Founders hope that their startups continually raise larger funding rounds at escalating valuations. But unexpected challenges, such as a global health crisis or a sudden surge in interest rates, can have a significant impact on a company’s ability to maintain its valuations.

Some of these startups may have to resort to down rounds, which are new financings at a lower valuation than the company’s previous price. While founders and investors generally try hard to avoid down rounds, contrary to popular belief, these deals don’t necessarily have a devastating impact on a startup’s future.

“Our first investment, when we started our firm in 2021, was a down round recap of a company that had to have a total pivot during COVID,” Nikhil Basu Trivedi, co-founder of Footwork, said onstage at TechCrunch Disrupt 2024. “Their initial business was in the college housing market, which got decimated the moment the pandemic hit.”

Footwork reset the company’s cap table and created a new stock option pool for the entire team, said Basu Trivedi, adding that the company’s new business, a subscription platform for restaurants called Table22, “managed to survive and thrive from that experience.” Last week, Table22 announced an $11 million Series A led by Lightspeed Venture Partners.

Although, by far not all companies that have to take a down round have a complete revival. Elliott Robinson, a partner at Bessemer Venture Partners, said onstage that if a company is struggling, “there’s a pretty good likelihood that someone else in your space or a competitor is dealing with many of the same challenges.”

Robinson encouraged startups in those positions to stay the course. “If you’ve taken a down round, that’s okay,” he said. “In a tough market environment, that can actually be a win. You might not see it or feel it until four or six quarters out, but a lot of the time the market can open up to you if you want to stick with it.”

Prominent companies that took valuation hits include Ramp, which was valued at $5.8 billion last year, a 28% haircut from its previous $8.1 billion price. The fintech gained some of its value back this April when Khosla Ventures priced it at $7.65 billion.

Down rounds weren’t very common during the pandemic-era boom, but their prevalence as a percentage of all deals has more than doubled from 7.6% in 2021 to 15.7% in the first half of 2024, according to PitchBook data.

Startup prices dropped significantly after the U.S. Fed hiked interest rates, and many companies remain overvalued relative to their performance, said Dayna Grayson, co-founder at Construct Capital. Some of these companies are possibly considering down rounds, but for many of the founders, these deals are very stressful.

In a down round, employees and founders end up with a smaller ownership percentage of the company.

“I think the scariest thing for a lot of founders is how to manage morale,” Grayson said. “But you can absolutely incentivize people through down rounds.”

Robinson, who has guided three portfolio companies through flat or down rounds in the past year and a half, explained how investors motivated the employees and executives of one of these companies to remain committed after a down round. He explained that while everyone at the company experienced a loss in valuation, investors established a bonus pool to reward the entire team with cash bonuses if they could achieve a 60% revenue growth over a specific time frame. Robinson said that founders and top executives would also receive additional equity in the form of stock options if they achieved specific revenue targets.

“That allowed us to make the company-wide and executive goals very transparent,” he said, adding that it “reminded people that the core underlying business is still solid.”

The question on the minds of many venture capitalists now is what will happen with many AI companies raising capital at high valuations.

“I think it would be hard to argue there are not overinflated valuations in the market now,” Grayson said.

Basu Trivedi, who invested in several AI startups, including AI detector GPTZero, said that many AI “companies have the fundamentals to justify the hype and valuations,” but later added that it is still hard to tell which AI companies will succeed. “Some of these categories are so competitive,” he said. “There’s like 20 companies doing something really similar.”