In a matter of weeks, the venture capital landscape has taken a sharp downward turn. With market and public uncertainty around COVID-19, the fundraising environment has become tenuous for companies seeking to raise in 2020. Startups have already begun battening down the hatches and extending their runways in order to survive. If your startup has no choice but to raise an equity round in the next couple months, and interim financing isn’t an option, this guide will provide some structure for navigating the process.
Impact of the Current Environment
Let’s start on the bright side: VCs currently have lots of “dry powder” they need to deploy, so deal volume in Q3/Q4 may not be hugely affected by the crisis. That said, if your original target was Q2 for that Series A, now is the time to consider how you can extend your runway. In either case, a startup fundraising in the next few quarters will face significant downward pressure on valuation; as one unnamed investor put it, “flat rounds are the new 3X up rounds.” Term sheets are also likely to include more investor-friendly provisions going forward, as investors will require more incentive to offset the increase in perceived risk. Post-close, VCs will likely exercise more control over the day-to-day operations in their portfolio companies – founders should expect more questions about cash management & runway in both quarterly board meetings and monthly updates.
It’s possible that the harsh funding environment will persist into 2021 if VCs have difficulties raising their next funds and the operating environment hasn’t improved. You’ll want to start new investor outreach sooner than was necessary in the past as capital will likely be more scarce during the 2021 fundraising cycle. It’s important for founders to understand the status of their current investors’ funds and progress they’re making towards raising their next ones. Keeping current investors in the loop with regular product updates and financials will ensure that everyone is up to speed when you do kick-off fundraising. Now more than ever, good communications will pay dividends down the line.
Raising a Down Round
Due to current conditions, a company with metrics that might have previously merited a healthy valuation increase could now be looking at raising a ‘down round’. Put simply, a down round is when you raise new money at a lower valuation than you received in your last funding round. If this happens, there are several knock-on effects that a founder should be aware of:
- Psychological ramifications: When employees see their equity decrease in value, they can become demoralized, and can become distractible or disgruntled by the lack of perceived progress
- Underwater stock options: As soon as a down round occurs, several employees’ options will become “underwater” if the company’s valuation was higher at the time of their option grant. There are three potential options for addressing this: 1) Do nothing, 2) grant additional equity, and 3) reprice/exchange outstanding options. Be sure to discuss the implications here with your counsel to ensure you’re following proper guidance across the board.
- Anti-Dilution Provisions: Almost all financing documents have some sort of anti-dilution protection baked in. There are different types of anti-dilution protection, but all of them result in founders/employees giving up more of their ownership than anticipated during a down round.
It’s worth recognizing that we live in unprecedented times and today’s operating environment is the polar opposite of the one we knew at the start of 2020. That means different strategies will be needed and will require you and your business to adapt. In order to steer through this crisis, clear, consistent communication with investors and employees is crucial for gaining buy-in on your company’s plan.