Down-round protection is a term that is frequently seen in equity financing term sheets. The good news is that if everything goes as planned for your startup, this term has no effect. However, in the event that things don’t go as planned and your venture decreases in value between rounds of financing this term can kick-in and really punish the founders.
At the highest level, this term means that if the valuation at a round of financing (pre-money) is lower than it was at the previous round of financing (post-money), the investors from the earlier round get “made whole” by getting more stock issued to them. With the founders getting what’s left over — resulting in the founders accruing all of the decrease in valuation. For some examples and more conversation on this topic, keep reading below!
What Is a Down-Round?
First, what is a down-round? A down-round is something to be avoided like the plague if you’re an entrepreneur. It occurs when you set a valuation at one point in time and then have to reset the valuation lower at a later date. Essentially, it means you have destroyed value in your company between two points in time (at least in the eyes of your investors).
The concept behind down-round protection for investors is pretty simple. If they give you their money based on an agreed upon valuation and then at a later time your company is worth less money than when they invested, one of two things happened (from their perspective).
1) You took their money and used it so foolishly that you actually decreased the value of the company
2) The valuation that was agreed to in the first place was too high.
Of course, there are lots of other things that lead to a down-round and in most cases the founding team has not been sabotaging their own ship — but that’s not really the point here.
If down-round protection is included in the terms of the earlier of two financing events, the founding team takes a disproportionate share of the decrease in value. In this tool, we’ve modeled the most onerous type of down-round protection to illustrate the concept clearly, but in practice there is usually a formula included in the terms to define just how disproportionate the founding team’s hit is. Mechanically what occurs is that the investors get issued more stock — so, while in this tool you can create a scenario where the founder’s stake is negative, that is really only to make a point…in actuality, you would own the same number of shares, your investors would just get issued more shares so that you get heavily diluted. And of course, your shares would be worth less.
Try setting up a scenario where the pre-money in round 2 is less than the post-money in round 1 — then toggle the down-round protection check box. You’ll quickly get a feel for how this works and how it adversely affects the founder(s).