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
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
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.
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The Pension Plan Protection Act of 2006 added to ERISA a new
section 408(b)(19), which provides an exemption for the
"cross-trading" of securities between accounts
managed by the same investment manager, subject to certain