primary solutions: an option repricing or issuing top-up grants, also known as refresh grants. According to Carta, in market downturns, a significant percentage of companies facing down rounds explore option repricing or refresh programs to retain key talent. The right choice depends on your company's specific circumstances, including accounting complexity and desired employee perception.

Solution 1: Option Repricing

An Option Repricing directly lowers the exercise price of existing underwater options to the new, lower fair market value. For example, an employee holding 10,000 options at $2.00 per share would see them repriced to the new value of $0.50 per share. This is often the simplest solution for employees to understand as it restores the potential value of their original grant. However, it can come with significant accounting complexities, potentially requiring variable expense treatment under US GAAP. For UK companies, similar considerations apply under FRS 102.

Solution 2: Top-Up Grants

Top-Up Grants involve issuing new equity grants at the current low valuation, leaving the old underwater options in place. In the same example, the employee might receive an additional 10,000 options at the new $0.50 price, bringing their total to 20,000 options. This is often administratively simpler and cleaner from an accounting perspective. The downside is that it is more dilutive to the overall cap table and can feel more complex to employees, who now hold two separate grants with different terms.

Critically, these actions have direct accounting and legal consequences. For US companies, the fair market value of shares for employee stock options is determined by a 409A valuation. A new 409A valuation is required after the down round to set the new, lower exercise price. Consulting with your accountants and legal counsel is essential before deciding how to handle employee equity dilution, as the rules under US GAAP and FRS 102 are specific and unforgiving.

Managing Down Rounds by Controlling the Narrative

The final challenge is managing the story you tell about the down round. A startup valuation drop can be perceived externally as a signal of failure, impacting your ability to hire talent, sign partners, and attract future investors. Your job as a founder is to frame it as a strategic recapitalization for growth, not a rescue round. This process begins with clear internal communication before extending to your external stakeholders.

Internal Communication: Transparency and Trust

Be transparent with your team about the valuation change, but immediately pivot to the positive outcomes. Explain that you have now secured the capital needed to extend the runway, hit critical milestones, and achieve the company's long-term vision. Crucially, explain how you are addressing employee equity to ensure they share in the future upside. A scenario we repeatedly see is that founders who communicate openly and confidently retain their team's trust and commitment, turning a moment of uncertainty into one of renewed focus.

External Communication: Strategy and Opportunity

With external stakeholders, the message should be similarly strategic. For existing and new investors, focus on the operational progress you have made despite market headwinds. Highlight that the new valuation creates an attractive entry point and that the fresh capital will be used to accelerate growth in specific, well-defined areas. For an E-commerce startup, this might mean investing in inventory and marketing for a promising new product line. For a Biotech or Deeptech company, it means funding the next crucial R&D phase to reach a key inflection point.

Your narrative should consistently answer the question: “Why is this a smart investment now?” By focusing on the future and the opportunity the new capital unlocks, you can mitigate the negative perception of a down round and reposition the company for success in a corrected market.

A Founder's Checklist for Navigating a Down Round

Navigating a down round is a test of leadership, strategic thinking, and operational discipline. For founders at the Seed to Series B stage, often without a full-time CFO and relying on tools like QuickBooks or Xero, a pragmatic, step-by-step approach is crucial.

1. Model Everything First: Before initiating any conversations, use a spreadsheet to model every possible scenario. What is the precise impact of a Full Ratchet vs. a BBWA provision on your cap table? How does a top-up grant program affect your fully-diluted share count versus an option repricing? Knowing your numbers is the foundation of any successful negotiation.
2. Develop a Proactive Investor Strategy: Do not wait for investors to dictate terms. Approach them with a clear-eyed assessment of the situation and a proposed solution that balances their interests with the company's long-term health and the motivation of your team. Use tools like a Pay-to-Play provision to encourage participation and alignment among your investor base.
3. Choose Your Employee Equity Solution Carefully: Weigh the pros and cons of repricing versus top-up grants. Repricing is often better for morale and easier for employees to understand, but the accounting treatment under US GAAP (for US companies) or FRS 102 (for UK companies) can be a burden. Top-up grants are cleaner from an accounting perspective but are more dilutive. Consult your legal and financial advisors to make the right choice.
4. Craft and Control the Narrative: Communication is paramount. Frame the round internally as a strategic move that secures the company’s future and realigns the team for the next phase of growth. Externally, present it as a strategic recapitalization that positions the company to win in a challenging but more rational market environment.

A down round is not an end point. It is a financial tool that, when used correctly, provides the runway necessary to build a resilient, valuable company. By effectively managing investor negotiations, retaining key talent, and controlling the narrative, you can turn a challenging fundraising moment into a solid foundation for future success.

For fundamentals, see Valuation Basics.

Frequently Asked Questions

Q: What's the difference between a down round and a flat round?
A: A down round occurs when a company raises capital at a lower valuation than its previous funding round. A flat round, by contrast, is when a company raises capital at the same valuation as its previous round. While not ideal, a flat round is generally perceived more favorably than a down round as it signals stability rather than a decline in value.

Q: Can a down round ever be a good thing for a startup?
A: While challenging, a down round can have positive outcomes. It can reset expectations to a more realistic level, making it easier to achieve a valuation increase in the next round. It also provides an attractive entry point for new investors and a chance to reprice employee options, which can powerfully remotivate a team for the next phase of growth.

Q: How should I explain a down round to my team without causing panic?
A: Be transparent, direct, and forward-looking. Acknowledge the lower valuation but frame it as a strategic decision to secure the company's future. Immediately follow up with your plan to address their underwater options and emphasize that the new capital gives you the runway to achieve key goals, creating future value for everyone.

Q: Do all early investors have anti-dilution protection?
A: Not necessarily, but it is a very common feature of venture capital term sheets, especially for preferred stock issued in priced equity rounds. Simpler investment vehicles like SAFEs or convertible notes often have different mechanisms. Always review your specific investment agreements to understand what rights your investors hold before negotiating a new round.