What happens to employee equity in a down round?

News headlines have shifted from sharing tales of record-setting funding rounds and IPOs to tracking plummeting valuations.

After investors poured record-breaking amounts of money into tech companies in 2021, inflated valuations started bursting the following year, resulting in valuations and multiples dropping dramatically.

Many founder and leadership conversations have changed from "How much can we raise?" to "Can we raise?". With investors holding on to their cash more tightly, tech companies seeking funding are confronting the prospect of raising at a lower valuation than in previous fundraisings – the dreaded ‘down round’. 

With more down rounds ahead of us, employees need to understand the consequences of a down round for their equity.

 Down rounds shouldn’t be a cause for panic

A down round is never an appealing prospect. But especially in market corrections, down rounds don’t necessarily mean the outlook is all bad. After all, one down round doesn’t mean the valuation will never grow again. 

What’s important is that companies are transparent with employees about whether a down round is coming up, and how this will impact their equity.

The bad news for the team is that some employees’ equity might be ‘underwater’. This means that the price they’ll pay to exercise their share options is higher than the value of their equity stakes. If you exercised your shares in this context, you might lose money.

But this negative outcome would only apply to those employees that joined and were awarded equity between the last funding round and the latest down round. 

Any employees who raised earlier at a lower valuation would still be ‘in the money’. And any ‘loss’ isn’t crystallised unless those employees sell their shares, which would not normally happen without a liquidity event like a public listing, merger or acquisition. So being underwater isn’t ideal, but it’s not necessarily cause for alarm. 

What might make a difference to someone’s financial outcome is the length of time employees get to exercise their options as and when they leave the company. More and more, companies are adopting progressive policies which allow employees five or even 10 years to decide whether to exercise their options. 

If your equity is ‘underwater’, being able to wait and see what happens to the business over a number of years releases some pressure and gives you more awareness of the risks and opportunities of becoming a shareholder.

But many companies still operate restrictive policies that give employees as little as 30 days to decide whether they want to exercise their options. 

This often leaves people weighing up whether to pay out thousands of pounds to acquire shares in an early-stage company where the eventual return is highly uncertain – or to forfeit their right to their equity altogether.

Additionally, it’s worth remembering that a down round doesn’t affect all shareholders equally. 

Investors usually have preferred shares with downside protections that preserve the value of their stake to a certain extent in the case of a down round. Employees with common shares don’t enjoy the same privileges.

What companies should do to protect employees in a down round

As an employer, the first thing you should do is be transparent. If you have to raise a down round, tell employees that’s what you’re doing, and describe the potential effect on people’s equity depending on their situation. 

This will be very different for different people so if companies can manage it, describing what it means for each individual in a one-on-one context is the best practice. If this isn’t the case, consider sending out a tailored note via your equity management software.

Next, there are ways to mitigate the impact for employees’ equity stakes. Companies can try to correct for any decrease in value by issuing each employee additional share options at a lower strike price, or by repricing options.  

In the latter case, the company effectively cancels existing options and reissues new options at a lower strike price. This method is most likely to be used by late-stage pre-IPO companies like Checkout.com which, at the end of 2022, lowered the price at which staff can exercise their stock options from $252 to around $65. 

Notably, Checkout didn’t wait for a ‘down round’ to reprice equity – instead the leadership team took proactive steps outside a fundraising environment. 

Both of these approaches will probably involve negotiations with the board and investors. They can also create significant additional workload for the finance, people, operations and legal teams, depending on which function has responsibility for equity plan management.

These steps aren’t easy but taking these actions demonstrates to your employees that you take their equity seriously. Indeed, negotiating a down round with transparency and effective mitigation can help maintain your team’s trust and motivation through difficult times. 

Companies don’t have to throw their hands up and shrug in the face of a down round. By prioritising employees’ needs, companies can retain top talent and come out of a correction cycle fighting.

Don’t let down rounds get you down

For employees and companies, down rounds are just one aspect of operating in the challenging world of startups. They don’t have to be apocalyptic events.  

The views and opinions expressed are not necessarily those of AltFi.