Between inflation, rising interest rates, geopolitical tensions, and growing
recession concerns, 2022 was a year of reckoning for both public and private
markets. Since the beginning of 2022, the tech-heavy Nasdaq Composite has declined
23% (versus the S&P 500’s 14% decline) and global venture funding reached a thirteen-quarter low in Q1 ’23. Further dampening
investor confidence, the failure of several long-standing institutions serving the
startup ecosystem, such as Silicon Valley Bank, Signature Bank, and First Republic
Bank, sent shockwaves through capital markets and the broader financial services
industry. Today’s market represents a radically different fundraising climate—one
not seen in nearly 15 years. Many founders find themselves in uncharted territory as
concerns linger around the overall health of the fundraising environment, from
venture capital to growth equity.
The View from 30,000 Feet: How is the Market
Trending?
With seismic changes occurring across the broader
capital markets and tech multiples at a multi-year low, we are seeing some key
trends emerge in the venture landscape:
- The macro environment has impacted investor
sentiment. Given the recent political and
economic uncertainty, much of private market activity has been put on pause.
Despite ample dry powder in the venture space, some investors are not
willing to step up to price and set valuation terms, particularly in
later-stage funding rounds.
- Early stage valuations have been more
resilient. According to recent Pitchbook
data,
growth-stage companies have been more adversely impacted by the recent
market correction and current macro environment than early stage companies.
This is in part, due to the growth-stage’s proximity to public markets,
whereby investors are confronted with a large gap between the valuation
multiple that a growth-stage startup raised at in its most recent round
versus where its public peers are trading at today.
- Up rounds are still happening, but taking
longer. Despite challenges in the broader
public equity markets, companies with proven traction, a path to
profitability, and good unit economics are raising up rounds. However, with
continued macro and market uncertainty, investors have become more
discerning with longer and more rigorous due diligence, causing rounds to
take longer to come together.
- Flight to structure. In the startup world, it is customary to raise
capital through the issuance of preferred equity, and for founders and
employees to hold common equity. As deals became more competitive in recent
years, investors also purchased common equity in an effort to obtain the
maximum amount of ownership in a given financing round. With today’s more
volatile and uncertain markets, investors have returned their focus to
preferred equity. Increasingly, they are also requiring terms that provide
downside protection and minimum return thresholds, such as payment-in-kind
(PIK) dividends, liquidation preferences higher than 1x, valuation ratchets,
and participating rights. That said, while structure is becoming more
commonplace, it is more prevalent in growth rounds than in early stage
rounds. For more on this topic, please see this article written by our Growth investment team on the
impact of different structures.
- In SAFE hands. A
SAFE, or Simple Agreement for Future Equity, is a financing structure
pioneered by Y Combinator. With a SAFE, a company is able to raise capital
without formally assigning a value to the business in exchange for certain
protections for the investor upon conversion (typically either a valuation
cap, a discount to the next financing round, or both). Historically, SAFEs
have been primarily used by companies that are pre-product or pre-launch. In
the current climate, we have observed the SAFE structure being utilized by
an increasing number of revenue-generating Series A and Series B companies,
who need to raise an interim round to get to certain milestones ahead of a
more formal priced round. Such companies usually have the internal support
to defer an interim valuation event.
- Convertible notes have taken off. Convertible notes are a form of debt that can be
converted into equity either at a valuation cap or at a discount (typically
20-30%) to a company’s next financing round just like a SAFE. However,
unlike SAFEs, convertible notes offer downside protection given the asset
class of debt, as well as potential minimum-guaranteed thresholds. They also
incur interest (that can convert into equity in the next priced round) and
have a predetermined maturity date which creates a ticking clock for the
company to raise future financing and repay its debt. In this current
climate, we are observing a number of companies raise convertible notes as
well as the emergence of creative new structures such as pre-IPO convertible
debt with a conversion price set at a premium to the company’s eventual IPO
price.
- Recaps
are due to make a comeback. When
companies looking to raise capital find interest from investors who are not
willing to sit behind the company’s existing investors, or preference stack,
the standard solution is for the new investors to “reset” the ownership by
proposing a financing not only at a different valuation (in order to achieve
their ownership objectives) but also to put the new investment at the top of
the preferred stack (most senior), and sometimes reduce the existing
preference stack to make a return for the new investment more likely. This
form of financing, through an ownership restructure, essentially
force-converts existing preferred equity holders into not only a common
equity position, but also often at a down-ratio whereby their ownership
percentage is also significantly reduced. A variant of this deal structure,
known as a “pay-to-play,” offers existing preferred investors the right to
participate under the new financing terms and by doing so, are offered a
conversion mechanism to preserve some or all of the preference of their
original investment. While pay-to-play financing structures tend to be
uncommon in strong markets, we have seen more of these situations arise in
the current climate and expect to see this trend increase.
What it Means for Startups: The 16 Commandments of
Raising Equity in a Challenging Market
Despite the current environment, we believe that great founders and great businesses
will always have options when raising capital. Amidst this period of market
uncertainty, we offer a series of recommendations and advice—our “commandments”—for
founders looking to raise in this “new” normal.
- Be flexible on structures and sources. Our Managing Partner Ben Horowitz puts it best: “If you are burning cash and running out of
money, you are going to have to swallow your pride, face reality, and raise
money even if it hurts.” For startups looking to raise in this current environment, it is imperative
to internalize that there are a number of viable paths to raise equity (as
depicted by the diagram below), including down rounds and flat rounds. There
are also many alternative pools of investment capital to tap into beyond
VCs, such as strategics, sovereign wealth funds, and family offices.
Eliminate artificial boundaries and taboos from your vocabulary: “I want a
valuation of at least $X,” “I won’t accept convertible debt,” “I don’t want
strategics on my cap table.” Be open-minded when different opportunities
arise. Having an inflexible attitude will greatly decrease your options and
make it more challenging to raise capital.
- Don’t begin conversations with price
expectations. Founders should avoid
anchoring conversations around price expectations or last round’s valuation.
You run the risk of not receiving any term sheets if you convey up front an
expectation of a high price. Securing even a low-valuation term sheet early
on will help build competitive tension, which you may be able to leverage
towards additional term sheets and better terms. You just need one “yes” to
get the ball rolling.
- Optimize for size, not dilution. For
founders who have raised capital during the last few years, the standard
approach has been to optimize for dilution given the easy accessibility to
capital. However, in today’s environment, founders should instead consider
optimizing for round size. If a round has come together and you are being
offered more capital than you had intended to raise, taking the incremental
dilution now for the additional capital can be a prudent move. This will not
only offer a runway extension, but also help avoid a potential situation
down the road where you are forced to raise again following a short
interval.
- Start early to account for the unexpected. During a period of market uncertainty, it is
critical to prepare and build in sufficient buffer time to account for
unanticipated obstacles, such as partner-level meetings taking longer to
schedule, extended confirmatory diligence, or other unforeseen funding
delays. By starting your fundraising journey early, you can ensure that you
have a time-cushion to fall back on when the unexpected happens.
- Prepare
well to run an efficient process. Take
time up front to thoroughly rehearse your pitch, sharpen your delivery,
improve your deck, and prepare a data
room. Diligent preparation and deliberate
planning will help reduce your chances of making an error, which can be
costly and time-consuming to fix later on. Completing a fundraising process
expeditiously is imperative in this environment. You do not want your
company to become a “stale listing,” which in real estate, refers to
properties that have spent too many days on the market. Stale listings are
often caught in a vicious cycle: the perception is that something is wrong
with it, which keeps other would-be buyers from purchasing it. Similarly, in the venture
capital world, startups may also be viewed as “stale” or
unattractive to investors. The key to avoiding this stigma is to run an
organized and efficient process aimed at creating competition.
- Engage
your insiders. Proactively engage with
your existing investors (insiders) about your upcoming fundraising plans.
Having an insider commit to participating in or leading your round may serve
as a strong endorsement and vote of confidence that can encourage other
market participants to also invest in the round. However, insiders may be at
different stages of their fund lifecycle and may have limited reserves so it
is important to have honest and open conversations with them on whether and
how much they are able to commit.
- Nurture ecosystem relationships.As our team has
discussed in the past, we believe it’s never too early to
begin building relationships within your ecosystem, from both a commercial
and strategic partnership perspective. Relationships take time to nurture,
so this is time well-invested and will pay dividends in the future. These
developed relationships can be incredibly useful in helping to catalyze a
potential financing, whether it be a bridge round alongside existing
investors, a strong signal for new investors to co-invest as part of a
larger financing round, or a stage-setter for a potential strategic
transaction in the near to long term.
- Ask yourself the difficult questions. Even before you meet with investors, think about
where investors may push back. Why are newer cohorts showing lower
retention? Why is CAC rising? Why have organic acquisitions stagnated? This
enables you to anticipate key investor concerns and proactively address them
by preparing materials and answers in advance. Investors want to engage with
founders who are thinking critically about what they’re doing right, what
they’re doing wrong, and what they intend to do differently.
- Pressure-test your burn multiple. Stress-test your burn multiple, which we define as cash burned divided by net
ARR added. In other words, how
much cash are you burning to generate each incremental dollar of revenue?
Evaluate how your burn multiple is changing across months and quarters and
explore what you can do to improve this metric. Moreover, identify areas
that are your largest sources of burn, which areas represent “burn-sinks”
vs. burn-investments and have a rationale for why spending is justified.
Investors are looking to invest in companies that are able to balance growth
and cash burn, as well as those who know how to do more with less.
- Don’t pursue growth at the expense of profitability. The Rule of 40 (Ro40), defined as the sum of a
company’s revenue growth and profitability margin, is a metric used by
investors to gauge a growth-stage startup’s performance. It succinctly
captures the trade-off between growth and profitability. Companies with
identical Ro40 scores aren’t necessarily treated the same, since the
pendulum between growth and profitability swings over time. During the
strong market environment of recent years, the scale tipped in favor of
growth, with investors rewarding startups that were able to demonstrate
rapid growth even at the cost of poor unit economics and profitability.
Since then, the goalposts have moved drastically—the “growth at all costs”
mantra has come to an end. Today, investors are putting more weight on
profitability. If your unit economics are in the red, consider prioritizing
efforts to improve your company’s profitability even if it means achieving
lower growth in the present. Growth efforts can always be ramped up later in
the company’s journey, but the quest for good unit economics can feel like a
Sisyphean task when already operating at scale.
- Be deliberate and precise on use of proceeds. Investors want to partner with founders who
efficiently overcome roadblocks. It is not enough to show how much and where
you plan to allocate future capital; you must also demonstrate that the
juice is going to be worth the squeeze. Which acquisition channels are not
saturated and thus will provide the best returns on marketing spend? Which
customer segments will you deprioritize because their unit economics will
not work even at scale? Which features are you pushing to drive better
retention? Demonstrate to investors that you know your business inside-out
and present a realistic plan on how you will mobilize funding to target the
highest ROI levers and achieve specific milestones.
- Grow into your valuation at normalized multiples. If you’re a company that raised capital over the
past few years, you likely did so at a strong valuation. Given the recent
market correction, your focus today should be setting near-term financial
targets that enable you to grow into that valuation at normalized multiples. Balancing offense and
defense is key—recalibrate your business plan and adopt operational
discipline by evaluating how you’re going to use the capital you’ve raised
in the most efficient manner possible to hit the required financial
milestones ahead of your next raise. Please see this article written by our Growth investment team on how to
think about navigating down markets and scenario planning.
- Don’t
myopically view a structured up round. In today’s climate, there are some who believe
that securing an up round, even in the form of structured equity, can be
a Fountain of Youth that will help maintain both the actual and
perceived health of the company. However, founders should be aware that
an up round is not a solution for all of the company’s issues.
Implementing structure into the company’s capitalization solely for the
sake of preserving your last round’s valuation is not an act that is
easily reversible and will have downstream effects on future financings.
For example, future investors may expect that in subsequent rounds they
too will receive the same rights, thereby further diminishing returns to
common equity holders, including founders and employees. As such,
startups that are several years or rounds away from a liquidity event,
may be better off raising a “clean” flat round or down round than an up
round that comes with structure such as higher liquidation preference,
participation parameters, ratchets, and other atypical governance
rights.
- Treat deferred valuation as a Band-Aid, not a cure.
To address the potential valuation gap
between a wide bid and ask spread, some companies are electing to raise
capital via SAFE or convertible note structures that defer the topic of
pricing. The rationale behind this approach is that it gives the company
more runway and resources to achieve key milestones ahead of an eventual
formal priced round. The notion of deferred valuation as a magic bullet
solution is alluring, but may ultimately present challenges and could derail
the eventual priced round. Founders should exercise caution and consider
this approach carefully before committing. If you have immediate liquidity
needs or anticipate reaching near-term milestones, then this solution
between financing rounds may be suitable for you. However, depending on your
specific circumstance and the terms of the instrument, it may also lead to
misaligned incentives between existing and deferred round investors, as well
as present long-term issues with your capital structure if milestones are
not met.
- Communicate with candor. There may be a tendency to not discuss or
communicate a fundraising outcome that on the surface seems sub-optimal. One
misconception is that it might spook employees, partners, and vendors by
raising concerns that the company’s prospects are limited or challenged. On
the contrary, it is imperative in such instances to be transparent with
employees about where things stand and to listen to their concerns. Candor
and honesty in such moments will help build loyalty and enable you to lead
more effectively.
- Preserve optionality. As you embark on your fundraising process, there is
a chance that you may not be able to secure the funding you need. As such,
it is important to be prepared for the possibility of a sale, soft landing,
acquihire, or wind-down. Make sure to set aside sufficient cash and time to
explore these alternative paths and potentially dual-track alongside the
fundraising process.
Conclusion
While the strong market environment over most of the
past decade has yielded many positive fundraising outcomes, it is important to
take a step back and treat fundraising for what it is—a milestone versus a
destination. A flat or down round should not be viewed as a death knell for a
startup. Many successful, category-leading companies such as Airbnb, Doordash,
Block, and Meta raised flat or down rounds along their startup journey. The
current environment represents a great time to
build, without the distraction of hype cycles, speculative
valuation chasing, and unbridled market exuberance. While the capital markets
environment has undoubtedly changed following an extended market run, the future
most certainly holds great opportunity for founders and investors alike.
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