A new year is upon us and with it uncertain and uncomfortable market conditions. These conditions are accompanied by equally uncomfortable decisions. For startup founders, determining which path is right for their business may require a fundamental rethinking of how they measure success.
The business climate of 2023 will be unknown to many of those who founded a company in the past decade.. Until now, a seemingly endless stream of relatively cheap capital has been available to any start-up the venture capital world deemed to have high growth potential. Everyone wanted a piece of the "next Facebook." With interest rates close to zero, the risks were relatively low and the potential rewards astronomical.
Burning money in search of growth became the norm; you just got more money when it ran out. And the debt? Who needs it? Existing investors were happy to play along, even if their stake in the company was somewhat diluted: rising valuations kept everyone sated.
Over the years, this pattern of rapidly rising valuations and a pie growing fast enough to offset any dilution—fueled by the "free money" that made almost any investment justifiable—crystallized into a mythology at the core of startup culture. It was a culture that almost everyone fed from, from founders and investors to the media.
Rising valuations generated great headlines, sending a signal to both potential employees and the markets that a company had momentum. High valuations quickly became one of the first things new investors looked for when raising additional capital, whether through a private financing round or an IPO.
The financing route you choose has enormous consequences for the future of your company; it should not be clouded by ego or driven by media appetites.
But tough economic conditions tend to dispel complacency with harsh realities, and this year we'll see reality take over when it comes to funding. Against a backdrop of rising interest rates and a generally negative macroeconomic outlook, the tap will turn on slowly, or not at all. Equity funding is no longer cheap or plentiful, and drought will grip founders.
It's easy to understand why many startup founders don't consider a downround. To get started, they would face the flip side of positive media mania, which risks eroding employee morale and investor confidence. In a culture where rising valuations are worn as a badge of honor, founders may fear that a round to the downside will make them Silicon Valley outcasts.
Down rounds don't spell the end of your business
The truth is that there is no single solution. The funding path you choose will have huge consequences for the future of your business, so don't let your egos cloud you or get carried away by media appetites.
At Thoma Bravo we help companies to get through that fog. We challenge founders and business leaders to step back and reassess operating decisions made under different market conditions.
It is essential to ask and consider these questions methodically when raising new capital:
- Where am I gaining and losing in the market, and how should that inform my investment plans?
- Does my quota-based sales force investment plan still make sense, especially if performance is low and many reps are unproductive?
Is it time to invest in new markets where competition is more intense, or should I focus on my core products and services, where I have more "right to win" and higher margins? - Could I start using the cash on my balance sheet, tighten my belt on operations and finance myself for the next period or even until the time of exit?
- If all of these questions lead to the same conclusion, namely that funding is needed, then founders need to weigh the pros and cons of each possible avenue of funding.
The first impulse may be to resort to convertible bonds. They can be attractive for a number of reasons: As a combination of debt and equity, they are a faster route to money, they are slightly less expensive to issue than pure equity, and because they generate part of their return from a coupon, they do not typically force existing investors or management to adjust the company's equity valuation.
But those benefits come at a heavy price.. Investors seek annual returns of up to 20%, making them very expensive as debt. The capital is likely to rank higher than all capital raised to date, and may come with restrictions on where the company can spend the money. In addition, the funder may not bring any strategic value beyond the capital.
For some startups, these tradeoffs are worth it. But for others, especially those with very high valuations, a down round may be the best option. Existing investors tend to experience minimal dilution with rounds down, and you have the advantage of resetting value expectations in a difficult market. This can take the pressure off and put you in a position to exceed expectations. If that's the case, it's much better to make that decision while you still have the freedom to do so.
When those conditions inevitably change for the better, I hope we can look back on the companies that decided to do a round to the downside not with critical judgment, but with respect. Those decisions demonstrate prudence, a lucid assessment of risk, and that the founders valued flexibility. Above all, they demonstrate that the founders knew how to navigate difficult markets by making tough decisions, rather than clinging to a collective mythology of so-called exponential growth.
For anyone looking for an indicator to invest in, those signals—more than the hype or headlines—will stand out for all the right reasons.
