If you started a company in the last two to three years, chances are you’re flush with investment capital. Congratulations, it must be nice.
However, unless you’ve been living under a rock, you’re aware that the hot venture capital (VC) market we’ve experienced comes on the heels of one of the worst funding environments in recent history. And, as you peek your head out from under, you’ll also see that the funding market – angel, VC, or otherwise – is starting to take another downturn.
Alas! Just when you were getting used to infinite VC funding to power your AWS servers and employee lunches.
But, if you plan on raising a round of financing, it’s important to take the current market into account. It’s cold, for lack of a better, word, and many venture capitalists have stopped investing altogether in the near-term. In fact, the level of funding committed fell by 11% in the first quarter 2016 when compared to the same quarter a year ago. Further, the number of deals declined by over 100 during the same time period, and the rest of 2016 is expected to be much the same.
So, how can you effectively fundraise in an environment that’s become unapologetic to startups that claim to have the next big “thing”? Well, it’s as easy as one, two, three.
1. Focus on Your Business
It’s important to understand that closing a round might not happen as quickly as it once did, if at all. Therefore, it’s up to you as the business owner to run a tight ship that extends your runway, proves your concept, and validates your business model.
If you’re lucky enough to have an existing round open, then perhaps it’s best to raise a larger amount than originally planned. The down market is changing the previous strategy where companies used to raise small seed rounds to gain traction before going after the large fundraising rounds. Now, you might need to raise your seed and series-A in one fell swoop.
But, if you haven’t yet opened a round, the benefit might actually be on your side. You see, the best way to raise a large round and build a successful business is to start running a successful business first. It isn’t rocket science.
So, rather than spending money on research and development (R&D), for example, it’s better to allocate capital toward the revenue-producing parts of your business. Prioritize sales and marketing over everything else. Reduce your burn by reducing your unnecessary operating expenses.
Focusing on this type of efficiency allows a company to improve business processes, extend its runway, and validate its business model. Then, when it come times to raise a round in this down market, the business concept has already been proven, and all a VC needs to do is add money to ignite the rocket boosters.
2. Decide Between Deal and Source
A down funding market inherently puts the power in the hands of venture capitalists and angel investors. When the market’s hot, there’s greater competition between funds to find deals. When the market’s cold, the opposite’s true, and startups compete with each other for the limited available resources.
This means, of course, that the deal structure for a round may not be advantageous for a startup, and it’s important to be weary. With multiple liquidation preferences, senior liquidation preferences, participating preferred, and redemption provisions, it’s easy for deal structures to make your head spin. But, if you break it down into two components it gets much easier to make decisions in the down market
When raising capital, it’s important to optimize for “deal” and “source.” The deal part of a structure includes the key components and terms of a proposed deal, such as valuation, dollars raised, and the option pool. Source, on the other hand, describes the provider of the capital and the value they can provide from a relevancy and partnership perspective.
At first glance, it may seem important to optimize for the deal and try to get the highest valuation possible. However, in a cold funding market, it’s important to identify partners who will stick with you over the long-term. Therefore, in today’s environment, it’s more beneficial to find a capital partner that has the highest relationship value over time, rather than short-term valuation alone. A virtual reality (VR) company, for example, might prioritize a VR-specific fund over a general fund that’s offering a higher valuation.
What’s more, focusing on the source over the structure actually helps with the deal itself. Positive partners want their investments to succeed, and they won’t handcuff companies with limiting terms. Additionally, choosing the right partner can help ensure that there are future rounds of financing, B- and C-rounds would be otherwise impossible.
3. Consider Bridge Financing and Convertible Notes
Sometimes the best way to raise funding in a down market is to not raise a round at all! Sounds counterintuitive, I know, but hear me out.
Maybe the right course of action is to ride out the storm and wait for a more advantageous funding environment. To do so, you first have to reduce your burn and run an efficient business, discussed above. However, if you’re an early stage company that still needs to build its product or prove its concept, consider bridge financing to get you over the hump.
The first possibility is to take out a bridge loan. Eek, debt, I know! Bridge loans are shorter-term loans that last anywhere from a few weeks to a few years. However, as is the case with immediate financing options, the interest rate on a bridge loan is high and can even cause future financial struggles. Act with caution when taking out any type of corporate debt.
The second possibility is to structure bridge financing through an equity deal. This deal structure is normally initiated with a VC firm and offers a smaller amount of equity for short-term funding options. For example, if a startup wants to sell 25% of its equity in a series-A round but wants to wait for a better market, it can sell 5 – 10% of its equity to a VC in return for six months runway, which can get them to a better market.
However, the third – and possibly the best – scenario is through a convertible note. These types of notes are used by early stage companies that don’t want to put a value on their business yet. Instead, they opt for debt financing that can be convertible to equity at a later date. Therefore, convertible notes are structured as loans with the intention of being converted to equity. The major benefit is that although these notes carry interest, interest payments aren’t paid in cash like other debt instruments but are instead paid as additional shares when the note is converted to equity. However, to compensate the investors for increased risks, the equity is usually offered at a discount.
Well, there you have it: Three tips on raising money in a down market. It’s not rocket science. Run an efficient business, focus on revenue, prove your concept, and pick a funding partner who is in it for the long-haul.
However, if you’re instead looking for bridge financing options, things can get more complicated, especially with a convertible note. In our next article, we’ll touch on the specifics of this funding instrument, including its short-term and long-term benefits.