When everything goes to plan, the value of your company will increase in each subsequent round of investment. If your company was valued at $10 million (including the invested capital) after the last round, you might hope that the company is valued at $20 million by the next round. In theory, this is the natural order of the venture world. Entrepreneurs take capital and create value, making the company worth more than it was before.

Unfortunately, we live in a messy world where reality and theory diverge. In some instances a company will be worth less at the time it is seeking its next round of capital. The company that was once worth $10 million may now only be worth $5 million.

This change in value can occur for any number of reasons. The company’s revenue model may not have panned out as planned, a key customer defected or a critical partnership may have fallen apart, leaving the intrinsic value of the company to be worth less than it was before. Alternatively, the market for venture capital tends to ebb and flow. When capital is in short supply the valuations of company’s may decline if the company was overvalued in its prior round.

Whatever the cause, down-rounds (rounds in which the company is de-valued relative to a prior round) do happen and investors know this. When down-rounds take place, the existing shareholders of the company before the investment (founders, staff and investors) often experience a significant decline in the percentage of the company which they own. As a result, VCs often require that companies accept anti-dilution provisions which protect their ownership stake when the company is devalued. When a down-round takes place these terms effectively decrease the ownership percentage of the founders and the staff more significantly than the ownership percentage of the investors.

This protects VCs and their investors from crisis scenarios where assumptions made by management prove to be inaccurate or when the company’s valuation proved to be unsustainable as the capital market fluctuates.