Can startups recover from down rounds?
The spectre of a down round is never easy for founders and early investors to come to terms with. Coming off the back of a 10+ year growth story in VC with valuations inexorably increasing - until now - this is an event that many startups will have never experienced. All boats rose on the valuation high tide of 2021. Now all but the most seaworthy risk running aground as the tide finally recedes. For 'internal' down rounds, the equity stakes of non-participants (notably the founders) can be heavily diluted. Where new investors have appetite to come in, all shareholders will take a hit, unless they have previously negotiated anti-dilution protection (as we highlight below). The prospect of a down round may be too much to stomach for current investors who may no longer see a reasonable prospect of returns. If there are no other practical options to extend the runway, founders may be told to put up the 'for sale' sign (as we explore further below). But in cases where companies want to continue operating and existing investors are supportive, down rounds will happen. A bridge round, perhaps in the form of a convertible loan, may push out this pricing event. But unless the business over-performs as wider markets continue to deteriorate, this awkward moment invariably arrives. Should founders view this as a point of failure, or can there be real hope that fighting to live another day truly makes sense?
A recent investigation by Pitchbook throws light onto the post down-round prospects for startups. Even though this only relates to the US market, the insights are still illuminating. Using a dataset of 1,421 companies raising a down round between 2008 and 2014, the research tracked the ability of beleaguered companies to continue growth via further capital raising. Note that an aged dataset like this is essential for full cohort analysis in subsequent years. Remarkably, just 188 of those companies tracked were unable to raise further financing or complete an exit immediately after taking a down round, thus suggesting that down rounds aren’t an instant company killer. The high number (755) of companies able to eventually exit also corresponds with the high proportion of down rounds occurring at late stage, where the comparison with depressed public markets is unavoidable. Here, investors are less likely to abandon a company; they instead look to recoup investment where they can, even if it is less than the total invested in the company. The majority of such exits undertaken by this cohort in 2021 (just over 50%) occurred via corporate acquisitions with the balance split evenly between PE buyouts and public listings.
Of the exits completed after taking a down round, a much higher than normal proportion of this group exited through a buyout from a private equity (PE) firm. They are often better candidates for some form of restructuring typical of the PE modus operandi. Since 2016, 166 buyouts of companies that had previously taken a down round have occurred, constituting 19.4% of the exits for this cohort. Within the broader venture ecosystem, just 11.5% of exits occur via PE buyout. The data also shows that investing into a down round could prove to be an investment strategy with decent returns. Pitchbook concludes: "The fact that 88% of known exit valuations for companies taking a down round were higher than the down round valuation should increase the confidence in down round participants. The [recent and ongoing] decline in capital availability, especially for companies with lagging financials, is a natural market occurrence. Down rounds are a part of markets, but rather than heralding the end of the company, the data shows they should rather signal a shift in company expectations."
Watch out for these fundraising terms
As venture dollars slow, deal terms are trending back towards investors. These terms won't be the headline topics discussed as you move towards a term sheet, where due diligence and valuation receive the greatest scrutiny. But when the offer finally arrives, a slew of punitive terms can suddenly hit founders like a cold shower. This is a classic a case of 'forewarned is forearmed'. In deteriorating markets, the top 3 terms to look out for are: Liquidation Preferences above 1x, Participating Preferred stock, and anti-dilution provisions. Institutional investors usually insist on preference shares, that much is normal and accepted. But the devil is in the detail of the specific preference rights they hold. A 'liquidation preference' ensures that if a company exits with a lower valuation than expected, the company’s preferred shareholders will receive their money back before other shareholders receive proceeds from the exit. This is usually set at the 'industry standard' of 1x. When the liquidation preference goes above 1 - and we have seen 2x or more in previous downturns - this should be a big red flag. Even a reasonably priced exit could then leave the founders with nothing.
The second term to watch out for is 'Participating Preferred stock'. Preferred stock can be Participating or Non-Participating. Participating preferred means that, when the proceeds from an exit exceed the liquidation preference, preferred shareholders will receive additional cash on top of their liquidation preference. An example, courtesy of Carta, is the easiest way to explain this: Say an investor invests $2 million in 'participating preferred stock' for 50% of the company. If that same company were to be acquired or sold for $5 million, the investor would receive their $2 million liquidation preference off the top, and then split the remaining proceeds with the common shareholders based on their pro rata ownership (in this case, 50%)—which would equal $1.5 million (half of the $3 million remaining after the liquidation preference has been paid). That means the investor walks away with $3.5 million, leaving only $1.5 million left to split between all common shareholders. Participating preferred stock therefore allows investors to “double-dip” and receive their liquidation preference PLUS their pro rata share of the remainder (instead of choosing between their liquidation preference and their pro rata, as is the case with Non-Participating preferred).
The third term to be wary about is anti-dilution protection. Such provisions adjust the number of common shares that preferred stock can convert into in the event a company later has a down round of financing. This gives investors some assurance that in such circumstances their percentage ownership won’t be excessively diluted by the new investment. Anti-dilution adjustments can be calculated in several ways. The most common is to take a "weighted-average" (which accounts for the number of shares being sold in the down round as well as the price). These adjustments can also take the form of what’s known as a “full ratchet,” which effectively reprices the shares of the existing investors with the anti-dilution protection at the down round price. (Carta also provides a worked example of this). The upshot is that such retrospective repricing can heavily dilute the holdings of other shareholders, including the founders, in the event of a down round. Whilst punitive terms like this are likely to creep back into term sheets in the coming quarters, the best way to repel them, as ever, is to ensure competitive offers. If FOMO rules, such terms can be much more easily negotiated away.
VCs tell founders to put up the 'For Sale' sign
With global venture investment declining sharply from 2021 highs, we have now reached the beginning of the 'sell-off' phase: VCs anxious that some portfolio companies will now run out of cash before raising their next round are telling founders to find a corporate buyer. With funding campaign timelines lengthening and fewer deals being completed, more and more startups are exploring M&A options - well before they had imagined. The number of requests from founders to now run 'dual-track' campaigns - undertaking a funding round and an M&A process in parallel - is on the rise. With M&A cycles typically taking much longer than equity funding, investors are pushing founders to start the process now whilst they still have a decent amount of cash runway on hand. Entering an M&A discussion with only a few months of cash remaining is no more than a fire sale with the prospect of any kind of investment return wiped out: At early stage, if current investors are folding their cards, the corporate M&A route may be the only viable exit option right now. At late stage, given that the IPO market is still essentially closed and PE buyouts under pressure as the cost of debt financing soars, this again may be the only practical choice.
The dual-track approach will be a well-recognised path for many that survived the 2008 GFC or the dot.com crash of 2000. Prior exponents will know that this process is much trickier to navigate than a 'straightforward' equity raise. For example, openly declaring your M&A intentions to the field of potentially interested parties at the outset would most likely be a recipe for disaster, especially for early-stage businesses. A far more nuanced approach is required that doesn't spook the suitors. The starting point is ideally an existing corporate relationship; this could be due to an existing commercial engagement or equity investment in an earlier round. In other words, the corporate is not starting the whole process cold and some lines of communication are already open. But all eggs should not go into one basket and, just as for equity rounds, the key to driving the best outcome (valuation) is through competitive bids. FOMO rules again - even in M&A. Dual-track processes should therefore feature a much longer list of corporate names at the outset. Inevitably, by casting this much wider net, founders will find many of these targets will not have dedicated CVC arms that are well practiced in the art. Dealing with more traditional corporate development teams is often a much tougher slog. Technical due diligence is deeper and everything just takes longer.
Preparation for a dual-track approach is, by necessity, more complex than preparing for investment. They key difference is that the motivation of every prospective acquirer will vary and so approaches must be more carefully tailored. This is no longer just the financial ROI evaluation that a VC will make. Corporates assess small acquisitions through a range of lenses: For example, is this a 'tuck-in', a 'bolt on' or an 'acqui-hire' play? Often the larger company is buying the startup for its technology or its product, instead of building something similar from scratch. In the case of an acqui-hire, usually the least desirable outcome for the seller due to the typically lower price tag, the company is acquired for its team. Generally, the more 'strategic' the underlying motivation the higher the price, so this is key intelligence to uncover early on. Through 3Q22, the number of acquisitions of late-stage VC-backed businesses has only been trundling along but bankers and VCs are predicting this will all change over the coming months. Adobe's $20B acquisition of Figma may have broken all records last week, but it is still an outlier in the current market, despite the excitement caused. In normal times, early-stage acquisitions generally don't move the needle much in M&A markets and often go unannounced due to their small scale. Expect this to change over the next few quarters.
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