Listed tech companies globally have seen a sharp fall in their share prices since the beginning of the year. That trend has been largely due to rising interest rates and quantitative tightening by the central banks to combat inflation. The impact of this fall has percolated to the global private capital markets, creating a significantly tougher funding environment for start-ups.
To be sure, the impact isn't uniform across all stages of funding. It is less applicable to early-stage start-ups, where investors focus on the "story" – the opportunity, the total addressable market (TAM) and the product. Funding has become more difficult for growth and late-stage start-ups where investors typically evaluate companies using traditional financial metrics such as revenue, profits and cash flows.
In the current market environment, investors are less willing to take risk and prefer start-ups with little or no cash burn. They’re looking for deep value in the form of “down rounds”, which implies that the valuation of the current round should be lower than the previous fundraise. New investors expect existing investors to recommit or are waiting for a credible investor to jump in.
Apart from the usual rights such as liquidity preference and anti-dilution adjustment, investors also are expecting additional protection through terms such as MOIC (multiple of invested capital). This guarantees a minimum rate of return for their investment. All this has led to fund-raising becoming increasingly difficult and the size of the round shrinking. The public listing option for late-stage start-ups also has become difficult given the overall weak investor sentiment. It's important for start-ups to adjust to this new reality. While they should focus on improving unit economics and eliminating unnecessary costs to reduce cash burn, at the end of the day there is really no substitute for having cash in the bank. Founders by nature are optimistic – a key requirement to build a business. Hope, however, is not a strategy, and they should prepare for the worst – a prolonged tough funding environment. As John Keynes famously said, "When the facts change, I change my mind."
Below are key aspects for start-up entrepreneurs to consider for fund raises in the current environment:
- Be flexible on the valuation – Founders are sensitive to down rounds given there is an anti-dilution adjustment clause, and they also fear business appearing weak. A company's value is a combination of financial metrics and the valuation multiple that investors are willing to ascribe to. Valuation multiple is a function of multiple factors including peer group multiples, relative positioning and investor sentiment, something individual companies can't control. These multiples have contracted and would impact companies' valuation irrespective of their underlying business strength.
- Current focus should be on primary issuance; secondary sale doesn’t help – In order to reduce the entry price for prospective investors while trying to maintain valuation, companies sometimes offer a blend of primary issuance and secondary sale. Secondary sale is by existing shareholders and can be at a discount to primary. In the current environment where finding investors itself is tough; we believe it is prudent for start-ups to not dilute any opportunity to raise capital and thus focus on primary issuance.
- Expand investor base – All start-ups aspire for high quality global funds as their shareholders. However, start-ups, especially in the current environment, should also target non-traditional geographies and investors. As examples: 1) family offices have emerged as a large and stable source of capital, and 2) Many Middle East funds are increasingly moving beyond just being LPs (limited partners), providing capital to Venture Capital / Private equity firms, to direct investing.
- Explore venture debt – It is more expensive than equity as it typically carries coupon plus some equity component. The typical time horizon is 3-5 years. As pure equity investments have become harder, these funds have become quite active and start-ups should also target them for their capital requirement.
In addition to the above, start-ups also need to have a focused communication strategy targeting investors with an aim to help them gain confidence. Investors by nature are sceptical and consider no news from a company to mean bad news. Key aspects on this include:
- Provide regular business updates – These updates should include some key financial metrics. A regular update on the business progress enhances investor confidence and gives an opportunity to regularly engage with the investor community.
- Consistency in positioning – Frequently changing business positioning raises questions about management’s strategy and their ability to succeed. In the worst case, investors may perceive the management to be opportunistic and changing positions to pander to what they believe investors want to hear. Investors gain confidence when there is steady a consistent strategy a consistent strategy.
- Increase founders’ and management profile – Increasing founders’ profile and showcasing management depth provide confidence on the companies’ execution capabilities.
- Clear internal communication – Companies have to sometimes take tough business decisions especially related to employee retrenchment as part of their efforts to reduce cash burn. Employees tend to know when times are tough and the absence of any communications from the management leads to uncertainty, which impacts employee morale and their work. It is therefore important that management communicates frequently and transparently with the employees, and also address their concerns with an effective employee communications plan.
This combination of adjusting to the reality of current market sentiment and a targeted external communication strategy (with thoughtful employee engagement provided when required) can help improve the chances of a successful fund raise. Start-ups should remember that investor sentiment is cyclical and will rebound. However, before the upturn occurs, some companies won’t survive while others may become too weak to remain as standalone businesses. Those with capital – and a smart communications and marketing approach – will come out stronger.
Gaurav Malhotra, EVP, APAC, Edelman Smithfield
