As startup prices soared in the runup to last year’s Facebook IPO, entrepreneurs, investors, and tech observers sometimes griped about lofty valuations.

Just mention Foursquare, say, or LivingSocial, and they’d go off.

These are tech companies that snagged a lot of press and tens (or hundreds) of millions of dollars before solidifying their business models. Investors say they’re worth tons of money—but in the end, that’s a gamble, and the companies may actually be worth nothing.

After a few years of massive hype in the startup sector, absurd-sounding valuations are starting to correct themselves. Startups are confronting the prospect of raising "down rounds" from investors—or rounds of financing that value the companies at less than the previous round.

LivingSocial, for example, was once valued at $5.7 billion; it’s now worth a quarter of that, or less, depending on whom you ask.

But more often, down rounds happen at a far earlier stage, a result of too-lofty valuations assigned in initial financings. 

What happens when companies that were once worth billions of dollars suddenly find themselves worth much, much less? And why were they ever valued that high in the first place?

 

 

Down rounds can bring in much-needed cash that can give a company time to find a business model or turn things around. But they create complications for both past and future investors. And they are one of the most demoralizing things that can happen to a startup.

For a while, it was cool to start a company, and investors wanted to find the next Facebook.

Over the past few years, a lot of people have tried to become entrepreneurs. 

People who dreamt of running their own businesses left their 9-to-5 jobs in droves and convinced investors to throw millions of dollars behind their ideas.

Many of the businesses started were consumer-facing—things like photo apps and social networks that require a lot of people to use them to survive. They weren’t transactional businesses that make money when they sell something. And that was okay—a lot of investors encouraged entrepreneurs to build up their user bases before trying to generate revenue.

But when some of the biggest consumer Internet companies, like Groupon, Zynga, and Facebook, went public, their stock prices got slashed. Suddenly, these incredibly valuable companies weren’t worth as much money as the tech world initially thought.

Now, investors are spooked and they’re closing their wallets.

Because of the setbacks larger tech companies are facing, new companies are having a tough time raising money. Investors are closing their wallets, and startups are struggling to find the cash needed to keep themselves afloat while they figure out a way to make money.

This concept of investors getting pickier about the companies they fund is sometimes called the Series A crunch. Series A rounds of financing are usually the first true equity investments in a company.

The problem is that many startups get their seed funding as convertible debt from angel investors, with terms that essentially set a price on the company. Venture capitalists may be willing to invest—just not at that price. If they come in with an offer below that price, then the angel investors get rewarded with more of the company, squeezing the founders’ stakes.

That can cause friction between founders and investors. And if they can’t sort it out, often the only option is to sell the company cheaply or just shut down.

Back down to reality

A down round doesn’t doom a company. But employee morale takes a real hit, as David Cummings explains in a blog post.

To summarize: When companies raise tons of money at big fat valuations, everyone is excited. Savvier ones calculate the difference between the exercise price on their stock options and the implied value of company shares in the latest round.

When suddenly that big, awesome valuation is taken away, everyone is bummed.

"The risk of a down round is that employees are far less incentivized to work because the value of shares, potential upside opportunity, and general spirit of the company are all diminished," an investor tells Business Insider.

Investors have protections against down rounds. They’re typically issued new shares to make sure their stakes in the company aren’t diluted by new investors. But that has to come out of someone else’s proportional stake—typically founders.

Down rounds can make founders’ stakes in the company worth much less, if not entirely worthless. In some cases, their stake may become so diluted that the founders are better off leaving the startups for a new venture. Any time a founder departs, it’s a red flag for employees.

No one wants to raise a down round, but sometimes entrepreneurs don’t have a choice. When you raise millions of dollars initially, it can be almost impossible to gain enough traction to justify a higher valuation the next time around. In other instances, a startup’s burn rate may be too high, and entrepreneurs may be forced to hold out their hands to investors without much leverage.

Don’t get confused: Haircuts aren’t down rounds.

One important thing: Don’t confuse down rounds with the up-and-down reports of companies’ valuations as they’re in the middle of negotiating new financings.

Fab and Square are two examples of companies that appeared to accept slightly lower valuations in recent financings than what they’d initially sought. That’s called negotiating—companies want higher prices, investors want lower prices, and they typically meet in the middle.

But those investments were still done at a big increase to prior rounds—Fab tripled its valuation, and Square nearly doubled its valuation. Accepting a haircut from an initial negotiating position is smart business and doesn’t (or at least shouldn’t) have any negative impact on employee morale.

Twitter, likewise, has seen its value fluctuate between $8 billion and $11 billion in private transactions where small number of shares trade hands between investors. But because those are secondary transactions where the company didn’t issue any shares, they have no real effect on employees—their shares aren’t diluted, and their stock awards were typically issued at far lower prices anyway.

The hard choice.

For some companies, though, down rounds are on the table.

Foursquare was reportedly seeking a new round of financing, but investors were only willing to budge at a much lower valuation, in the $400 million range, instead of the $600 million–$700 million valuation Foursquare reportedly got when it raised $50 million in 2011.

On Thursday, LivingSocial’s CEO admitted the company is now worth under $1.5 billion instead of nearly $6 billion. (And there are questions about whether it’s really worth that much, given the hidden terms of its latest financing.)

Those are the more visible examples. Far more numerous are the companies that raised millions in seed funding from well-known angel investors only to quietly disappear, with the founders taking those 9-to-5 day jobs they were hoping to escape.

We’re going to see this happen more and more. It’s all part of the startup cycle. Some companies will survive. Some will try to get acquired.

Others will fail. And a lingering question will haunt them: Did they ask for too much, too soon?