Although venture capital activity remained strong in the UK during the first quarter of 2022, the same cannot be said for the rest of the world. Recent Data of Pitchbook and the National Venture Capital Association shows that the total value of US stock transactions in the first quarter of 2022 was lower than in any quarter of 2021.
At the same time, inflation, rising interest rates and political instability are conspiring to undermine confidence and usher in another period of macroeconomic uncertainty around the world.
Valuations have also dropped sharply. the BVP Cloud Indexa popular benchmark for public SaaS companies, is down more than 40% since November 2021. Weakness in public technology stock prices has started to affect earlier-stage private market valuations and terms in deals are made, as the entire sector adjusts to the new valuation environment.
With increased uncertainty, management teams and boards are developing more conservative growth scenarios to help preserve cash. At the same time, many companies are also rethinking their capital raising strategies in the face of a cooling fundraising environment in which rounds are likely to be flat or even negative.
Fundamentally, they have to decide between waiting in the hope that they can raise capital at a higher valuation in the future (and potentially forgoing short-term opportunities) and exploring alternative sources of capital to help fuel their continued growth, including equity capital. risk. debt.
Longer funding cycles, deals that favor investors
While the full impact of the current economic uncertainty is yet to be seen, a slowdown in venture capital activity here in the UK is very possible. If that happens, investors are likely to seek to mitigate their risk by requiring additional protection provisions.
Although best-in-class tech companies will continue to secure investments on attractive terms, for many the process of raising capital could become more challenging in a number of ways (as is already the case in the US):
- Term sheets could be issued much more selectively
- Negotiations and due diligence could take longer, exposing companies to greater execution risk
- Valuations could remain under enormous pressure as investors look to isolate returns
- Investors may require more aggressive protection provisions
Faced with the prospect of longer processes, uncertain valuations and less favorable investment terms, many companies may choose to suspend their plans to raise equity capital.
If you are the CEO or member of the board of directors of a technology company, you will have a choice: reduce your need for capital or seek alternative sources of financing.
Cash is king once again
With so much capital flowing into the sector over the past decade, many companies seized the opportunity to invest heavily in growth as they sought to acquire customers and scale their business. However, faced with market uncertainty and the prospect of a more challenging fundraising environment, many will need to reassess their growth strategies and put a renewed focus on their cost structures.
That means eliminating or reducing expenses where possible and prioritizing investment towards activities that help generate new income or preserve existing ones.
While cost reductions almost always come at the expense of growth, companies that have reached critical scale or have highly flexible operating models and can run their businesses without spending cash will be able to put off new funding and wait out the storm. .
Of course, achieving positive cash flow may not be a possible or even desirable strategy for everyone. Some simply will not have reached the scale necessary to operate at breakeven. And for those businesses that are still growing, albeit at a slower pace than before, there is a strong case for continuing to make investments to support customer acquisition and retention.
Regardless of a company’s particular situation, having extra cash on the balance sheet during times of uncertainty can also serve to increase strategic flexibility (for example, to make opportunistic acquisitions) helping the company not only survive but thrive.
In fact, there are signs that boards are increasingly encouraging their companies to take steps to increase their target lead time from 12-18 months to 24 months.
Using debt financing to bridge the gap
In light of the current environment, many companies and their investors will re-evaluate their financing strategies. That includes using venture debt, a form of debt structured specifically for growth-stage tech companies, to extend their reach from nine to 18 months and defer raising capital until market conditions normalize. For technology companies that need capital and can support debt, venture debt offers a number of attractive features for the current environment, including:
- Faster access to capital. Venture debt deals can close in as little as four weeks and can often be completed without in-person meetings.
- Avoid a possible round flat, or even down. Venture debt can help companies avoid dilutive financing and defer raising capital until economic conditions and valuations have stabilized.
- Avoid suboptimal deal terms. These may include veto rights and unfavorable settlement preferences. Debt financings do not include such terms and, unlike equity, can be refinanced or renegotiated if necessary.
Given the challenges of raising capital at favorable valuations in the current environment, many companies are turning to existing shareholders for financing. While existing investors may be willing to continue to support the business, they may not be able to meet the capital requirements of the business in full. In situations like these, venture debt can also be used to supplement the experts’ investment to help the company secure the full amount of capital it needs and give the experts confidence that the company has a fully funded plan. .
When considering risky debt, it’s important to understand how solutions offered by different providers may differ in terms of debt availability (ie, leverage) and deal terms, such as covenants, amortization, and overall pricing.
In general, traditional bank solutions will be the least expensive but offer less leverage availability and have more structural elements. Often they also have to be combined with a simultaneous round of actions.
By contrast, risky debt solutions offered by non-bank providers, such as specialized technology credit funds, can offer greater availability of leverage and structural flexibility.
It is not over yet
There is no playbook for managing during periods of great uncertainty like the one CEOs and boards of directors find themselves in today. The macroeconomic landscape has had a material impact on virtually every aspect of running a high-growth technology business, including fundraising.
While only time will tell what the long-term impact on business financing will be, the truth is that businesses will continue to face challenges they can and cannot foresee.
Now more than ever, they need to examine all sources of capital and make sure they are funded enough to come out of this period stronger than they came in.
Shane Jayaprakash is a Principal at Espresso Capital, a leading provider of innovative venture debt and growth finance solutions with offices in London, San Francisco, Los Angeles, Chicago and Toronto.
Since 2009, Espresso has helped more than 300 technology companies and their investors accelerate growth, expand runway, and increase strategic flexibility with non-dilutive capital. Learn more at espressocapital.com.
This article is part of a paid partnership with Espresso Capital.