If a company raises a round of equity financing, and then raises a new round of equity financing at a pre-money valuation lower than the last round’s post-money valuation, is it a down round? Yes. But what if it raises that second round at a lower pre-money, but at a higher post-money valuation than the previous round? In my opinion, that’s still a down round.
The frustrating thing is there is no clear definition written anywhere, so hopefully this clears up the confusion.
Why do I think it’s a down round? Because it means that the company has lost value since it’s last financing and won’t be more valuable again unless new cash is injected into the business. (Before any new cash is put into the business, it is less valuable than it once was. The definition of “pre-money” is the value before more cash is put in).
On July 2015: New Co. raises $1M at a $4M pre-money. Before this round, the company was worth $4M, but has received $1M more of cash, so is now worth $5M (the initial value, plus the new capital).
July 2016: The company has used its $1M of cash to create less than $1M of value (let’s say it used $1M to create $900,000 of value (that’s not a great return) — so it raises its next round at a $4.9M pre-money valuation.
If it only raises $50,000, it’s obviously a down round. The post-money would be the original value ($4.9M) plus the new $50k cash totaling: $4.95M. Every existing investor would own something worth less than before, and the new investor would own exactly her cost basis.
The confusion comes if the company raises more than the difference between the pre-money and the previous post-money. In this case, $100k, let’s say New Co. raises $1M.
That means the investors said: “The company used to be worth $5M, but after using its resources it is now only worth $4.9M. If I give the company $1M it’ll be worth the $4.9M it’s actually worth, plus $1M of cash so a total of $5.9M, but only if I give the company new cash. Before doing so it’s worth less than it once was.
Two important things happened:
(1) The company went from being worth $5M, to $4.9M and the only thing bringing it back to $5.9M is new cash. There are two moments in time: The time right before a new financing, and just after. Pre-Money describes before, and post-money describes after).
Only looking at the post-money valuations ignores what the company was worth after the last round of financing, and before the next. The pre-money describes what the value was just before the new financing.
In our example, the company was worth $5M, and then $4.9M when being evaluated by a new investor, and then is worth $5.9M once the money has been wired.
(2) Secondly, just like if only $50k had been invested, all existing investors own something less valuable except the new investor, who only owns the value of her cost basis.
Can The Share Price Be Lower After an Up-Round?
Yes — but only in the case where new shares are issued as part of the round via options, warrants, or some other event. These are often correlated or connected to the round of financing — but I think it’s important to note this is the only case where shares can be lower in price — and are not due to capital being injected, but to some other circumstance in connection to the round.
In that event, it is an up-round, because the company has become more valuable — but it means that existing investors own a smaller value than they once did before. So it’s not a great experience for those previously involved.