Why Silicon Valley Is Deathly Afraid of Down-Rounds

By Markets Fool.com

The start-up scene is, in part, defined by excitement and possibility. What happens when that excitement dies?

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In this clip from Industry Focus: Tech, Dylan Lewis welcomes Chris Hill to the show to talk about down rounds -- what they are, and why they're one of the worst things that can happen to a start-up owner.

A full transcript follows the video.

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This podcast was recorded on Aug. 5, 2016.

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Dylan Lewis: One of the big things they touch upon in the show, Richard meets with a friend who had his own start-up, things didn't really go particularly well for him, is the idea of a down round, and the fear of a down round. Chris, do you want to touch on that a little bit?

Chris Hill: Yeah. It's yet another thing they do that they get right on the show. A down round is simply, you do your series A financing, you have an implied valuation of X. If you do another follow up round, and the valuation of your private company drops, first of all, it's such a catastrophic sign. You can just tell, in the scene where they're having that conversation, it's the worst possible thing that can happen outside of a tragic accident of some sort.

Part of what's exciting for companies at this stage, when they're private, when they're growing, is the excitement around it. It's a great scene where they're going to all the meetings on Sand Hill Road, and you can just see that Richard and Ehrlich are the two characters of the show, the two main drivers of the business -- and we'll get to business leadership in a second -- you can see, they have this strut in their step, because they know they're in the driver's seat. Everybody wants to invest in their company. If you have a down round, it's the exact opposite. You're going hat in hand to all these VC firms, trying to convince them that you're still worth investing in, and you have no leverage whatsoever.

Lewis: Yeah. It's kind of the kiss of death in a lot of ways. You think about a publicly traded company that has a really poor earnings report. It's like, OK, they've had years of success. There's an ebb and flow with that business, but we know in general, things are going pretty well, and they're on the up-and-up. A down round is like, this is the second time we've gotten a glimpse at this company's valuation, and some of their growth metrics, and they look terrible. You don't have that nice, steady backlog of success that you can point to. It's much more volatile and much more disruptive, and that's why it can be particularly difficult for companies in that space. That's why you want to see that nice, steady climb up. In the show, they even allude to, "I could have taken less money and set my expectations a lot lower." And that's ultimately what they wind up doing -- they shun an incredibly high valuation for the same amount of equity but less money so they can give themselves more realistic growth targets. That was actually a suggestion that came from Marc Andreessen. We talk about some of the research they do on the trips they go on before each season to get ideas for the writers' room. That's something he proposed, like, "Yeah, someone could do that, if they wanted to." I've never seen it in the world, but I think it's kind of interesting.

Hill: It's got to be pretty heady. It's got to be really hard to be sitting across the table from someone who is saying not only, "Here's how much money we're going to give you, and, by the way, this means, the company that you have built is now worth $100 million, $200 million." It's hard not to be seduced by that, and to walk away and say, "You know, it's actually better for us in the long run to take a breath, go slow, get greater control over the company, and pass up a huge amount of money."

Lewis: Yeah. I wonder if that's something that might happen, reality and fiction blending together. Maybe some entrepreneurs will take that advice.

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