Whenever a startup company raises money, everybody involved hopes that it's an up round.
That was not the case for recent funding rounds at Foursquare and Jawbone, so there are likely more than a few frowns on the faces of executives, employees and legacy investors.
What's an Up Round?
In a financing "up round", new investors put money into the company at a higher valuation than previous investors. As a result, prior shareholders find themselves with the same number of shares but with each share being worth more.
The opposite happens in a down round. Additional shares are issued to new investors, but they pay less for them than prior investors did in the previous funding round. As a result, existing shareholders get an undesirable haircut on the value of their shares.
For prior investors and shareholders in a company, up rounds are desirable for obvious reasons; they increase everybody's net worth. But they are also good for the organization: with an up round, the higher the valuation, the less equity the company has to give away for any given investment amount.
What Happened at Jawbone?
Last week, Jawbone raised $165 million in new equity funding, as reported by Recode.net. But Jonah Comstock of MobiHealthNews notes that "the terms of the deal are peculiar in that they drop the overall valuation of the company by half, from $3 billion to $1.5 billion, but give employees a larger pool of equity, causing their shares to maintain value."
That sort of rejiggering of employee equity as part of a financing round is not uncommon. If employee share values drop too much, a company's top executives often quickly come to this conclusion: "I can make more by leaving this place and abandoning my shares than I can by staying."
I've been there, done that. At a startup I was at, my co-founders and I negotiated something similar to give us proper motivation to stay, after the economy tanked and our valuation plummeted.
Still, despite the employees surviving Jawbone's down round, it's not a good omen for their future prospects. It suggests that the promise of the company, as it was understood previously, is not as rosy as expected.
What About Foursquare's Valuation?
Same story at Foursquare. The New York Times reported this week that Foursquare raised $45 million in a new round, at a valuation that is roughly half the prior valuation of $650 million for a funding round in 2013.
The lower valuation suggests struggles at Foursquare, but there are alternative explanations for down rounds that are more macroeconomic. For example, it might simply be that the investors of a few years ago were irrationally optimistic, or that they were so loaded with cash to invest that they bid valuations up and overpaid for their investments in startups.
That's likely part of the story for Jawbone and Foursquare. The New York Times article notes that the investment in private companies dropped 30 percent in the last quarter of 2015 from the previous quarter.
"The short of it is, expect more down rounds," said Anand Sanwal, chief executive of CB Insights, the firm that calculated the decrease in private company financing. He told The New York Times that "you might be able to raise, but not at the valuation you might have gotten even just a year ago."
Key Takeaways for Company Owners and Founders
Many company founders don't fully understand the basics of business valuation. For you entrepreneurs and business owners out there, there are a few lessons to learn from these down rounds at Foursquare and Jawbone:
- Know What Your Business Is Worth - If you own a business, it's a good idea to understand what it's worth and get a valuation report regularly from a qualified valuation company. If your business is complex, or you want a precise valuation, hire a valuation expert or consult with a business broker or investment banker. If you just want a ballpark valuation and your business is of a common type and structure, I recommend BizBuySell.com's business valuation reports.
- Make Decisions That Increase Organizational Value -- There are many drivers of your company's valuation and you need to understand them. As part of getting a professional valuation, you'll learn more about these value drivers. Larry Van Kirk, managing director of Valuation Research Corporation, recently said in a Private Company Director interview that "after performing a standard valuation, we are often asked to speak to the board to discuss the drivers of value and steps that could enhance value. For example, if the board is considering an expenditure for a new piece of equipment, it may want to consider the impact on cash flow and, ultimately, value." Every decision you make can impact your valuation.
- Get the Money While You Can -- It's tempting to take as little outside investment money as you think you can get away with. With that strategy, founders keep more of the company and reap huge rewards if the company valuation soars without requiring more funding. But, in a hot market, my recommendation is to take as much money as you can get if investors are foaming at the mouth to bid up your valuation. Reality takes a harsh toll on hockey-stick projections, and having cash in the bank to weather the storm without having to go through a series of down rounds in a beautiful thing.
- Treat Every Dollar as Precious -- Startups get amazingly stupid when they are flush with investor cash. If being frugal and smart with your expenditures is what got you to the point where you can raise a lot of money, then don't abandon that important strategy of being a tightwad. Investors will pressure you to spend. Ignore them. Say things like this: "Really? Advertise in airports? That would be so stupid. We need to improve the product more so it earns the business it deserves. I'm not wasting our war chest on that. The answer is No!"
- Be Wary of Completely Unrealistic Valuations -- Forbes contributor and newbie startup CEO Chris Myers explains how a high valuation in his company's initial funding round had negative repercussions later. Companies interested in buying his company were valuing his firm at a lower valuation than that of the prior investment round. That killed the deal, even though Myers wanted to process. "The investors who joined us in our most recent round wouldn't accept a sale price that was lower than their investment price," he said.
Remember, in the end, the market will define your valuation.
Sure, you can play games with valuation. For example, I could get my brother to invest $1,000 in Gaebler.com at a $1 billion valuation, giving him one-millionth of the company. But that's not real.
No, in a real financing round or company sale, with adequate competition, the right market price will likely emerge. As a founder or owner, you job is to execute well on all fronts to drive that valuation up.
If you focus on running a great company and serving your customers well, you likely won't have to worry about down rounds.
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