The value of this article will be directly proportional to the significance of the market downturn that creates general uncertainty and affects the ability for startups to fundraise. All downturns are different in a variety of ways. But the concepts covered in this article can be adjusted to match the current situation that is causing you to read this.
The Cause of the Downturn Matters
Most market downturns have some effect on the availability of new funding capital that most startups depend on at various stages of their evolution. But not all downturns have the same effect on customer demand for technology products.
The great recession that started in 2008 triggered massive rounds of layoffs and associated slowdowns in both consumer and business spending, pretty much across the board. Contrast that with the COVID pandemic, which dramatically impacted most industries but actually benefitted some. Additionally, the impact of these downturns were multi-year, whereas a typical recession might only last a couple, or few, quarters. Again, all downturns are different.
The first thing tech startups need to get a handle on is the expected timing and impact to the availability of funding capital versus the same for consumer/business demand for your product. Also, being able to predict the duration of the downturn would be nice, but is rarely easy to do.
Quick Drop Followed by Slow Recovery
Usually the downturn seems to happen over the course of days or weeks where as the corresponding recovery happens over quarters or years. And it’s not always the case that a rapid downturn (days) is followed by a more rapid recovery (quarters).
I believe that any possible downturn speed can be followed by any possible recovery speed. I don’t actually know this to be true, but am just thinking about a handful of prior scenarios.
As a sudden market downturn becomes apparent, the initial reaction by most investors is to freeze. Everything from the severity and duration of the downturn to the exact effect on certain industries, geographies, consumer demographics, etc. is very cloudy. Why make a decision at a time like that when waiting some amount of time for things to get clearer lets them make a more informed decision?
This means that the market doesn’t need to fully recover, or even mostly recover, in order to enable investors to start making decisions. Rather, the general situation needs to be mostly understood and with some general consensus on the things that were initially really cloudy. The near-term future can look bleak, but if it’s predictably bleak, that’s a lot better than mostly unpredictable.
During this phase of paralysis, investors will still take meetings, especially institutional investors. But you should think about these meetings as being more for relationship-building and information gathering than pushing towards a near-term decision. That’s not ideal, but still plenty valuable to pursue.
Time as a Resource
I regularly boast that TIME (aka – runway) is a startup’s most valuable resource (see related article titled “A Startup’s Most Valuable Resource”). The reason this becomes increasingly important during a downtown is due to the uncertainties of funding availability and customer purchase interest. When a downturn starts, you can’t reliably predict how long it will last or how severe it will be. But if the downturn is likely to be serious, you can’t stand still and do nothing.
Most startups in this situation should do things to extend their runway until the future becomes clearer, both related to funding availability and customer purchase intent. Slowing/pausing the pace of new hiring is often the least impactful action to take. Reducing prices (or running promotions) to accelerate income could be something to consider. Negotiating incentives for pre-payments of multi-year contracts might be a no-brainer. And doing things to reduce churn can be really helpful. But after that, it gets pretty hard and painful, because one of the only things left is taking salary cuts or doing layoffs. Those are painful.
I can’t guide you much further on this, because every downturn is different and every company’s situation is different. But don’t punt this discussion/debate down the road for a month or two, hoping things will be crystal clear. Instead, discuss your options immediately and decide if any of the possible actions should be taken immediately to give some benefit.
Early and small funding rounds that are sourced from angel investors are really difficult. That’s because angels are investing using their personal net worth, which presumably just took a big whack due to the downturn. Angels in this situation are much less excited about the upside potential from investing in your opportunity versus being freaked out about the 20% or greater drop in their investment account balance.
Side Note: This means that the best angels to target have one or more “intersections” with your business plan. In my article titled “Threading the Needle for a Successful Pre-Seed Round“, I describe the concept of hyper-intersected angels and how desirable they are for pre-seed rounds (ie – product not launched, no revenue). During a market downturn, similar levels of intersection are needed in order for angels to invest in a seed round.
Venture funds are very different. That’s because they’re investing others’ money and are expected to provide a solid return on investment. They would rather not sit on the sidelines for very long for a couple of reasons. First, they need the market (startups, etc) to think they’re still actively investing. They don’t want to have to spend a long time unwinding a rumor about them not actively investing. Such a rumor affects the quantity and quality of deal flow they get. Those things are life blood to a venture fund.
You might argue that with a fund’s capital already raised, why not exploit the downturn by taking advantage of better prices (valuations) and terms? Let’s explore that further.
If the investors can’t yet predict how long, or how severe, the downturn will be, they can’t well judge how likely it is that a startup can leverage a new funding round to reach the needed outcomes to either become profitable or unlock the next funding round. So, they might actually wait until that’s a little clearer. In fact, I often see a month or two of mostly paralysis amongst VC’s, due to this factor.
Side Note: Almost all VC’s will continue to take new meetings. That’s because they never want a rumor to spread that they’re not investing. But such a VC will not be very aggressive with their follow up, and they might give homework assignment after homework assignment, to help drag things out.
Assuming the downturn affects all tech startups (versus only those serving certain affected industries), the thing that will differentiate a given venture fund’s behavior more than anything is the age of the fund they’re currently investing from. After a new fund is raised, it often has a three-year investment phase. Maybe a bit shorter or longer, but let’s use three years for this example.
If a fund is in its third year of investing, they’re already starting to raise their next fund. But since many of their prospective LP’s are freaked out and possibly still paralyzed, their next fund might not come together by the end of year three on their existing fund. That could easily cause them to stretch their investment horizon into a fourth year, which means investing less frequently, making smaller investments, or both. Neither are good for fundraising startups.
If, instead, the fund is in its first year, and especially if in its first months, a totally different behavior might exist. They know many other funds will be slowing down and generally being more conservative. They can take advantage of that lack of competition to get into some really good deals at good valuations (more on valuation shortly).
If you’re meeting with venture funds during a downturn, try to find out where they are in the life of the fund and, more specifically, their period for making new investments. Asking that question might be a little delicate, because during a downturn they’ll probably know why you’re asking. But try to find out anyway, even with an Internet search for their public announcement about the fund when it was newly launched.
Funds Actually In the Bank?
Smaller funds in the $10-50M range might actually collect all investor commitments up-front. But when you see an announcement about a new $200M fund that was raised, it doesn’t mean they have a fresh $200M sitting in a bank account for making investments. Rather, the fund issues what are called “capital calls” to their committed investors. They do this either on some pre-determined frequency or as they commit to a new investment.
A fund’s key performance metrics (IRR, etc) start getting calculated as funding is DRAWN from their LPs. So the issue of fund performance might not actually cause a fund to start investing again quickly.
During a market downturn, the investors are still legally committed to honoring any capital calls, and there is usually some punishment for not doing so. But, knowing the situation most of their investors are in, the fund partners might be a little more reluctant to call on them to do so with the same frequency as before. It’s a touchy issue for the fund partners to balance.
Impact to Fundraising Terms
The first thing to happen during a downturn is a drop in valuations. And the higher they escalated during the prior phase, the more they’re likely to drop after the downturn. This means you can mostly ignore the funding deals that got done by “startups like yours” a couple of months ago.
With this, part of the initial dilemma for the investors is they don’t know what the right valuation should be. They don’t know where and when the bottom will occur, and their pattern-matching brains don’t have enough comparables to give them guidance. Bottom line – prepare to see your previously-desired valuation take a haircut, and maybe a big one.
The fluctuations in valuation from peak to trough might look like a roller coaster in Silicon Valley, but more like rolling hills in places like Texas. The drops during a downturn might be more severe with growth stages of funding (ie – Series B or C) versus pre-seed and seed stages. And since valuations and round sizes tend to trend together, lower valuations mean smaller round sizes at any given stage.
One thing to watch for, as the balance of negotiating power shifts to the investor, is more predatory terms on the term sheet. The first thing to look for is more aggressive liquidation preferences in equity rounds of funding. Instead of a typical 1x preference, you might see 1.5x or 2x on your term sheet. You might even see that nasty “participation feature” on the liquidation preference, which we commonly refer to as the “double-dip” provision. As usual, you’ll want your skilled corporate attorney to educate and guide you through any term sheet negotiation.
A tool that’s used for new funding during a downturn is to authorize an extension of your previous round. It might have fully closed months or longer ago. Re-opening it for new investment, but at the same terms as before, is quite common to see.
Existing investors are definitely the best candidates to approach because they already know you and have tracked your progress. But new investors might also take interest in making an investment at the terms that were used to close a previous round. This is basically a valuation haircut and using legal documents that were previously negotiated and executed.
Re-opening a convertible note or SAFE at the same terms of a prior round would also be considered a round extension.
Startups might want to nudge up the valuation, or valuation cap from the previous round. But doing so essentially is just a new round of funding. That’s fine if you can get it. But moving quickly on a round extension, before the downturn gets too bad, can be the best way to bring new funding in the door and to extend your runway.
Hopefully the downturn that’s causing you to read this article isn’t of the magnitude of the great recession or COVID-19 pandemic. I also hope this becomes a time that causes you and your organization to exercise a new muscle for maintaining resiliency during a crisis. You will surely encounter more, over time, as you build a great company.
Side Note: For more about building company resiliency, read my article titled “Mock Crisis to Maintain a Well-Oiled Machine”.