Niklas Zennström: we need to talk about down rounds

I’m expecting to see a lot more down rounds in 2023. Data shows an uptick in such rounds in Q3 this year (capital  raised at a lower price per share than a previous fundraise) with almost 19% of all European VC funding now fitting this criteria. This is up from 12% in Q2, and the trend is continuing into Q4.

Until recently, the European technology ecosystem seemed on the verge of minting multiple $100 billion companies, making today’s bear market valuations an especially bitter pill to swallow. Not only are there implications for early shareholders, down rounds can be perceived as a negative reflection on the business itself. Company A seems to have a great product and is growing fast - so why is it worth less today than a year ago? 

Context is essential. Valuations are fluid and often say more about the wider market and competitive dynamics than a given company’s business performance or true potential. 

In a buoyant market for instance, the sceptics have a point. If all the boats are rising, it doesn’t look so great when you’re lagging by the shoreline. But that’s not what’s happening right now. The economic slowdown has spread beyond the public markets, and technology investment in Q3 is around 40% down on the same period in 2021. At series A, pre-money valuations have fallen by as much as 62% from their highs earlier this year, and series B is 57% down. Even firms with exceptional growth could find themselves with one fewer zero on their term sheet. There’s little to suggest valuations will change in 2023. 

In this environment, down rounds aren’t an automatic indicator of a failing business. They’re just economics in action - an unfortunate reality of scaling a company through a volatile and uncertain market.

 As an entrepreneur and an investor I’ve seen the practical impact of a market downturn from both sides. We started Skype in 2003, in the aftermath of  the dotcom crash. It was a down market and we couldn’t raise money to grow, so we started as a bootstrap. After going out to the market we raised just one $100,000 cheque, which even back then wasn’t a huge sum. We stretched that funding as long as we could, and when it ran out there were lean times. Often we weren’t sure how we’d make payroll, but we always found a way. We stayed alive until our company started building momentum and the market improved. 

Founders right now are facing similar choices, wondering if it’s better to make cuts, slow growth and create a more sustainable balance sheet, or raise at a less satisfying valuation and continue rapid expansion.

The right approach depends on the company, their balance sheet and goals. There’s no one size fits all, and these are hard choices - albeit with reason to be optimistic. I’ve written about some of that before. But today I want to address down and flat rounds in particular. Even in the current market down rounds have a stigma attached. Not only is this nonsensical but, in my experience, potentially fatal.

When a founder is raising money, they should aim to talk to a variety of quality investors with the experience to support their mission for the next phase, and ideally, to secure term sheets from several of them. Even in the current market, Europe’s evolved investor base means founders with solid missions and financials have the pick of future partners. There’s plenty of capital available, with $84 billion sitting with European venture and growth investors, ready to be invested. It’s just the more opportunistic ‘tourist’ investors who have vanished. 

But because down and even flat rounds have a stigma attached, founders can be tempted to put off fundraising plans in the hope the market will improve. For a company that is pre-profit, that means eating into future runway (the number of months left before the firm runs out of money). And the less runway a business has, the riskier it becomes. In just six short months a start-up’s fundraising prospects can shift from having a choice of clean term sheets from supportive investors, to rescue financing littered with aggressive liquidation preferences and exit clauses. This creates a misalignment in vision - with later investors less incentivised for long term success. That’s not a situation anyone wants to be in.

And to consider the alternative. A well executed down or flat round, way before the point of no return, could prove a masterstroke. Any founder with the courage to raise money early, on clean terms, can continue to scale at a time when others are slowing down and losing talent. This may be the single best time to hire great people away from the competition and consolidate one’s market position. Whether the market changes in one or three years, these firms won’t have stood still. 

Just look at any of the tech giants - all have weathered storms. In 2009 Facebook took a $5 billion hit in valuation in response to the global financial crisis. Google was founded in 1998, and almost immediately experienced the dotcom crash. Despite the abundance of caution the crash brought, they consistently doubled down on growth. Talented engineers were looking for work, and Google was one of the few players left to fill the space. This downturn will bring market consolidation, and being well positioned to capitalise on that is no bad thing. 

You might be wondering about my agenda in making my thoughts public. Atomico has historically invested earlier, and hasn’t led many down rounds. Instead, we’ve seen founders struggle with these decisions years after Atomico's initial investment - and that tends to put us in the same boat as the founder.

The current cost of capital is aligned with 2020, suggestive of a pricing ‘reset’. The problem we see is that a combination of misplaced embarrassment and hope that the situation will change is preventing founders from raising at all. That means these founders stop building, and technology stops being developed. This paralysis could stop some amazing technologies in their tracks if we don’t kill the stigma.

For a down round to work, the raise must strengthen the partnership for the long-term in the interests of all stakeholders - founders, investors and the team. Today it’s about survival, but in the longer-term it’s about growth and opportunity. The founder and their team must be financially incentivised, and investors have to be thoughtful in the terms offered. Nobody should feel short-changed. 

Here at Atomico we see the reset as an opportunity for the whole European ecosystem. It can help Europe mature exponentially quicker by developing resilience, and long-term thinking unblinkered by hype. We can create a stronger ecosystem, founders and talent with perspective, and the maturity to weather less favourable conditions. With this comes consolidation of competitor firms into a smaller group of winners, who will grow faster with greater market share.

And perhaps we’ll come out of this period a little less focused on short-term valuations. Somewhere along the way we started to assign disproportionate  weight to early-stage term sheets. Valuation is an important metric, but sometimes we all need reminding that it’s only one measure of success. Ambitious companies with game changing products need time, and European tech as a whole is worthy of a much longer horizon.

Raising a down round is never going to be easy, but within Atomico at least, we’re detoxifying the term. Down rounds are just a moment in time. We think in decades, not months.