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Don't fear the down round: What HBO's Silicon Valley gets right and wrong about negotiating a lower valuation

By Dennis Keohane , written on April 17, 2015

From The News Desk

While the unevenness of the jokes in last Sunday’s season two premiere of HBO’s Silicon Valley, “Sand Hill Shuffle,” really can’t be debated, the viability of one of the episode's major plot lines definitely warrants further examination.

No, it's not the plot line about how plunking down your testicles on a conference room table will get you a better valuation. (Let's hope that's not behind the recent unicorn wave...Some of us have eaten lunch in those conference rooms.) It's the warning about taking too much money at too high a price. It's meant to be one of those incongruous moments where the show takes a break from predictable sitcom tropes and barely serviceable dick jokes that's supposed to show just how much the writers' really do understand how startups work in the Valley.

Near the end of the disjointed first episode, Richard (Thomas Middleditch) is approached by Monica (Amanda Crew) who urges him not to take the monster round of funding that's been offered to his startup Pied Piper, because it will overvalue the company and possibly lead to a dreaded “down round.” Richard later surprises the new managing director of Raviga Capital, Laurie Bream (Suzanne Cryer), by negotiating her offer of $20 million investment at a $100 million valuation down to $10 million at a $50 million valuation. (Which is, by the way, still pretty steep for a Series A led by a totally unproven team with a Google-equivalent trying to drive it out of business.)

The logic behind the move, as the Monica character succinctly explained, is that having too high a valuation and an overly large funding round can be more of a curse than a blessing for a company in its infancy. She points out that many companies have difficulty not only surpassing, but matching the initial price in a follow-on round. Especially if the first round is based off hope and hype and later rounds will have to be based on actual results.

What matters here is the valuation, not so much the amount raised. Everyone only keeps making paper wealth and feeling good if each milestone rewards the company with a higher price of what it's "worth." A so-called down round-- when the valuation decreases from a previous round -- gives the perception that a company is in trouble or even worse: A dead startup still coding. Startups are as much a mental game as anything else, and it's demoralizing to toil away for a year only to hear that you've somehow destroyed value in the thing you are creating.

The concern is not just psychological. Founders and employees' common stock can get "crammed down" at the expense of preferred stock. In the wake of the dot com bust, a company would become so crammed down that VCs wound up owning nearly all of it. Several VCs had to create new pools of options just to keep anyone incentivized.

All of this demoralizes a team just as much as the founders and can lead to a very real risk of top talent jumping ship to a place where their equity actually grows. Even if a round is flat, shark-like competitors could use it to their advantage when recruiting talent.

Down rounds have very real implications for VCs too: The earlier investors' stakes can also get diluted, which gives a firm who jumps in on a down round more value for the same equity at a lower cost. Early stage VCs have a big problem with investors coming in later, taking less risk, and getting a cheaper price. So much so, that it could sour them on continuing to participate in later rounds. The intra-VC squabbling could tank a deal when the entrepreneur just needs cash in the bank to meet payroll and keep going.

Monica's advice isn't without merit given the incredible dysfunction of Richard's team -- and perhaps it arrived in the script courtesy of some of the real venture capitalists listed as advisors to the show, like Greylock's David Sze or Cowboy Ventures founder Aileen Lee.

The question is: Hidden in the absurdity of the show, is there a genuine lesson here for entrepreneurs?

As the show ended Sunday night, a few VCs and entrepreneurs in the Valley did what VCs and entrepreneurs in the Valley (still) do and hit up Quora to see if others had actually seen this play out in the wild. Several responses said that, certainly, mentors had advised entrepreneurs that valuation isn't everything, and sometimes a lower price is a better deal. What stretches the boundaries of credulity, though, is an inexperienced founder actually demanding a deal with the same firm at half the price and amount.

Leo Polovets, of SF venture firm Susa Ventures, kicked off the debate, stating, “I haven't heard of founders literally negotiating lower valuations, but I've seen people take lower valuations either because they prefer the firm offering a lower valuation, or because the higher valuation sets up unreachable expectations.”

A founder picking the lower of two term sheets isn't that uncommon. Many top firms refuse to get into a bidding war, assuming their brand names will win anyway even with a lower price. In fact, at our PandoMonthly three years ago, Elon Musk told the story about being faced with this very dilemma. He said he ultimately regretted taking the higher priced deal for Tesla from Vantage Point Venture Partners, rather than a lower bid from Kleiner. Although, it wasn't totally Musk's fault: He said he would have if John Doerr joined the board and Doerr demurred. Perhaps he wanted Ray Lane to "get a win." Instead Kleiner backed Fisker. (It was a rocky few years for Musk, but he certainly came out of it better than Ray Lane or Fisker...)

But there's a difference between not prioritizing valuation above everything else, and actually asking the same firm for less. To get some more specific answers, Pando abandoned Quora and went directly to several major VC firms to ask if any companies had ever proactively negotiated a lower funding round. According to venture capitalists from CRV, Atlas Venture, Accel, Founders Collective Sequoia, First Round, and several others who wouldn't go on the record, that's pretty rare. So rare that we may have to come up with another mythical beast to describe it.

The closest we came were reports of startups who felt what was offered was fair and simply chose not to negotiate up. Although the fear of a down round in a follow-on is real, it's not so frightening that companies would actually negotiate a term sheet down.

And, really, that's as it should be.

As described above, a down round can certainly be bad. It can lead to death. But that's not the same as actual death. "Round" implies cash is still coming in, and that's all a company needs to fight another day. Two recent examples that worked through down rounds in the past are Veracode and Bit9 who are expected to IPO this year. Ben Horowitz details at length how he pulled one-time-darling Loudcloud/Opsware back from the brink of investor malaise and near bankruptcy in the wake of the dot com crash to sell for $1.6 billion.

Companies do however go under from running out of cash. So any fate that avoids that should ultimately be prioritized against the potential evils that too much cash at too high a price can cause.

Add to that the fact that founders-- particularly young, first time founders that the Valley is chasing after with fists full of cash-- typically believe they are bulletproof. They all overstate what their real "worth" is and no one thinks the downround is gonna happen to them. That's why they do something as nuts as starting a tiny company with no experience that's going to go up against Hooli... er, Facebook, Google, or Apple. "In my experience, founders are typically optimists (and often have a high degree of confidence in their ultimate success - whether justified or not)," First Round's Josh Kopelman said via email. [Disclosure: Kopelman is a Pando investor.]

Two things kill a company and two things only: Running out of cash or the founder giving up. There's a difference between near fatal and fatal.

And as Stewart Butterfield explained in our February PandoMonthly, gaudy "arbitrary as fuck" valuations do have benefits like recruiting talent, signaling staying power to customers, and stopping any smaller acquisition entreaties before they start.

That said, it's fitting that the specter of down rounds entered the show, because they are starting to enter the collective Silicon Valley consciousness as worries grow about the unicorns, deca-corns, and mini-corns. (I just made that one up. Let's say it's a company in the $750m-$1b valuation range. An aspirational unicorn, if you will.)

We should note that it benefits VCs to warn about the  risks of a down round. Investing at a lower price has obvious VC benefits, as does making sure their stake doesn't get crammed down later on by even crazier terms.

Which raises another interesting point about the show: Mike Judge and crew seem to be the only people in popular culture more sympathetic to VCs than to entrepreneurs. Personality quirks aside, the VCs like Monica seem to be the level headed moral compasses of the show, and the ones riding to the rescue with a check to bail Richard out when he listens to his idiotic "mentor" and dysfunctional team.

In season one, Peter Gregory seemed insane waxing on about sesame seeds and Burger King until the episode later revealed he was making a genius contrarian investing move. He wasn't stupid or hapless-- just quirky. Even in scenes where he was riding away in his tiny smart car and wearing his toga, he was revered as a genius investing God who could solve problems with the stroke of a pen. He'd just look weird doing it. VCs are mostly angels on the shoulder of Richard, while chaotic, inept Erlich nearly tanks the company week-on-week, and Gilfoyle and Dinesh waste time squabbling over girls and titles. Richard can -- at most-- be described as well meaning.

A cynic might wonder if all these lovable, brilliant VCs are another refelction of the number of VCs acting as advisors to the show's writers.

Whatever the reason, the fact that the show is so pro-VC means it's not a huge surprise that the writers have more sympathy for a VC's point of view on funding terms as well. We look forward to next week's thoughts on liquidation preferences.