What it means
Startups raise money by selling shares at a price set by a valuation. If the business does badly, new investors will only put in money at a price much lower than the previous round, which is called a down round.
A washout round is an extreme form where the price is so low that earlier owners are heavily diluted, meaning their share of the company shrinks. Washout rounds often come with extra terms that favour the new investors.
These can include liquidation preferences (the right to be paid first if the company is sold), anti-dilution protections and a reset of the share option pool. Together these changes can push existing holders to the back of the queue for any future payout.
The logic from the new investor's side is straightforward. The company has problems, the risk is high, and they will only invest if the price reflects it and they get control.
Recapitalisation (restructuring the ownership and debt of a company) can also clear out old preferences and cluttered ownership that would discourage future investors. Some washout rounds include a pay-to-play clause.
Existing investors who take part in the new round keep their rights, while those who do not see their preferred shares converted into ordinary shares or diluted further. This pressure encourages earlier backers to put in more money or accept a much smaller stake.
For founders and employees, the main danger is that their shares and options become worth very little. Management teams are often given a fresh option grant so they stay motivated to rebuild the company.
The nuance is that a washout round can save a business that would otherwise fail, so even heavily diluted holders can be better off than with no round at all.
In practice
Real-world examples.
Example
A software startup runs out of cash after missing its sales targets. A new investor offers $3,000,000 at a valuation 90% below the last round, on condition that the old preferred shares are converted. The founders accept because the alternative is closing the business.
Example
A biotech company needs funds to finish a trial but its earlier investors do not wish to continue. A specialist fund provides capital through a washout round with a pay-to-play clause. Investors who do not take part see their shares diluted heavily.
Example
A food delivery business has been burning cash for two years. Its board arranges a recapitalisation in which a new lead investor takes control, existing debt is converted into shares and management gets a new option pool. The old shareholders keep a small share of a company that now has a chance of surviving.
Formula
Calculation
Ownership after the round = Existing shares held / (Total existing shares + New shares issued)
New shares issued = New investment / Price per share
Suppose a company has 10,000,000 shares outstanding, and its last round priced them at $2.00 each, a valuation of $20,000,000. A founder holds 4,000,000 shares, which is 40%, worth 4,000,000 x 2 = $8,000,000 on paper. In a washout round, a new investor puts in $2,000,000 at $0.20 per share, receiving 2,000,000 / 0.20 = 10,000,000 new shares. The total becomes 20,000,000 shares, so the founder now owns 4,000,000 / 20,000,000 = 20%. The stake is now worth 4,000,000 x 0.20 = $800,000, a fall of 90% in value.Case study
Seen in the real world.
Brightfield Labs is an illustrative, fictional start-up that sells scheduling software to clinics. It raised $15,000,000 at a $60,000,000 valuation, but a slow sales year left it with four months of cash.
The only offer on the table was $4,000,000 at a $6,000,000 pre-money valuation, a cut of 90%. The new investor also wanted the earlier preferred shares converted into ordinary shares and a new 15% option pool for the management team.
In this illustrative story the board accepted, because without funding the company would have had to close. Founders went from owning 30% to under 12%, but they kept their jobs, the staff kept theirs and the company eventually recovered, which shows that a washout round trades ownership for survival.
Watch out
Common mistakes.
- Assuming a washout round only reduces percentage ownership, when it often resets preferences and control rights as well.
- Judging the round only by the price per share, without checking the new terms such as liquidation preferences and pay-to-play clauses.
- Believing founders always lose out, when in many cases the company would have failed without the round and a small stake is better than none.
Questions
People also ask.
How is a washout round different from an ordinary down round?
A down round just prices shares below the previous round, while a washout round is much more severe and usually restructures ownership and rights as well.
What is a pay-to-play clause?
It is a term that makes existing investors put in new money to keep their preferred rights, and those who do not take part are diluted or lose the protections.
Do employees with options lose everything?
They can see a large loss in value, but companies often issue a new option pool after a washout round so staff remain motivated.
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