March 7, 2012
Heads or tails: Does it make sense to bet on down rounds?

I was doing some data mining in our database of New England venture transactions (see Foley Hoag Venture Perspectives) for reasons completely unrelated to the topic I am about to address and inadvertently stumbled on this topic.  Let me start by saying that we are all prisoners of our own experience.  Probably there are people out there with a different experience, but in my experience down rounds happen because companies have started a downward spiral and it is just a matter of time and a certain amount of swirling before they get flushed by their investors.

It does not seem to matter what the articulated reason for the loss of valuation – market conditions, ineffective management, too early to market, too late to market, technology challenges, long adoption cycles, etc. – in each case one down round leads to another.  With each successive down round the common holders (and option holders) become more and more diluted and demoralized.  Key players start to leave.  Vendors are not paid and they put the company on COD terms.  These things all slow product development and sales and also harm morale.  Eventually the CEO is replaced (perhaps the entire team) and the new team is faced with the almost impossible task of bringing Lazarus back from the dead.

If this observation is really true, even in just a majority of cases, why would anyone ever invest in a down round?  The investor would simply be throwing good money after bad.

There seem to me to be a lot of reasons potentially at play:  The original investment thesis still seems good.  Investors and management (let alone founders) remain enamoured of the business.  Investors are not eager to admit to their limited partners that a mere 12 months or so after they put a large wad of cash into the business there is a total write off.  Investors are afraid that the next guy will pull off a miracle and make the business a success as a result of which they will look like they bailed too soon.

Well, here are some facts.  We sorted our database of venture capital transactions in New England  first by searching for companies that had follow on rounds since 2008.  We then looked at the follow on rounds to determine how many were up and how many were down.  About 71% were up and the other 29% were down.  We then searched the down rounds to see which ones had a subsequent round of financing (13%, as opposed to 49% of the up rounds).  Out of the financings that followed a down round, 30% were up, 15% were down, and the rest (55%) were even. On average the “up” rounds were up by about 56% from the down round price.

While the sample size is relatively small, the data shows that down rounds are much less likely to be followed by another round of financing, at least within the 2-year period we’re looking at. If they are followed by another round, there’s a good chance (85%, according to our data) that it will be an even or up round.

 Assuming you made equal bets across all down rounds and only 4% of the down rounds had follow on up rounds, that 4% would have to return a lot more than 56% you to break even on the portfolio portfolion of down round securities.

Now, among other things, this analysis does not account for (1) the possibility that some of the up rounds will improve even further over time or that some of the down rounds will return something, (2) the time value of money, or (3) a host of other factors that are of lesser importance but not of no importance.  Nonetheless, it does suggest that investors would be far better off betting on the flip of a coin than on a down round.

Dave Broadwin is a Partner with the Emerging Enterprise Center at Foley Hoag.  You can find this post, as well as additional content on the Emerging Enterprise Center Blog.  You can also follow Dave (@broadwin) on Twitter by clicking here.