Scaling a startup is difficult even in the best economic times. As the startup world confronts the realities of a wider economic downturn in 2022, early-stage companies face new challenges and questions.
No one quite knows the extent of the downturn, or how long it will last. One area of debate is startup fundraising, one of the most important aspects of the early-stage life cycle.
The number one reason startups fail is an inability to raise new capital. What happens to the fundraising landscape when economic pressure contracts multiples, lowers valuations and forces venture capital firms to be more conservative with spending?
We spoke to four experts from the VC and venture-debt world during a recent live event to answer this question. Aziz Gilani (Managing Director at Mercury Fund), Adam Midkiff (Principal, RC Capital), Caroline Tkatschow (Director, Innovation Banking at CIBC) and Mark Gilbert (Executive Director, Espresso Capital) all shared their insights.
The panelists touched on three major trends that are affecting startup funding:
- The presence of unspent “dry powder” capital provides hope for fundraising-ready startups
- A preference towards startups that work with “mission critical” B2B products and services
- Increasingly strict term sheets that protect VCs and investors in a riskier market
Here’s your guide to understanding how the economic downturn is affecting equity financing rounds, with insights from industry experts
There are different opinions on the extent to which startup fundraising is affected by the economic downturn.
The startup and venture capital ecosystem enjoyed a nearly 15-year run of growth and success prior to this year. Economic downturns are natural – and always have an end.
In May, Silicon Valley investment firm Y Combinator warned startups[1] to “prepare for the worst,” and discouraged companies from raising capital over the next 6-12 months.
On the other hand, VC darlings like Venmo, Instagram, Uber and WhatsApp all launched in 2008, amidst The Great Recession, aka the last major economic downturn. By nature, startup investments aren’t meant to yield immediate returns, so the longer-term horizon gives VCs more freedom to write checks.
In short, startup fundraising can be harder than it was just a few months ago. However, growing a potentially successful company is far from impossible.
“If you’re building a business that produces a real benefit and produces real cash flows, then the time horizons associated with venture capital mean that these individual dips in the market aren't going to affect you too much,” said Aziz Gilani, Managing Director at Mercury Fund. “You just have to focus on building a capital-efficient business.”
Keeping track: 3 fundraising trends for startups
Reading through investment news can make your head spin. We’ve distilled down the major news into three trends to follow:
1.There’s “dry powder” capital still available.
In the context of VC and private equity, dry powder is essentially unspent capital that investment entities have on hand. Over the past few years, firms typically deployed capital from their funds quickly: over the course of 12-18 months. Luckily, 2021 was a record year for VCs – they doubled their 2020 numbers and raised $330 billion[2] for their funds, with more new funds than ever. Not all of that has been pledged to startups.
“That capital needs to get invested over a reasonable time period,” said Adam Midkiff, Principal at RC Capital. “I think there is this buoyancy effect that may occur where you have these overall concerns, but it doesn’t quite feel the same as what it did back in 2008.”
One important note: many investors are slowing down their rate of deployment for capital during the economic downturn. VCs might now deploy their fund over 2-3 years, because there’s more uncertainty about when they’ll be able to raise a new fund.
There’s still money available even though VCs will likely look to stretch it longer than before.
2. “Mission-critical” B2B companies are often best positioned for funding.
For consumers, discretionary spending typically drops in tough economic conditions. Families might skip their yearly vacations or avoid buying luxury items. Businesses do the same.
“When budgets are shrinking and these products are not hooked into core systems, you’re probably going to see a higher churn,” said Mark Gilbert, Director, Espresso Capital. “Those deals might be scrutinized a little bit more heavily.”
Unfortunately, the 2022 downturn has negatively affected FinTech, MarTech and EdTech startups.
“Mission critical” services that are more essential for daily operations – cloud infrastructure, cybersecurity, IT, HealthTech – are more likely to succeed. Additionally, businesses aren’t likely to separate with products or services that require high switching costs for a new system.
“Thinking about companies slashing budgets and kind of going through their own cost exercise – what’s that software that they need to have versus what’s nice to have to run their day-to-day business,” said Caroline Tkatschow, Director, Innovation Banking at CIBC.
If your startup is in one of these more recession-proof categories, you’ll likely have a better time conducting an equity financing round with VCs. Startups in other industries might want to explore non-dilutive sources of capital like venture debt.
3. Term sheets are becoming more restrictive.
As discussed in the live event, in the 2008 downturn, VCs were forced to protect their investments with more restrictive term sheets. If you’re raising capital in 2022, looking back might be helpful.
“We haven't had a down market here in about 13 years,” Gilani said. “Find a term sheet from the year 2008 or 2009 and probably all the terms that were in that term sheet are probably going to come back into vogue.”
Terms will be more investor and lender friendly. Gilani advised founder to familiarize themselves with terms like:
- Participating Preferred Stock (this impacts how a transaction gets paid out)
- Liquidation Preferences greater than 1 (investors are paid back first upon a M&A or sale)
- Cumulative Dividends (a right associated with preferred stock)
VCs are being affected by the economic downturn as well, which means they have no choice but to protect themselves with instruments such as these.
Generally speaking, if your startup is a.) growing its revenue, b.) maintaining high gross margins, and c.) building a scalable business model, you’re still going to be able to raise capital in 2022 and beyond.
VCs still have capital sources to pull from, but they may require more stringent terms to protect themselves. Certain industries are more recession-proof, but any company with a path to profitability stands a better chance of closing a deal.
[1] Y Combinator Warns Startups In 2022 To Plan For Economic Downturn (crunchbase.com)
[2] Six charts that show 2021's record year for US venture capital | PitchBook
Looking for more insights on how the economic downturn is affecting startups and VCs? Check out our free webinar, “Raising Capital in Uncertain Times: Investor and Lender Perspectives.” Four experts from VC and venture-debt firms joined the webinar to discuss current trends and offer tips to growing companies.
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