The Damaging Psychology of Down Rounds

Mark Suster

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Yesterday I wrote a post about “proprietary dealflow for VCs.”

In the article I discussed the downside of raising capital at a too high of a price and referred people to a previous article I had written encouraging founders to raise “At the Top end of Normal” as opposed to stratospheric prices.

In the comments section Siqi Chen wrote a great question

“Whenever I hear advice about pricing a round too high for the next round, I can’t help but think: well, if the choice (ceteris paribus) is between

a) doing what is effectively a down round preemptively when I don’t have to, by underpricing my current round in this market vs

b) accepting the market price along with some risk of taking a down round in the future, if I don’t hit my milestones, why would I ever choose b)?”

Since it is a great question with a subjective answer I wanted to broaden the reach of my answer beyond the comments section. I would love it if other people would weigh in on the comments section below if you’ve had experiences with down rounds.

The Damaging Psychology of Down Rounds

There is an important psychology that exists in investments. I don’t make the rules so don’t shoot the messenger. But psychology DOES play a big role in investment decisions. Even when investors themselves might not realize it is at play.

The rule is, “Always be over-subscribed.”

What does that mean?

It’s far better to be raising $1.5 million and get $2 million in interest (or perceived interest) than to be raising $1.5 million and only manage to get $750,000.

“What’s wrong with them that they couldn’t raise their money?”

Damaging psychology. People want what they can’t have. They want what they must work to get. So if you’re not a sought-after commodity investors may avoid you.

I know it shouldn’t be like this. They should either believe in you and your business or not, but I promise you I’ve seen this type of behavior repeatedly over the past 15 years.

And what’s worse than being under-subscribed?

A down round. That’s why.

But why?

Well, a down round is even more complicated than having no demand for your investment round.

First, a down round sends a signal that something is wrong with your company. Something didn’t go to plan. And no amount of explanations, “we raised in a frothy market. We know that. You’re getting a great deal when we’ve made huge progress.” or whatever simply won’t erase the “something is wrong” psychology.

But here’s the kicker.

As has been pointed out by Dan Primack based on FLAG Capital data, there are fewer than 100 “real and active” tech VCs in the country. If we count seed funds and large angels maybe that number goes up by 2x?

Point is – it’s a small industry. Everybody knows everybody. And we think of it like a Prisoner’s Dilemma played in multiple games. Whatever I do now it going to affect my future deals.

Often that is a good incentive because it keeps VCs from screwing people over since a bad reputation or bad working relationships could cost you deals in the future.

But in this case it works against the founders. Many VCs would prefer to avoid having to cram down other VCs by investing at a lower price or even if it’s not a cram down they prefer not to invest in a down round that forces the VC to take a “write down” on their valuation sheets they should their LPs.

And most VCs are over-whelmed with deals. So given the choice of pissing off your VCs (and you) they simply give you a polite response and move on to the next deal (with less hair on it).

What can you do if you’re already in this situation?

I’ve written about this before. I always tell entrepreneurs, “Clean Your Own Shit Up First.” (before fund raising). It’s the one post where my wife actually complained I went too far in trying to come up with an authentic image to represent the post.

So what do others think? Have you been involved in companies with a down round? Has it been easier / harder than I describe?

Do you think there’s a case for not raising at too high of a crazy price either for psychology reasons or for restructuring reasons?

Psychology

Mark Suster

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