What is a washout round?
An example of a washout round (sometimes called a “burn-out round” or “cram-down deal”) is when a fresh funding round usurps an equity holder’s power. When such financing is completed, the new issue significantly reduces the ownership interest of prior investors and owners. New investors can take over the firm because the former owners need more funding to prevent bankruptcy. Washout rounds are often linked to startups or smaller businesses that lack a solid management team or stable financing.
Understanding Washout Rounds
A washout round of funding is often extended to take over a business, sometimes to get asset management and new investors to think they can use it as leverage. The game usually values the company’s shares so cheaply and in such high demand that the stakes held by previous owners and investors may be considered almost worthless. Although the percentage of returns may vary, funding is usually structured so that previous owners are forced to accept the judgment of the new investors.
The washout round is often the last funding source available to business owners of failing enterprises before their firm is pushed into bankruptcy. Washout rounds usually happen when businesses need more performance targets established to get further funding from investors. For instance, during the dot-com boom of the late 1990s, when many firms were wildly overvalued, there were several washouts.
What Happens During a Washout Round?
While it is conceivable that part of the prior management of the firm may stay on, there is a strong likelihood that the leadership will be replaced during a washout round. It seems improbable that new owners would choose to preserve the status quo in light of the business’s overall performance and the leadership choices that necessitated a washout round. Specific management and operations may be kept for brand identification. However, the new owners may discover that finding purchasers for the company’s assets—like product lines, client databases, and intellectual property—will provide the highest return on investment during a washout phase.
Washout rounds may happen to organizations that increased in value but experienced a sudden or gradual turn of circumstances that made it impossible for them to expand under their existing management and operations. For example, a business developing a breakthrough bioscience or medical device may not have another significant product ready to replace its flagship product if authorities reject it. Similarly, a service provider may not meet its revenue growth targets if it cannot achieve the degree of market penetration necessary to turn a profit. Due to these situations, businesses may find themselves searching for washout-round financing, which, as a final alternative, could save the brand.
Conclusion
- A washout round of financing occurs when new investors force the company’s current stockholders out of control.
- Washouts are a final alternative for preventing insolvency or ending operations, and they are often connected with emergency fundraising rounds for smaller or new businesses.
- The current management may be kept on board, but depending on how the transaction is set up, they will probably be replaced (i.e., washed out).
