Noah Schottenstein is an associate at Baker Botts LLP.
The entrepreneurial ecosystem has seen an unprecedented rush of investment over the past five years. But deal activity slowed considerably in 2016 and has leveled off during the first part of 2017. As trends continue to revert to the pre-2013 means, entrepreneurs should be careful about continuing to operate under the assumption that a fresh equity round on company-favorable terms will always be available.
Now is the time for startups to engage in strategic planning so that future liquidity needs will be met. This article discusses market trends and how debt financing and other protective measures can engineer optionality that can help a startup not only survive, but potentially thrive during a period of financial distress.
Pay attention to market trends
As Brad Feld recently wrote in a piece reflecting on the internet bubble, although a shift in the markets can sometimes feel like it comes overnight, there often are warning signs. The power of the phrase “it’s different this time” means that most companies are operating “in a state of blissful denial” and are not prepared for market changes, Feld warns. So take heed.
Although it is impossible to predict exactly when a crisis will occur, disregarding the general warning signs is a recipe for disaster. And many of those warning signs are appearing on the horizon. For example:
- Investor-favorable deal terms are on the rise, with a notable increase in deals containing 2x-3x liquidation multiples and participating liquidation preferences.
- Deal activity and financings have been flat or falling across most sectors, stages and geographic regions, with a few notable exceptions such as a recent spike in “mega” investment rounds for a handful of late-stage companies (Lyft’s $600 million round, Houzz’s $400 million round) and life science/real estate sectors (PitchBook, PwC).
- A number of well-funded startups have encountered fundraising difficulties and either closed (Beepi) or have been forced into severe cost-cutting measures (SoundCloud).
- Overall exit activity remains in a prolonged slump, with exit values propped up by a limited number of outsized deals: PitchBook reports that the investment-to-exit ratio has never been higher and that just four exits account for 48 percent of total exit value to date in 2017.
- LinkedIn reports that hiring growth across the software sector is flat (and down a seasonally adjusted 11.1 percent in the San Francisco region).
- The Federal Reserve is “pressing ahead with plans” to normalize interest rates, which may cause investors to lose their taste for funding startups — a particularly significant possibility considering that, according to a report by Upfront Ventures, “a large correlating factor driving our industry is large pools of capital chasing higher yields due to low interest rates affecting other asset classes.”
None of this is to say that a crisis is about to happen. But there is enough economic headwind that startups should start paying closer attention and develop strategic liquidity options while it can be done on favorable terms.
Avoid funding tunnel vision
It is imperative for startups to become knowledgeable about all of the various tools that can help meet long-term and emergency financing needs. This includes taking on debt and planning for organizational restructurings, neither of which are issues that the typical entrepreneur is inclined to consider, especially after just closing a new round of equity financing. But both methods can prove invaluable in extending a startup’s runway and are best done when the startup is on financially solid ground.
Debt: Many companies avoid debt because of the negative stereotypes about it. Investors, in particular, often sound the alarm about the dangers of debt, particularly the recent growth in convertible notes. But when used correctly, debt can serve a valuable role in a company’s capital structure. That is, not as a substitute to using equity to fund growth, but in lieu of having to raise more money than is immediately needed — with the attendant equity dilution — for cash-flow smoothing and emergency purposes, i.e. building runway.
If a startup has closed an equity round, then debt may be available on attractive terms. In fact, debt is most often available immediately after closing an equity round. And when markets are open and lenders are eager to lend, startups can obtain debt on favorable terms.
Organizational restructuring: When done correctly, restructurings can significantly extend your runway. But a successful restructuring requires a significant amount of planning and forethought, and is always full of tough choices.
It is critical to identify how costs contribute to cash-flow generation, how to focus the organization on the best business opportunities and to facilitate buy-in from all affected stakeholders. Identifying solutions can be particularly difficult for fast-growing companies, particularly those that are operating in new and untested markets.
So don’t make it unnecessarily difficult by approaching the issue of restructuring as a last-minute solution. It is well established that companies that downsize as a knee-jerk reaction to their own financial difficulties cause significant detrimental impacts on productivity and revenue generation. This is playing out right now in the case of SoundCloud, which deliberately delayed taking preventative measures and created an employee morale crisis as a result.
Create financial optionality
Finally, no matter what you do, make the conscious choice to create financial optionality. For instance, both equity and debt can come with good terms or bad terms — an equity round on unfavorable terms can be just as dangerous, if not worse, than the challenges that can be associated with taking on debt. After all, the debt can be repaid if you can improve your cash flow, but a value-destroying liquidation preference or ratchet may stick with you for life (or recapitalization).
Plan for contingencies and develop options that the company can utilize if needed. A common example is obtaining a revolver or line of credit that can be set aside for emergency purposes. Working with a professional can help identify which structures work best in a given circumstance.
Although the markets are tightening, they still remain open. Strategic thinking and the willingness to make small concessions in the present can lead to great protections for the future. So strike now, while the iron is hot. You may not get a second chance.Featured Image: Bryce Durbin/TechCrunch