Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Wash-Out Round

What it is:

A wash-out round is a round of financing that dilutes the original shareholders so much that their voting power is essentially "washed out."

How it works (Example):

For example, let's assume that John starts Company XYZ, which makes a novel new product for wine-lovers. John receives a massive order from Macy's, but in order to make the product and turn a huge profit, he needs $1.5 million to buy equipment and hire five new people.

John goes to an investing conference and meets three wealthy angel investors. They offer to invest $2 million in the company in return for 75% of the equity in Company XYZ. This would leave John as a 25% owner of the company he started. With only 25% of the company under his control, John will not be able to outvote the three new investors if he disagrees with a decision they want to make. The $2 million he raised from outside investors was a wash-out round.

Why it Matters:

Wash-out rounds are often hard for entrepreneurs to stomach because it often means giving up control of their companies. Entrepreneurs that were essentially "one-man shows" can find themselves being steamrolled by outside investors, or maybe even fired. It's no mistake that wash-out rounds are sometimes called "cram-downs."

From a financial perspective, a wash-out round isn't always bad. In John's case, if the $2 million investment eventually grows the firm into a $12 million company, then John comes out ahead: 25% of $12 million ($3 million) is worth more than 100% of $2.67 million. (Note: When the investors in our example bought 75% of the company for $2 million, that meant they valued the whole company at $2.67 million.)