Down round
Also written Downround
A financing round priced below the valuation of the previous round — the event that triggers anti-dilution protection and re-prices every earlier investor's conversion.
In plain language
A start-up raises at Rs 400 crore. Eighteen months later the next round prices it at Rs 240 crore. That second round is a down round.
The workbook's definition is exactly that: a financing round in which the valuation of the company is less than it was in the previous round. It can happen because the company under-performed, or because external factors reduced investor confidence with nothing wrong inside the company at all.
It matters far beyond bruised feelings. A down round is the trigger event written into anti-dilution clauses, and when it fires, every earlier preference investor holding that protection converts at a better price — at the expense of the founders and of anyone without protection.
How it works
Chapter 10 arrives at the down round from two directions.
Milestone valuation. Venture investors often refuse to price off a forecast, because nobody knows when the company will be profitable. Instead the valuation is pegged to technical or commercial milestones set out in the business plan. Failing to meet a milestone does not automatically mean the investment disappears; it may mean a downward revision in valuation, a down round on the follow-on investment, or a delay in future investments.
Anti-dilution rights. The basic principle of the ratchet is that if there is a down round after the investor invested, the investor is compensated by converting their preference shares into equity at the lowest issue price the company has used. Two computation methods exist — full ratchet and weighted average — and full ratchet is always more favourable to the preference holder, because it converts at the lowest available price, while weighted average protects only part of the value.
There is also a blunter defence. A veto right on further share issuances lets the investor simply refuse to allow a down round, which the workbook describes as an alternative route to the same protection as a full ratchet clause.
Note the asymmetry: a pre-emptive right is a right, not an obligation. An investor holding one may decline to participate in the down round and still claim anti-dilution on the shares already held.
A worked example
A consumer fintech raises a Series A from a Category I venture capital fund:
| Round | Price per share | Pre-money valuation | Amount |
|---|---|---|---|
| Series A, March 2023 | Rs 400 | Rs 400 crore | Rs 80 crore |
| Series B, September 2025 | Rs 240 | Rs 240 crore | Rs 60 crore |
The Series B is priced 40 per cent below the Series A. That is the down round.
For the Series A fund holding 20 lakh compulsorily convertible preference shares at a conversion price of Rs 400:
| Protection held | Revised conversion price | Equity shares received | Extra shares |
|---|---|---|---|
| None | Rs 400 | 20,00,000 | — |
| Weighted average | say Rs 331 | 24,16,918 | 4,16,918 |
| Full ratchet | Rs 240 | 33,33,333 | 13,33,333 |
At the Rs 240 round price, the full ratchet is worth roughly Rs 32 crore of value to the fund, handed over by the founders and the unprotected shareholders through dilution.
Which is why the founders will fight hardest over a single clause in the Series A term sheet, two and a half years before anyone knows whether it will ever be triggered.
Why NISM asks about it
Chapter 10 (Investment Process and Governance of Funds), section 10.4.1 on milestone valuation — with the definition in the accompanying footnote — and section 10.4.3 on anti-dilution rights. Expect a definition question ("a round priced below the previous round"), a cause question (under-performance or external factors), and a link question connecting a down round to the ratchet.
Common exam traps
- A down round is about the price of the round, not the company's performance. External factors that reduce investor confidence produce one just as readily as a missed target.
- Failing a milestone does not cancel the investment. It may cause a downward revision, a down round or a delay — the workbook lists all three.
- Full ratchet always beats weighted average for the preference holder. Weighted average protects some of the value; full ratchet converts at the lowest available price.
- Anti-dilution compensates through more shares at a lower conversion price, not by a cash refund and not by cancelling the new round.
- A pre-emptive right is not an obligation. Declining to fund the down round does not forfeit the ratchet on existing holdings.
- A veto on further issuances can block a down round outright — the workbook offers it as an alternative to the ratchet, not as a supplement to it.
Check yourself
1.A "ratchet" protects the AIF from a future down round. State whether True or False.
- a)True
- b)False
Show the answer
Answer: (a) True
True. The basic principle on which the ratchet operates is that in the event there is a "down round" subsequent to the investor's investment, the investor will be compensated by converting the preference shares into equity shares at the lowest issue price by the company.
A down round is a financing round in which the valuation of the company is less than it was in the previous round, caused by adverse performance by the company and/or external factors that reduce investor confidence.
There are two methods of computing the revised price and conversion ratio:
- Full Ratchet - convert at the lowest issue price. Always more beneficial to owners of preferred shares.
- Weighted Average - the new conversion price is total consideration received from all issues divided by total shares issued till date. It helps protect some of the value of the preferred shares.
Why this matters most in VC deals: since investments are made in early stages, the investor looks for downside protection first and returns later, and the risk of over-valuation where the model rests on future growth is addressed more stringently in VC deals.
2.The essential difference between an affirmative right and a veto right is that:
- a)An affirmative right applies only to shareholders holding above 26 per cent, while a veto right applies to all shareholders
- b)An affirmative right requires the investor's express consent even where an ordinary 51 per cent resolution would suffice; a veto right allows opposition to an action even if it has the requisite majority
- c)An affirmative right is exercisable only at general meetings, while a veto right is exercisable only at board meetings
- d)An affirmative right is statutory under the Companies Act, while a veto right is purely contractual
Show the answer
Answer: (b) An affirmative right requires the investor's express consent even where an ordinary 51 per cent resolution would suffice; a veto right allows opposition to an action even if it has the requisite majority
Affirmative rights are corporate actions that require the approval of the investors irrespective of the extent of their shareholding. Even if an action can be accomplished through an ordinary resolution (simple majority of 51 per cent), an affirmative right means the business cannot be carried through without such shareholder's express consent. They are positive control - the power to influence corporate actions - and they create an obligation on the promoters and company to seek prior approval before taking decisions on covered matters.
In contrast, a veto right is to oppose a corporate action even if it has the requisite majority. It is negative control, or the right of an investor to say no as a defence to protect his own interests.
Veto powers are insisted upon in some of the same corporate actions as an alternative to affirmative rights. The workbook gives a neat illustration of the overlap: the full ratchet clause can be used even through a veto power on further issuances of shares by the company, so as to protect dilution of the investor's equity in a down round.
Neither right depends on a shareholding threshold - that is the whole point of them - and both are contractual, negotiated in the term sheet.
Where this is taught
Free preparation for NISM Series XIX-DRelated terms
- Anti-dilution rightsA special shareholder right to buy a proportional number of new shares when a company issues fresh securities, so the shareholder's existing percentage ownership does not shrink.
- Preference shareA share carrying a pre-defined rate of dividend, paid before any equity dividend, with priority over equity in return of capital on winding up — but normally no voting rights.
- Pre-money valuationThe estimated value of a start-up immediately before it receives external funding from a Category I or II AIF. Add the new investment to it and you get the post-money valuation.
- Post-money valuationA start-up's pre-money valuation plus the new money going in — the number that fixes what percentage of the company the incoming investor owns after the round.
- Non-participating liquidation preferenceA liquidation preference where the investor takes either the guaranteed multiple of its investment or its pro-rata share of the proceeds on conversion — whichever is larger, but never both.
- Weighted average anti-dilutionThe gentler of the two anti-dilution methods: the conversion price is reset to the average price of all capital raised to date, not to the lowest price the company has ever issued at.
- Non-binding Letter of IntentThe document a private equity fund gives a target after initial due diligence, proposing an investment amount, a valuation and a stake — none of which it is yet obliged to honour.
- Growth investingA common private equity strategy of taking a minority stake to help a company grow further — typically at the intersection of VC and PE, where the company is still growing but may already be profitable.
- Participating (double-dip) liquidation preferenceA liquidation preference under which the investor first receives its guaranteed multiple and then also shares in the remaining proceeds in proportion to its shareholding — paid twice, hence "double-dip".
- Sticky loan in venture debtWhat venture debt becomes when the borrower's fortunes turn: the lending AIF is left holding founder shares in a distressed company as collateral, and because they are untraded the loan cannot be readily recovered.
- Capitalization TableThe record of who owns how much of a company — every class of shares, each investor's stake and the employee option pool. An AIF's name goes on it when the shares are allotted.
- Equity KickerAn equity sweetener attached to a loan — warrants, preference shares or a right to convert part of the debt at an agreed valuation — usually up to 10% of the loan amount in Indian venture debt.
- Protective provisionsTerm-sheet rights letting a class of preferred shareholders — usually minority or preference investors — approve key company decisions such as new share classes, board size, dividends or dissolution.
- Automatic Conversion ClauseA clause that forces convertible debt or convertible preference shares to convert into equity when a pre-defined trigger occurs — a revenue level, a funding round or an IPO — unlike an optional conversion right.
- Bridge RoundShort-term financing that funds a company's working capital between two funding rounds, provided by banks, debt funds, venture debt funds or venture capital funds.
- Affirmative RightsInvestor protection rights under which specified corporate actions of an investee company need the AIF's express consent, whatever the size of its shareholding — described as "positive control".
- Liquidation PreferenceA right that, if the investee company is liquidated, the AIF's preferred securities are paid a set amount — its investment or a multiple of it — before other shareholders receive anything.
- Venture Capitalist MethodA start-up valuation method: estimate the company's value at exit, discount it at the VC's target return, and set the stake needed for the investment — adjusted upward for future dilution.
- Price of Previous Transaction MethodAn IPEV valuation method that marks an AIF's whole holding in a company at the price of its latest follow-on investment; a first investment is carried at cost until a follow-on reprices it.
- Milestone ValuationAn investor protection under which a venture investor pegs the company's valuation to technical or commercial targets in the business plan, so missed milestones can mean a lower valuation or delayed funding.
- Veto RightsAn investor's right to block a corporate action of the investee company even when it has the requisite majority — "negative control", as opposed to the "positive control" of affirmative rights.
- Pre-emptive RightAn anti-dilution right letting a shareholder keep its percentage holding by taking up its pro-rata share of any new shares the company issues in later financing rounds — a right, not an obligation.