Public Capital Market Uncertainty Impacts Tech CEO Fundraising and Exit Strategy in 2022

Overview

Introduction

Last year’s funding strategy won’t work. Prevailing market conditions — including risks caused by disruptions such as war, pandemic, tariffs/sanctions, rising energy prices, sociopolitical de-globalization, inflation and ongoing supply chain hiccups — are signaling a market downturn. The current steep decline in global public market valuations reflects the risk for investors associated with a potential for near-term economic downturn.

It is tempting to compare this with 2000 or 2008, which both showed a steep decline in private investment. But there are notable differences in today’s scenario, impacting tech CEOs 2022 growth and fundraising strategies:

IT spending is forecast to continue growing.

Gartner predicts steady growth in IT spending through 2026, with significant growth in cloud infrastructure investments. Although the public equities markets have sold off considerably, this has little impact on startups’ ability to sell their products and services. In the July 2022 Gartner for Finance Leaders survey, 97% of respondents reported they were planning to maintain (28%) or increase (69%) their investment in digital technologies as a strategy to combat a potential market slowdown.

In addition, while there is an impact of market headwinds, this impact seems to be contained to specific segments and is not dramatically impacting the overall technology market.

Traditional VCs and PE firms are continuing to invest.

VCs and PE firms, flush with capital in new and larger funds, continue to invest, albeit with more investor-friendly terms and at lower valuations. VCs like to use the analogy of a storm above the ocean: “When you are investing way down deep in the ocean (early stage) you are not affected by the storm above.”

The capital overhang is quite large, given the record amount of committed capital to VC and PE investors globally. There is plenty of capital on the market for great companies and promising new ideas. Pitchbook and Crunchbase both show a healthy flow of capital into early stage companies, albeit at a slower pace than the frenetic investments last year.

Nonetheless, this cumulative potential for an economic downturn and steep decline in public market valuations is now impacting private capital markets, and consequently, the decisions that tech CEOs must make today.

Impacts and Recommendations

The intense competition for investment into private companies from mid-2020 through early 2022 caused a temporary bubble in the equity capital markets. With the collapse of public market valuations, investors in private markets have begun to shy away from highly priced companies with unproven products/services and unclear pathways to profitability. They are now taking less risk with their investments.

Public market valuation drops and the specter of a future recession do not directly impact private market valuations, but a reduction in expected exit valuations on the public markets will change the ratio of payoff for risk taken. This will impact what investors are willing to accept for later-stage private financing valuations. This cascading effect will eventually find its way down to earlier-stage private companies and hamper their ability to raise capital.

Simply put, follow-on financing may become difficult for tech CEOs to find if investors feel the company is overpriced. A down round or recapitalization may be necessary to rightsize the valuation of the company.

We expect a steady increase in down rounds, pay to plays, recapitalizations and washout rounds. We also expect an increase in the use of protective provisions such as redemption clauses, full ratchet anti-dilution, participating preferred and higher liquidation preference multiples. This will be especially true for companies that have raised funding rounds at lofty valuations without the revenue growth or cash flow to support them.

A shift in investor risk taking and lower valuation expectations is a challenge, however. And poor management teams will certainly feel the pain for their missteps. But good teams will be rewarded for their performance.

Companies with lofty valuations will need to show more progress in revenue growth to raise their next round of financing.

Recommendation:

• Reassess valuation as a potential issue in the next round of financing, and have a frank discussion with shareholders about expectations and solutions.

During economic downturns even the top-tier VC funds flush with new capital alter their investment strategies that may slow down or delay their deployment of capital. Before the latest downturn, investors still followed leading indicators and adjusted accordingly.

Invariably, when investors see market risk they place more emphasis on fundamentals and performance metrics to mitigate market and execution risks. Most investors will examine:

• Strong, proven leadership appropriate for the stage of the company’s development

• Validation of problem-solution fit for seed stage companies

• Metrics that prove product market fit for growth companies

• Longer financial runways to reduce the need for follow on capital

• Lower valuations to improve ROI potential for the risk taken

In general, this translates into investors expecting the company to have more revenue, less customer/revenue concentration, stronger sales metrics or proven management teams.

Companies that could previously easily raise capital may see difficulty convincing investors, especially if they have not hit critical milestones. Companies trying to raise a growth round of financing will find that investors will demand more proof of product market fit than previously anticipated, pointing to milestones that may take the company longer to achieve. In addition to referenceable customers, working partnerships and accelerated pipeline growth, investors will want to see improving metrics on product usage, customer engagement, pipeline conversion rates, churn rates and more.

This has the effect of extending the time between seed rounds and growth rounds, forcing many early-stage company tech CEOs to focus on fundamentals, measured investment in growth, capital efficiency and hitting critical milestones.

In addition, the fundraising process may take longer than anticipated, consuming time and financial runway. This increases the risk that companies will not be able to raise capital before running out of cash.

Recommendations:

• Plan for the worst. Update financial planning assumptions to include changing investor sentiment, valuations and potential changes to customer behavior. Develop scenario plans, including a worst-case scenario, and be prepared to act.

• Extend your runway or reach positive cash flow. If you cannot easily raise capital from outside investors, convince existing shareholders to bridge the company now rather than later when market conditions could be worse and your runway is short.

• Increase spend commensurate with cash flow increases. Examine new triggers for increased spending by delaying strategic investments until there is the cash flow to support the proposed burn rate. Focus on hitting milestones that prove product market fit before trying to fundraise.

• Do not plan to raise capital in six to nine months, as this could be the peak of the market downturn. When the market looks bleakest, investors are the most risk averse.

Tech CEOs must always consider shareholder value when deciding between selling the company today versus continuing down the go-it-alone plan. Raising dilutive capital, which is common for a go-it-alone plan, requires a higher future exit value to make the plan attractive. But previously cited escalating risk factors change this calculus and tend to dampen the prospects of a go-it-alone plan, making the early exit more attractive.

For startups that are running out of cash with limited prospects to raise capital, the only option is to find an early exit. This presents an opportunity for companies with strong balance sheets to support their growth through M&A.

Acquisitions will increase as impaired companies struggle to raise capital. This will offer larger companies an opportunity to address some modernization or digitalization issues by purchasing companies for their teams.

Recommendations:

• Reassess early exit options and compare them to an updated go-it-alone plan, taking into account risk, dilution and adjusted valuations. If the changes to the investment environment have impacted long term go-it-alone plans, an early exit may prove best for shareholders.

• Identify M&A opportunities among impaired companies that have good products/technology/team, but have not executed their strategy well and have run out of capital.

Gartner Recommended Reading

IT Spending Forecast, 1Q22 Update: The Russian Invasion of Ukraine)

Evidence

McKinsey’s Private Markets Annual Review, McKinsey & Company, March 2022.

Have Valuations Really Fallen Off A Cliff In 2022?, Crunchbase.

For Tech Startups, the Party Is Over, Wall Street Journal.