Accelerating out of the downturn: How entrepreneurs should think about fundraising in a bear market
The last three years have been a truly remarkable time for entrepreneurs. We came into 2020 on the heels of a ten year bull run, driven by loose monetary policy from central banks around the world that bolstered stock prices and venture capital funding.
When the pandemic hit, the initial expectation was that this would all come crashing down… and it did. In March 2020, VCs released blog posts and webinars predicting a tough time ahead for entrepreneurs. At Endeavor, we put together a series on Leading Through Crisis. However, despite its far reaching economic and social costs, the pandemic became a massive tailwind for technology entrepreneurs.
The lockdowns in response to the pandemic led to the acceleration of technology adoption. This, combined with significant government stimulus, lifted the stock market and venture capital funding to levels never seen before. In 2021, public markets reached all-time highs and venture capital funding broke records across almost all geographies and sectors.
By November 2021, the stock market had peaked. Inflation was now also at record highs and central banks began increasing interest rates in an attempt to combat the upward trend. By the end of Q1 2022, it was clear that 2021 was the anomaly. Fundraising figures in 2022 are down from 2021 levels across nearly all regions – although they are still high by historical standards. Latin America, perhaps the market that saw the highest increase in venture capital funding in 2021, has seen the steepest decline in 2022. Africa, one of the only regions that saw fundraising numbers increase in 2022, has finally started to see them decline.
The VC blog posts returned in March and April of this year. The advice was similar to what had been given in the early days of the pandemic: cut costs, reduce burn, raise internally, drive to profitability. The smartest entrepreneurs took this advice and made the necessary adjustments to their budgets and plans.
However, this was over six months ago. It is now clear that – for the near term at least – we are likely to be in a different funding environment than the one we were in for most of 2020 and 2021. The most common question we are getting from entrepreneurs is: “Now what?” They’ve cut costs, raised internal rounds, and extended their runway, but they still have great businesses with exciting long term prospects and are looking to execute against their vision.
Savvy entrepreneurs understand that in times like these, they must operate like Formula 1 drivers. F1 drivers brake just enough to navigate the curves on the road without losing too much speed and then accelerate immediately out of the turn to overtake rivals.
" Difficult environments often provide an opportunity for entrepreneurs who know how to navigate them."
Legendary F1 driver, Ayton Senna famously said, “You cannot overtake 15 cars in sunny weather… but you can when it’s raining.”
The next few years are going to feel a bit rainy to entrepreneurs who are used to the mostly sunny weather of the last decade.
" However, here are a few things we think will help entrepreneurs navigate this moment:"
Interest rates are like gravity
When interest rates go up, valuations go down. Investors underwrite to a certain expected return based on their cost of capital. Interest rates are the primary input into the cost of capital. When interest rates go up, cost of capital goes up, and the target return for a given investment goes up. For most of the last decade, we had Zero Interest Rate Policy (ZIRP) from most major central banks. Over the past year, central banks have raised interest rates and are signaling more rate increases. This will have an effect on the expected return investors need to justify making an investment.
In the public markets, high growth technology companies such as Facebook, Amazon, Coinbase, Zoom, have seen their stock prices drop by 40%-80%. We expect private markets to see a similar effect. Entrepreneurs need to come to terms with this and adjust their capital requirements and valuation expectations accordingly.
There are still record amounts of dry powder
According to an analysis done by Jon Sakoda, founder of venture firm Decibel Partners, VC firms have an estimated $290B worth of dry powder to invest in new deals. This is a record figure and roughly 50% more than what was available in 2020. Despite the change in the macro-economic environment that we’ve discussed so far, we believe that most of this capital will be deployed. However, we expect it to be deployed at a slower pace.
There are two main levers that investors are likely to pull in order to adjust their deployment to the new reality:
1) They will invest in fewer companies – looking to put more capital to work in companies where they have the highest conviction,
2) They will look to invest in the same number of companies, but at much lower valuations.
It’s not clear to us which direction the industry will go. Will we see more money chasing fewer deals or will we see VCs offering much lower valuations to companies? Said another way, will half the number of companies raise capital at peak valuations or will a similar number of companies get funded at half the valuations from the peak? We expect the answer to be a mix of both as different firms take different approaches.
Down rounds are not a death knell
Companies will find a very different landscape as they return to the fundraising market. For the best companies – clear market leaders with strong business fundamentals – capital will still be available, potentially at the same (or better) terms as last year. For other companies, capital will only be available at a discount to last year’s multiples, despite growth in metrics. Unfortunately, for most companies, there simply will not be any capital available.
We believe that over the next few quarters, raising flat or down rounds will need to be normalized. Over the past decade, down rounds were seen as a sign that a company was struggling. However, in a world where the strongest, fastest growing public companies – such as Snowflake – have seen their market cap drop more than 60%, we do not think it is realistic to expect private companies not to raise down rounds, regardless of how well they are performing.
Anecdotally, we have seen some of our strongest companies, led by very thoughtful entrepreneurs, raise down rounds and use this opportunity to bring world class investors on board. This article from April 2020, is a useful read on some considerations when raising a down round.
The majority of companies will raise over 3-5 rounds before an eventual exit. In any given round, optimizing for the highest valuation or anchoring to past valuation, without taking into consideration the market reality might not be the optimal approach. In 2008, during the global financial crisis, Meta (then Facebook) raised a down round at a 30% lower valuation than its previous round. Today, even though Meta is down more than 60% from its all time high, it is still valued 30x more than its 2008 down round valuation.
" Building a company is a long term game."
Clean terms are often the best terms
When entrepreneurs are anchored towards a certain valuation, investors are often able to meet the valuation by adding certain terms to the deal. Terms such as liquidation preferences, warrants, and anti-dilution clauses allow investors to offer the same headline valuation number, while protecting their downside and/or allowing them to meet their return targets. This a16z article on funding when capital isn’t cheap opens with an industry saying: “Give me your headline price, and I’ll give you a deal”.
These terms often distort incentives between the entrepreneur and their investors. For example, an investor with a liquidation preference might be willing to accept an acquisition offer at a price that generates a good enough return for them, but leaves everyone else with a sub-optimal outcome.
" Our general guidance to entrepreneurs is that while there are certain situations where structured rounds are advisable or even necessary, it is often best to simply raise less capital at a lower valuation on clean terms."
Once capital has been raised on clean terms, all parties can focus on building the company and driving as much value as possible for all shareholders. If a founder is able to drive growth and hit their targets, there are often ways to reclaim additional ownership of the company.
Fundraising is all about momentum
At Endeavor, we coach entrepreneurs to structure their capital raises in a way that generates and sustains momentum until culminating in at least 2-3 competing terms sheets. One thing we’ve often seen derail this process is an entrepreneur starting with a fundraising target that is too high, from a valuation and/or an amount perspective.
For example, an entrepreneur goes out to raise $50M at a $500M valuation and investors pass because they think it’s too expensive or the entrepreneur is looking to raise too much capital. Then the entrepreneur adjusts expectations and goes back to those investors looking to raise $30M at a $300M valuation. Unfortunately, the entrepreneur has now lost momentum and time,and the investors understand that the entrepreneur is only coming back because they didn’t receive interest from other investors. This puts the entrepreneur in a very weak competitive position.
The entrepreneur would have been better served by starting the process with more modest expectations. In this scenario, if the entrepreneur gets more demand than they expected, they can then decide what to optimize for (e.g. choosing the right partner, increasing the round size, getting the best valuation, etc).
When economies turn down, entrepreneurs turn up
At Endeavor, we are long term believers in the power of entrepreneurship to transform economies. As an organization that has operated in emerging markets for 25 years, we are all too familiar with economic uncertainty and tight funding environments.
Just spoke with an experienced LatAm founder
“High inflation, high interest rates, fear of recession, general macro and political uncertainty, limited access to capital. This is a home game!”
— Shu Nyatta (@snyatta) May 23, 2022
The name of the game is survival, and to do this entrepreneurs must balance aggression with pragmatism.
" We believe that many of the transformational companies of the next decade will be built or forged over this period of economic uncertainty. "