Holden Spaht
A new year is upon us, and with it comes uncertain, and uncomfortable, market conditions. Accompanying those conditions are equally uncomfortable decisions. For startup founders, determining which path is right for their business may require fundamentally rethinking the way they measure success.
The business climate in 2023 will be unfamiliar to many who founded a company in the past decade. Until now, a seemingly endless stream of relatively cheap capital has been at the disposal of any startup deemed by the VC world to have high growth potential. Everyone wanted a piece of “the next Facebook.” With interest rates near zero, the risks were relatively low and the prospective rewards were astronomical.
Burning money to chase growth became the norm; you’d just raise more money when you ran out. Debt? Who needs it! Existing investors were happy to play along, even if their share in the company was somewhat diluted — growing valuations kept everyone sated.
Over the years, this pattern of rapidly rising valuations and a pie growing fast enough to compensate for any dilution — fueled by “free money” that made almost any investment justifiable — crystallized into a mythology at the core of startup culture. It was a culture that nearly everyone, from founders and investors to the media, fed into.
Climbing valuations made for great headlines, which sent a signal, both to potential employees and the markets, that a company had momentum. High valuations quickly became one of the first things new investors looked to when it was time to raise additional capital, whether that was through a private round of funding or an IPO.
But tough economic conditions tend to dispel complacency with hard realities, and we’ll see reality checking in when it comes to funding this year. Amid rising interest rates and a generally negative macroeconomic outlook, the tap will run slowly –– or not at all. Equity financing is no longer cheap and plentiful, and as drought strikes, a sense of anxiety will grip founders. They can no longer burn cash without seriously contemplating where they’ll get more when it’s gone.
When that time comes, founders will be faced with a choice that could make or break their business. Do they turn to alternatives like convertible notes, or do they approach new investors for more equity funding? Tech stocks have been pummeled in the past year, which could mean their company’s value has taken a hit since the last time they raised capital, leaving them with the prospect of the dreaded “down round.”
It’s easy to see why down rounds seem out of the question for many startup founders. For starters, they’d face the flip side of the positive media mania, which risks eroding employee morale and investor confidence. In a culture where growing valuations are worn like a badge of honor, founders may fear that taking a down round would render them Silicon Valley pariahs.
Down rounds don’t spell the end of your business
The truth is, there’s no one-size-fits-all solution. The funding route you take has enormous consequences for the future of your company, and so it shouldn’t be clouded by ego or driven by media appetites.
At Thoma Bravo, we’re helping companies cut through that fog. We challenge founders and business leaders to take a step back and reevaluate operational decisions that were made in different market conditions.
It’s critical to ask and consider these questions methodically as you raise new capital:
- Where am I winning and losing in the market, and how should that inform my investment plans?
- Does my quota-bearing sales headcount investment plan still make sense, especially if attainment is low and many reps are unproductive?
- Is this the right time to invest in new markets where the competition is more intense, or do I refocus on my core products and services, where I have a greater “right to win” and higher margins?
- Could I bootstrap using the cash on my balance sheet, tighten my belt on operations and self-fund through the next period or even all the way to an exit event?
If these questions all lead to the same conclusion — that new funding is indeed needed — founders should then weigh the pros and cons of each potential path to financing.
The first impulse may be to turn to convertible notes. They can be appealing for a number of reasons: As a combination of debt and equity, they’re a faster avenue to money, they’re marginally less expensive to issue than pure equity, and because they generate part of their return from a coupon, they generally don’t force existing investors and management to adjust the company’s equity valuation.
But those benefits come at a steep price. Investors are looking for annual returns of up to 20% on such notes, which makes them very expensive as debt. The capital is likely to be senior to all equity raised to date, and they may come with restrictions on where the company can spend the money. What’s more, the financier may not provide any strategic value beyond the capital.
For some startups, those trade-offs are worth it. But for others, particularly those with very high valuations, a down round may be the better choice. Existing investors generally suffer minimal dilution with down rounds, and you have the benefit of resetting expectations of value in a challenging market. That can take pressure off and put you in a position to exceed expectations. If that’s the case, it’s far better to make that choice while you still have the freedom to do so.
Every financing decision is unique, but every time, it will be one of the most important decisions an entrepreneur makes. I encourage CEOs and investors to weigh the trade-offs with eyes wide open. Whichever financing solution you choose should be grounded in its ability to facilitate flexible support that allows you to build for the long term, regardless of market conditions.
When those conditions inevitably change for the better, I hope we can look back at companies that chose to take a down round not with critical judgment, but respect. Such decisions show prudence, clear-headed assessments of risk and that the founders valued flexibility. Most of all, they show that the founders knew how to navigate tough markets by making tough calls, rather than hanging on to a collective mythology of so-called exponential growth.
For anyone looking for an indicator to invest, those signs — more than hype or headlines — will stand out for all the right reasons.
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