Raising money for a new business can be difficult, and that’s certainly the case right now. Geopolitical tensions, inflation, and interest rate hikes are affecting the private markets and leading to a dip in company valuations. While the private market has been spared some of the volatility that investors are seeing in the public markets, founders are facing more uncertainty than what was considered “normal” over the past few years. Money is harder to come by, and investors are more selective. Entrepreneurs can’t rely on business as usual.
However, tough times spur innovation, and such times are how some of the world’s most powerful companies were born. The good news is that you’re not alone and there are ways to navigate these uncertain times.
Here are five critical things for founders to know right now:
1. Deal terms are shifting.
Keep an eye out for these terms! We’re seeing and hearing more about “investor-friendly” provisions coming back to the forefront, including terms that haven’t seen the light of day in a decade or more. Money is taking longer to reach company bank accounts, and it’s coming with more conditions attached. Term sheets are looking different as venture capitalists insist on terms that will help them better protect their investment.
What you should know:
Liquidation preference: Conversations around this term are returning to the negotiating table. Investors want more assurances they’ll get their money back if a company liquidates. In some cases, liquidation preferences are being raised from 1x to as much as 3x, meaning the investors will be paid three times their initial investment before proceeds are distributed to other shareholders. Founders should proceed cautiously. If a company sells for a lower price, there may not be much left after the investors are paid.
Participating preferred stock, participating preferred with cap: These terms are critical to determining who gets how much when a company is sold, particularly if it’s sold at a profit. Founders should pay close attention to whether the preferred stock is “participating” or “non-participating.”
Overall, holders of preferred stock get preferential treatment. They get paid first, in part as a reward for investing early and putting large sums of money into the company. However, how the rest of the money is distributed is determined by whether the preferred stock is ‘participating’ or ‘non-participating.’ And the costs could add up.
Investors are now more likely to want ‘participating preferred’ stock as it offers both a preferred payment upon liquidation and access to the company’s ‘common upside.’ Indeed, many consider participating preferred to be “double dipping”, as the preferred holders get their share off the top, and then get to return to the well, so to speak, to “participate” in the proceeds going to common holders.
If an entrepreneur must issue ‘participating preferred’ stock, they may consider trying to cap the participation at a certain multiple of the investor’s initial commitment.
Full ratchet anti-dilution: Once popular during the 2008 recession, full ratchet anti-dilution provisions are making a comeback. These provisions ensure the ownership of early investors isn’t diluted in case the company later sells new stock at a lower price, and whether the anti-dilution provision is considered “weighted average” or “full ratchet” depends on what components go into the calculation of that dilution.
Lower valuations, smaller rounds generally: Overall, it’s becoming harder to raise money. Investors are demanding more and are questioning valuations more often. They want to see traction and know the value a startup is creating. Many founders are bracing for lower valuations and are facing smaller rounds. Some entrepreneurs must also now consider how much they’re willing to dilute their ownership to secure that investment.
Tighter protective provisions: Essentially, protective provisions give investors veto rights over certain moves made by the company. In the past, investors may have been more willing to overlook these. Now, they want better economic terms for their investments and increased levels of control over the business. Overall, investors are becoming more risk-averse and are turning to these provisions as another form of protection.
2. Due diligence is taking a while.
Many investors are still actively pursuing opportunities. They’re just moving more carefully and are now demanding more robust due diligence before deciding whether to write a check. Investors are digging deeper into a founder’s track record and are closely examining a company’s opportunities and risks.
So how to get your due diligence right? One aspect that can be overlooked is simply getting your documents in order. Unfortunately, founders and executives can fall into the trap of waiting until the last minute to prepare for the due diligence process. However, proactive entrepreneurs can benefit from gathering and preparing documents early. Begin with small steps to make sure the company isn’t paralyzed by the process.
Regular maintenance and management of your data is also critical. Important documents may be scattered across various divisions of a company and sometimes beyond, such as with outside law firms. Increase collaboration across different parts of your business to ensure key documents don’t get misplaced or misfiled. Leverage technology to ease the workload. Develop a plan for where all your important documents should live. Founders and executives can set the tone for alignment and maintenance, and a digital platform can help with the execution.
3. Equity financing rounds take longer than they should (but don’t have to).
Several things can slow down the fundraising process, from extended negotiation of terms to reliance on manual tracking and management. Oftentimes, a business can grind to a halt as founders try to close a financing round, which hurts potential growth. There are, however, ways to prevent months of distractions and delays.
One solution is to let software do the legwork. Use technology to take the manual work out of fundraising documentation and diligence. Automating standard parts of the deal can boost efficiency and save time.
It’s also critical that you’re consistent with managing your equity management data. Make data maintenance part of your monthly routine by setting internal deadlines and developing a strategy on how to retain key documents.
4. Look beyond VCs for funding sources.
It’s time to get creative! Founders are looking at lots of other possible sources of funding to extend their runway, while not giving up any of their equity. Non-dilutive financing is one option. It’s a way to raise capital without requiring a founder to give up any ownership of the company. It’s especially attractive for new owners who want to retain control and secure funding with fewer strings attached. These highly flexible arrangements can come from a variety of sources and can allow all kinds of businesses to grow. Here are several options:
Revenue-based financing, which provides upfront cash in exchange for a percentage of the company’s ongoing revenue. Typically, the returns continue until the initial capital plus any accrued multiple has been paid back.
Asset-based financing, which is a loan secured by inventory, accounts receivable, equipment, or other property owned by the borrower.
Venture debt is a form of debt financing that allows a company to take on debt through loans rather than give up shares. There are several types, but term loans are the most common.
With the venture capital market slowing down, all fundraising ideas should be on the table. Crowdfunding, loans, and grants are worth considering, particularly for a founder who doesn’t want to yield ownership.
5. Set yourself up for the long run.
You have a great idea and are building a strong business. Get your foundation in place so you will be ready to scale quickly and eventually reach an exit or IPO.
Put together your roadmap to readiness.
Perfect your pitch.
Get your team in place.
Prepare your documents early.
Build a system to keep the data organized and accessible.
Once you’ve laid the foundation, try to prepare for all types of problems both expected and unexpected by learning to translate your business goals into milestones. Executives who focus on executing their company’s promises will find the sky's the limit.
With this year’s investment downturn, many are learning that the rules for startups are changing. Investors are moving more cautiously while demanding more. However, if founders prepare and get organized, they can find tremendous opportunities to build their business.
About the author: Bryce DelGrande is Head of Sales and Business Development at Shoobx, an automated equity management and data room platform that supports private companies through their full lifecycle from incorporation through fundraising, acquisition and IPO.