Washout Round (Venture Capital) - Explained
What is a Washout Round?
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Table of ContentsWhat is a Wash-Out Round?How does a Wash-Out Round Work? The Effect of a Wash-Out RoundAcademic Research on Wash-Out Rounds
What is a Wash-Out Round?
In a wash-out round, the shares of the company held by existing investors are diluted, thereby reducing their ownership to the company. After the dilution, majority of the ownership of the company are held by new investors. A wash-out round is otherwise called a cram-down round or a burn-out round. It is often the last form of financing open to small businesses before they become insolvent or go bankrupt. Emerging or small companies that are unstable financially use a wash-out round approach to sourcing funds.
How does a Wash-Out Round Work?
When owners of small businesses are in dire need of funds, they resort to wash-out round. Although, its conditions are not always favorable to the business, entrepreneurs and small businesses use us as a form of financing to hedge bankruptcy and insolvency. Usually, before a company uses a wash-out round, there must be pressing financial needs. If the company is unable to get financing from existing investors, especially if the performance is not encouraging, a wash-out round can take place. Small companies in the United States used wash-out round prevalently in the 1990s, this was the period of dotcom bubble otherwise called internet bubble.
The Effect of a Wash-Out Round
For small companies that use was-out round as a way of financing the business, they experience some unpleasant effects. In a wash-out round, the shares held by old investors are diluted and new investors gain a larger part of the ownership of the company. Hence, many investors leverage on wash-out round just to gain ownership of or seize a company. Also, in a wash-out round, the company diminishes in value and the company can sometimes be worthless. In reality, when a company uses a wash-out round, it means it is at the verge of bankruptcy. Once a wash-out round occurs, a company experiences a change in leadership and management body, previous leaders and managers are replaced with new investors which might have adverse effects on the company. A sudden decline in the value of shares of a company can cause a wash-out round to occur. Companies use this approach when there are no other ways of financing the business, at this point, old investors are also reluctant to finance the company. Generally, a wash-out round has unpleasant effects on the company and gives a bad outlook of the company.
Academic Research on Wash-Out Rounds