Fundraising for Tech Companies in a Recession

Published in
August 14, 2023
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Published by Forbes Finance Council

“Humans think in stories, and we try to make sense of the world by telling stories.” Yuval Noah Harari

The numbers suggest that 2023 is proving to be a difficult and challenging year for tech startup fundraising. The total amount of capital raised across all stages of development is down to $164.8 billion in the first six months of 2023 compared to $317.2 billion in the same period in 2022. This is a decrease reminiscent of a 40% drop in the first half of 2009, making it comparable to the impact of the global financial crisis of 2008 on early-stage fundraising.

Venture capital (VC) is a risky and alternative investment strategy to the mainstream. Irrespective of the cause of a financial crisis, liquidity is squeezed and the effect is more pronounced in the illiquid parts of the market, such as VC. How should founders and companies respond to this challenge?

The result of fundraising is a transaction, where cash exchanges money for an equity stake in the company. This money is used to finance growth and expansion and, ultimately, increase the equity value of the business. This would increase the value of the stake purchased by the investor.

Accordingly, the response of companies to the current crisis consists of three approaches: (i) continue fundraising and hope for the best, (ii) look for other sources of financing and (iii) minimize the need for financing. Let’s look at each of these in turn.

Equity Fundraising

Fundraising is still possible since some deals are happening; however, there is a flight to quality. This means that companies need to show better results and focus more on efficiency. Key differentiating factors are margins and unit economics measuring the profitability of acquiring a single customer.

Another consequence is a decrease in valuations. This is simply a function of demand and supply. Less demand for transactions from investors means that the new equilibrium in the market is achieved at lower valuations. For many companies, this is a real problem since they are faced with the prospect of down-rounds that put significant pressure on existing shareholders and founders.

Investors usually have anti-dilution protections, mitigating the issue to a degree; however, in some cases, using these rights might demotivate the founders. One way to sidestep the valuation problem is to favor convertible loans. This effectively delays the problem until a future priced equity round, giving the company funding and the ability to improve its metrics, as well as time for the market conditions to reverse.

Other Funding Sources

Other sources of financing are available in the market and should be explored. This includes revenue financing and venture debt, but also non-mandatory convertible loans, which are quasi-equity instruments. Leverage is an excellent financial instrument in a bull market; however, its validity as a stop-gap in crisis is questionable since it increases the risk of failure. Nevertheless, from a founder’s perspective, it’s attractive because it is mostly non-dilutive and, similar to convertibles, it delays the valuation problem.

Managing Your Funding Appetite

The last avenue available for companies is to decrease their own demand for financing. The most obvious way to do this is cost-cutting, and this can be done in conjunction with other actions. This is a necessity in times of crisis and can also be a useful exercise in increasing operational efficiency. In some cases, companies respond by prioritizing activities leading to near-term financial results, e.g., increasing revenues by raising prices or just refocusing on current sales. Nothing focuses the mind as much as a lack of runway.

The VC Side Of The Coin

The perspective of VCs is different. They also feel the liquidity squeeze of the market since their investment product is even more illiquid than tech company investing. In the first quarter of 2023, VC fundraising in the U.S. was down to $11.7 billion compared to $170.8 billion for the whole of 2022. This would indicate a whopping 73% drop year-over-year unless the market starts recovering in the remainder of the year.

As the ability of fund managers to fundraise decreases, they also start deploying the funds that they have more carefully. This decline in the supply of capital drives valuations lower in the market, increasing returns for VC funds in crisis vintage years, leading to an increase in funding for them and for their target companies, bringing valuations back up. Accordingly, for VCs, there is an opportunity now to be more selective and do more attractive deals.

Time is an interesting factor in this puzzle. On the one hand, as we know from time value of money, cash today is more valuable than cash tomorrow. This is the principal reason for VC managers starting to conserve their cash straight away, even though they raise long-dated capital from their investors, and their immediate availability of capital for investments is not affected. Time also introduces uncertainty because the duration of market weakness is unknown. As a result, cash becomes even more overvalued for all market participants, VCs and tech companies alike.

Lessons In The Art Of Fundraising

As discussed, the current fundraising gloom is not unique and many inferences from previous financial crises exist. The main one is that these are times when “cash is king.” Founders may want to consider taking as much cash as they can (they still may want to continue to consider it even if the cost is high), and also consider using every possible avenue to conserve cash. Another important lesson is the value of persistence.

If you think you are going through hell, just think of Winston Churchill and keep going. The most important lesson is the necessity to focus on your story. Fundraising is an art and central to this is the equity story of your business. What are you building and why? Why is it unique, why are you best placed to succeed, and why now? Storytelling is often overlooked and underrated in business, but it’s critical and its importance is magnified in times of crisis. After all, as Yuval Noah Harari observed, stories are what make the human world work.

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