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In our current economic environment, you would have to be hiding
in a cave not to see, hear and feel valuations sliding downwards
across the eco-system. It started in January 2022 when large-cap,
mid-cap and then smaller-cap public companies started to fall in
price. Past a certain point, we began to see private equity and
venture capital investors applying these lessons to late stage
private companies. In the time since February, we have seen the
slide come all the way through the business food chain until it
reached the startup.
In the global Silicon Valley, venture capital firms are getting
much more cautious when it comes to valuation points when deciding
to invest in new deals, and startups are facing an interesting
dilemma. Do they risk waiting for future funding rounds when they
would likely have to sell shares at a reduced price, or do they
look for a more creative solution?
What’s happening, really? We are seeing plenty of venture
capital funds with fresh piles of dry powder – the capital is
present. But private equity and venture capital investors made
promises to their own limited partner investors and need to return
capital and make returns.
What is the venture capital POV? VCs are seeing later stage
companies getting next rounds of capital and exits at valuations
based on lower multiples of revenue, and then, only if it’s not
unprofitable, and only on last twelve months, not future projected
twelve months. VCs are applying these lessons to the seed- and
early-stage of the market. We are seeing VC term sheets with lower
valuations and liquidation preferences based on seniority of last
money-in and often times a return at greater than one time (e.g.,
VC gets its money back plus a return before the common
participates).
If you are a startup founder, how do you navigate these
conditions in the equity markets?
First off, bridging with a SAFE is often a good bet. We are not
(yet) seeing investors play with SAFE terms on the YCombinator
form. We are seeing the occasional side letter accompanying a SAFE
investment, but usually containing only pro rata rights,
information rights and rights to sit in or participate on the board
of directors. If you are a pessimist, however, you might consider
whether valuations slide further in startup land, allowing SAFEs to
convert later into a lower valuation.
Another tool in the toolbox is the “extension round.”
Historically, an “extension round” referred to a startup
that raised additional capital on the same instrument at the same
valuation and terms when it was running out of money before it had
achieved the funding milestones for the subsequent round that had
been anticipated. Alternatively, it was used as a way to take in
“corporate” venture capital between rounds. Either way,
it was additional capital at the same price to carry on.
Extension rounds can help protect the startups valuation as
shares are typically priced at the rate of the previous round, or
sometimes higher, and usually have the same terms. They can also
help to buy some much needed time before the next major funding
round.
In 2022, however, as chronicled in the annals of Tech Crunch and elsewhere, startups have
turned to the extension round as a substitute for the next round.
This is because your next round is a signal to the market, to
investors, to competitors and to your employees, that you have
achieved increase. If the valuation you would get upon a
“next” round looks potentially flat or even down, rather
than have that discussion, it’s much easier and more palatable
to talk about extending the same round.
If you’re looking at an extension round, there are some
points to consider:
- There must be interest from investors: If you’re going back
to existing investors for an extension round, then it’s going
to be important that those investors have a reason to invest
further in the company. That means keeping them engaged and giving
them a reason to be excited about the trajectory of the company.
Show them growth, projections, positive news that would lead them
to further investment. - Cut costs first: Investors are going to want to see where you
have cut costs before you ask them for additional funds. Make sure
you are operating at the highest level of efficiency and don’t
have any excess or unnecessary expenses. It’s much easier to
make the case if you have this area buttoned up. - Will an extension round get you where you need to be: If you
secure an extension round and buy yourself a few months, will this
help you to meet the necessary milestones for your next funding
round? Really take a look at how this additional funding and time
will prepare you for the next round. If you don’t think it will
get you where you need to be, you might want to consider other
alternatives. - What is the impact to key employees and founders of the
extension capital on the common stock? How much is left in the
equity incentive plan? Can you make some grants at the same time as
the extension round? Do you need to increase the plan? If so, the
hill to get to an upround for the next round just got steeper.
Extension rounds won’t be the right option for every
startup, and there are certainly many options out there when it
comes to raising money. Do your research, weigh all your options,
and consult with your trusted advisors before deciding what is
right for you.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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