For all intents and purposes, 2022 was a remarkable year, in which the global economy experienced two simultaneous realities:
2022 also saw an historic IPO drought as the technology sector — central to the venture capital landscape—the last year has brought the steepest and widest drawdown for a generation. This wave of cost-cutting has also extended to other investment pools, and levied a brutal impact on funding rounds worldwide: Series B rounds and later have plummeted. Just plummeted.
Cooley, one of the top start-up-representing law firms worldwide, published a report noting the sharp decline for later-stage VC rounds among their clients, and the trend appears more brutal than many experts predicted, with the massive decline in total amount of VC capital raised as illustrated in the chart above.
Because of this shrinking investment pool, Founders and CFOs worldwide have had to dedicate a significant amount of effort towards extending their cash runway in order to survive this investment winter.
Uncertain markets make for excellent investment opportunities, provided one is willing to ‘buy the dip’, unsure if your investment was made at the bottom of the valley, or if the floor will continue to drop. Many established VCs have become overexposed within their portfolios thanks to dramatic valuation fluctuations over the last 5 years (otherwise known as “the denominator effect”), and pausing on new fund allocations. Though new institutional investors are appearing (particularly family offices, foundations and endowments) to fill the vacuum, the fact remains that Founders should be prepared for the “new normal” of a slower macro environment in VC, at least for the next few years.
First, new VC entrants drawn into late-stage ventures in hope of cashing out quickly during the boom have contracted their prior ambitions, given the state of the market. Second, limited partner (LP) investors are pulling back on some commitments as the value of their VC investments appear bloated, relative to a lower valued stock market, the denominator effect may force more LPs to continue tweaking their allocations through 2023 and possibly until early 2024. However, this doesn’t mean that all deals are off.
A slower VC macro environment does not mean it’s impossible for founders to begin fundraising. On that front, Founders and CFOs will want to focus on two key fronts:
Companies that have consistently performed as well as demonstrated strong and efficient finance processes will still garner plenty of interest from external investors seeking stability in a volatile market. However, that very volatile market will likely make investors more demanding in their term sheets. While this may not seem like a big deal for many; investors usually want assurances on their investment, Founders and CFOs will still want to do their due diligence to ensure the term sheets received do not contain any red flags.
Achieving a good deal with investors doesn’t start with talking to investors. It begins with understanding your company’s priorities, which will give you a framework for assessing term sheets when you receive one. While these can vary depending on your industry, fundraising stage and the investors you approach, there are a few key things to consider.
Not educating yourself on valuation concepts can lead to misunderstandings in the actual ownership percentages and other economics. For instance, not understanding the differences between pre-money and post-money valuation can lead to different estimates of valuation by the founder and investor. As a first step, identifying a realistic valuation if your company will help you weed out term sheets that grossly undervalue your company’s actual worth.
Familiarise yourself with all the terms in a typical term sheet so that you know what is being offered and the implications. It pays to know what you can compromise on and what you absolutely can’t accept. Making a list of deal breakers forces you to explore what really matters for your company.
While valuation and other general terms may be strong focal points for desirable term sheets, it’s also important to stay alert for specific redflags that could indicate an investor may not be a good fit for your company. Terms that limit future fundraising rounds or other harsh terms will be hard to renegotiate once a term sheet is signed, so it’s best to remedy them now. Jessy Wu, Investment Principal at AfterWork ventures, shared some thoughts recently on what some non-standard terms are. Here is a quick list of some terms to be wary of and why:
Every founder wants a high valuation for their own company. However, particularly for early stage fundraises, high valuations can hurt future fundraising prospects. In the course of financing, many startup founders full into the trap of trying to maximise valuations to avoid dilution of their stake in the startup instead of aiming for realistic offers.
In the short term, higher valuations offer validation for founders’ successful ventures, decreases dilution due to capital increase, and allows founders to retain more shares. However, these valuations also come with high benchmarks from investors; benchmarks that, if not met, can mean less funding in the next round of investment as investors in subsequent rounds may insist on lower company valuation.
Successful CEO-cum-founders are an extremely rare breed, but that doesn’t stop people from aspiring to be more. Every would-be entrepreneur strives to be a Bezos, Gates, or Zuckerberg, but few understand how difficult that can be. A majority of founders surrender management control by year four, often replaced by a board-selected CEO, with them taking up a president or other board advisory role.
Founders must ask how much equity they are willing to part with to secure investment. Do they want to maintain control over all business decisions or cede that control to someone potentially more qualified? Is leading worth more than securing financial gain, or is it better to concede some control in exchange for financial flexibility? Founders’ choices are straightforward: Do they want to be rich or king? Few have been both.
While 2023 isn’t quite shaping up to be a ‘founders choice’ market for investing like some predicted, for founders and CFOs helming companies with strong revenue and long cash runways will find themselves having an easier time navigating fundraising with VCs and other investors. Established investors, as well as new market entrants, have moved on from high-risk high-reward targets and now prioritise stability and reliability in their portfolios, a high-value commodity in today’s uncertain market.
Any investor you bring on board will likely have a long-term relationship with the company. A strong term sheet with terms and conditions that benefit both investor and founder will go a long way in making that relationship fruitful, and be a promising sign for future fundraising rounds. While so many decisions can be overwhelming for many founders and CFOs, particularly those new to fundraising, these decisions are vital to a successful venture.