Are we entering a recession? I don’t know, but of course we’ve already seen a significant market correction this year in the emerging company landscape. The Wall Street Journal reported in May 2022 that “for tech startups, the party is over.” If you are a startup founder, you may feel that checks from investors seem harder to come by and valuations seem lower. I am hearing “A flat round is the new up round.” I am also seeing more and larger convertible note rounds conducted by startups who already have a preferred round under their belt. I am also seeing a lot of insider rounds. I have seen a lot of startups look at ways to cut costs over the last few months.
I am not seeing down rounds yet – but we may start seeing them. They certainly have a stigma associated with them, and startups generally want to avoid them at all cost, e.g., by raising a convertible note round instead. So if you raised your Series Seed or your Series A round on what turned out to be an inflated valuation (because you raised while the “party” was still in full swing) and if you now need to raise again (and if you want to avoid a down round), then maybe you raise less now than you were hoping to, maybe you raise it from insiders, maybe you reopen your last priced round or maybe you raise on convertible notes.
Of course, if you raise too much on convertible notes, then, when those notes convert in the next priced round, the dilutive impact may be so great that it complicates your priced round – the new money investors in the priced round may insist that the existing holders bear the brunt of the dilution from all the converting notes, effectively driving down the pre-money valuation of the priced round and leaving the founders with an equity stake in the company that the new money investors (and the founders) may view as too small to be motivating. But this is a problem I usually see (when I see it at all) when a startup is raising money on convertible notes before the first priced round (not after). Post-Series Seed or post-Series A startups that I see raising money on convertible notes now are generally doing it on terms as company-friendly as reasonably possible, e.g., relatively high valuation cap if they have to have one.
So, what if down rounds are where we are heading and you have to do a down round? Because you’ve already cut costs to the point it really hurts, you’ve already raised a bunch of money on convertible notes and you get a term sheet for a down round (and you want to accept that term sheet because you need the money and because it’s the only term sheet on the table)? Are you doomed? I think probably not – first, congratulations on getting a term sheet in a tough environment. Historically, most down rounds have occurred at later-stage companies (earlier-stage companies may simply be unable to raise a follow-on round at all – they don’t even get the opportunity to do a down round). According to a report published by Pitchbook just last month, only 13% of companies raising a down round from 2008 to 2014 were unable to raise a new round or exit immediately after the down round investment. Again, I’m not seeing down rounds and we may not start seeing them at earlier-stage companies – but if we start seeing them and if you have to do one, then at least you get to live to see another day.
In conclusion and courtesy of Marc Manley, Managing Director of Willamette Valley Capital, who so graciously reviewed this blog post for me in advance of its publication, if you are asking yourself “what can I do now to extend runway?,” here are some ideas for you –
- Laser focus on cutting costs (mentioned above, but bears repeating). Cut big expenditures. And look at all the little expenditures. A little savings here and a little savings there adds up.
- Sell, sell, sell. Focus creatively on generating incremental revenue.
- Offer customers discounts for prepaying.
- Explore grants. SBIRs and other non-dilutive capital, when available, can be very helpful at extending your runway.
- Can you invest more of your own money in the company? That may be less dilutive in the long run.
- Ask employees and contractors if they would consider trading a reduction in salary in exchange for options.
- Ask suppliers if they would help your company to become an even better customer for the suppliers in the future by offering generous terms for current supplies.
- Do you have contractual revenues due in the future? Explore selling your accounts receivable to an investor, i.e., factoring.
- Explore revenue-based lending, e.g., the Entrepreneurial Development Loan Fund offered by Business Oregon, the state’s economic development department.
And remember – challenging times for you are tough on the competition as well. And it may be harder for new potential competitors to start. Companies that survive challenging recessions can go on to thrive when the market turns. Stay in the game. Survive now to thrive later!