Last month, I mentioned a recent trip to North America where after meeting with many investors and founders across different stages and sectors, I counselled startup founders to brace for turbulence.
Since the beginning of the year, major share market indices are down, with some tech company indices down even more.
Inflation across developed countries is running hot as economies absorb the massive stimulus packages triggered by the pandemic combined with cheap money.
Governments are now under pressure to pare back spending and central banks have moved to temper demand by jacking up interest rates.
In a higher inflation environment, investors will struggle with duration, which describes the time it takes to recover an asset’s price based on its generated cash flows.
Duration measures an asset’s price sensitivity to yield. In recent years, yields have decreased, meaning the duration of quality bonds has increased. This means they’ve become more sensitive to changes in yields as small movements can have a huge impact on the time it takes for an investor to get their capital back.
Investors are now adjusting their mix of investments to reduce their duration risk.
Companies with higher duration or price-earnings ratios, which many tech companies exhibited due to their high growth profile, have become less attractive than companies with lower price-earnings ratios, particularly those with exposure to ‘real’ assets or were undervalued, such as toll road operators, energy producers, food manufacturers or aged care providers.
The devaluation of listed tech companies has affected the short-term potential for similar businesses on the cusp of an IPO and will likely have a flow-on effect for businesses that are a few steps less mature.
While the length of this adjustment is anyone’s guess, as a long-term venture capital investor I don’t believe well-managed funds will suffer a significant impact on their long-term returns.
Differences between up and down rounds
In light of the current predicament, several founders have asked me about ‘down’ rounds.
Down rounds occur when a private company raises funds at a pre-money valuation that is lower than its last post-money valuation.
If a startup, for its first fundraising, raises $2 million at a pre-money valuation of $8m, it would have a post-money valuation of $10m (where the amount of funds raised is added to the pre-money valuation), with the founding team owning 80% of equity and investors owning 20%.
If the second round of financing involves $5m of new funds being raised at a 20m pre-money valuation (resulting in a 25m post-money valuation), the founding team would then own 64% of equity, first-round investors 16% and second-round investors 20%.
This scenario is an ‘up’ round because the second-round pre-money valuation of $20m exceeds the first-round post-money valuation of $10m.
Now if a startup were to undertake its first fundraising on the terms above but its second fundraising involved a $5m raise at a pre-money valuation of $8m, this would be a down round because the second-round pre-money valuation of 8m lower than the first-round’s post-money valuation of 10m.
At first glance, the founding team would now own 49.2% of equity, first-round investors 12.3% and second-round investors 38.5%.
The founders would have less than a majority of equity, first-round investors would have also suffered huge dilution and second-round investors would hold a big chunk of the startup’s equity.
What’s worse is that these numbers don’t include the impacts of anti-dilution measures that most professional investors include as part of their terms of investment, which provide them with protections against the startup issuing new shares at prices that are lower than the price per share paid by that investor.
This means the founding team would have even less than 49.2% of equity and the first-round investors would have more than 12.3%!
The impact of down rounds
There’s a range of different types of anti-dilution mechanisms from full-ratchet to narrow-based weighted average to broad-based weighted average.
In a full-ratchet scenario, investors get issued additional shares for nominal value so they retain almost the same percentage of shares in the startup as before a down round.
In a narrow-based weighted average scenario, investors get issued additional nominally valued shares based on the number of shares that have been previously issued. In a broad-based scenario, the weighted average accounts for all shares previously and about-to-be issued.
Full-ratchet anti-dilution protection is most favourable to investors, with broad-based protection being most favourable to founders.
Apart from the large impact of dilution on founders, down rounds can make a startup ‘uninvestible’ in future rounds. Let’s play forward what happens with the above startup with the down round.
The third time they go out for funding, they’ll need to have a pre-money valuation of at least 13m to achieve an up round.
If they’re doing well and wish to raise $10m with a pre-money valuation of $25m, the founders will now have 35.1%, first-round investors 8.8%, second-round 27.5% and third-round 28.6%. (These numbers assume the first-round investors don’t take up their anti-dilution rights. If they did, the founders would have a smaller share of equity and first-round investors a larger.)
In this example, the founders would own a little more than one-third of the startup with investors owning the rest, making it difficult to maintain the motivation of founders and management.
And if the startup requires additional rounds of funding, the founders would have even less equity.
Avoiding a down round
How can founders avoid the impacts of excessive dilution and creating an uninvestible startup?
Extending current runway by cutting costs and improving unit economics is one approach. Some investors will likely be more cautious in the short-term, so the longer the runway a startup has, the more opportunity it’ll have to prove out its product-market fit and pathway to repeatable revenue.
Startups with an acute need for funding can pursue a bridge round that’s likely supported by existing investors.
A non-priced bridge round, usually in the form of a convertible note, provides valuation flexibility for the startup as it allows the additional funding to be priced based on the next priced equity round.
Assuming the business performs well, the next priced equity round should be an up round, thus avoiding excessive dilution.
For startups that are forced into a down round, renegotiating anti-dilution terms with existing investors remains an option. Existing investors might be persuaded to temporarily waive their anti-dilution rights for the benefit of the founders and success of the business.
Another way to avoid a down round is to accept additional structure in future rounds.
New investors may be motivated to provide an up round if they’re given further downside protections such as participating preferences, favourable liquidation preferences or other such mechanisms.
While I’m a fan of reducing structure and keeping deals as simple as possible, structure has its place in certain circumstances.
- Benjamin Chong is a partner at venture capital firm Right Click Capital, investors in bold and visionary tech founders.
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