Guest Post by Dror Futter, Esq. – McCarter & English, LLP
The venture community is buzzing with talk about bubbles. Even if we are not on the verge of a 2000-style collapse, multiple signs of contraction in the venture space make it clear that entrepreneurs need to start planning their response. Based on past downturns, it is impossible to overstate the importance of having cash in the bank and a flexible cost structure to weather the storm.
This article highlights what ventures can do to increase their ability to survive a slowdown. Many of these recommendations are appropriate for any market condition, but some will impact growth. As a result, entrepreneurs will have to reach their own conclusions about the likelihood, timing and severity of a downturn before determining their response.
How Will a Downturn Impact Your Venture
- Tougher Terms – If you thought fundraising was difficult until now, you ain’t seen nothing yet. If the VC market contracts, financing is likely to become more difficult process, more expensive and more investor-friendly Valuations will drop and “down rounds” will become more frequent. As investors seek to protect their downside, today’s 1x non-participating liquidation preference could become tomorrow’s 2x participating, or worse. Dividend provisions will migrate from “when and if” to “accruing.”
- Investor Tensions – A venture slowdown will often create a split between investors willing to continue funding and those unwilling or unable. Even if your deal documents do not include a pay-to-play provision, VC’s have historically shown great creativity in fashioning what are effectively retroactive pay-to-play provisions. Angels and smaller early-stage funds may not be equipped to participate in the rights-offerings and pay-to-play obligations characteristic of a downturn. As a result, they will be diluted. Funding rounds with uneven participation from insiders can reshape the balance of power on the board and shareholder base, and create tensions among investors.
- Market Impact – Depending on the nature of your company and the immediate causes of the slowdown, a downturn may impact your customers and suppliers, and thereby impact your business, forcing you to revisit forecasts and longer term plans.
- New Metrics – A venture slowdown will change the metrics of how you are evaluated. For many companies, “cash-flow positive” will be the new “exponential customer growth.” Ventures will be asked to demonstrate a credible path to profitability.
Why Does Fundraising Become More Difficult
In a slowdown, investors typically exhibit several behaviors that reduce available funding.
- Circling the Wagons – Venture funds will focus on ensuring the survival of their own portfolio companies. Further, investors will increase their reserves for follow-on funding, leaving less money available to make later-stage investments in new companies.
- Darwinian Selection – Venture funds’ tolerance of mediocrity will drop. Funds will focus on supporting clear winners to the detriment of struggling ventures and pivots.
- First Timers Head for the Hills – One of the unique aspects of the current venture cycle is the unprecedented degree to which non-traditional investors have fueled the market – angels in early stages; mutual funds and private equity firms in later stages; and corporations’ investment arms. Many of these investors have never experienced the down part of the venture cycle and are likely to withdraw in a shutdown.
- Exit Valuations Drop, Lowering Valuations Overall – There has been a contraction in IPO and venture M&A activity. This will increase the time it take most ventures to exit and lower exit valuations. This combination will reduce expected returns and translate to lower valuations at all funding stages.
It’s All About the Runway
With fundraising more difficult, the gap between success and failure often comes down to the length of your runway – the amount of time before you run out of funds. Runways are generally shorter than most entrepreneurs think. In theory, bankruptcy is an option to avoid paying most obligations, but for reputational and other reasons, venture firms prefer to guide their ventures to orderly shutdowns. As a result, you will need to set aside reserves to make sure creditors are paid.
It is easiest to raise funding when you need it least. Going to the market when you lack sufficient funds for next month’s payroll does not inspire investors’ confidence. There is significant anecdotal evidence that venture finance terms are tightening, but they remain relatively venture-friendly by historic standards. If you have not raised funds recently, consider accelerating your fundraising timetable, and establish credit lines if you can. Interest rates remain low and loan covenants are relatively light, with credit eligibility criteria and loan terms certain to stiffen in any downturn. Remember – no venture has ever died from excess dilution or suboptimal deal terms, but the same cannot be said for ventures that run out of money.
In a shifting venture environment, deal terms become a moving target and the degree of change varies by investment sector and stage, and geography. Contact several sources to understand the market. Stubbornly clinging to last year’s financing terms could chase away potential investors.
Finally, always have a thorough understanding of your investor base, including which investors are running out of cash. To the extent possible, without damaging the relationship, get a sense of where you stand in an investor’s portfolio – a star who will continue to be funded or a middle-ground player who will be left high and dry.
Downsizing the Team
Personnel is usually the largest cost for any venture and, therefore, a prime target for extending the runway. In the United States, most venture employees are employees-at-will, so absent a company policy or a specific contractual requirement, an employee can be terminated without notice. However, terminating even at-will employees carries risk, with terminations potentially subject to claims of discrimination based on age, gender, race and other factors. The best defense for discrimination claims is documented evidence of poor performance, so develop sound processes for formal employee feedback and reviews.
Remember that wage payment is not optional. People usually can agree to work for less, assuming that it is above the applicable minimum wage, but once wages have been earned, they must be paid. Failure to pay wages (or taxes) are two areas where officers and directors can be held personally liable if a venture shuts down. Also, employees generally have more termination rights abroad, especially in Western Europe, so consult local counsel. Consider engaging new personnel through a consulting agency to give the company more flexibility on termination.
Real Estate is usually a venture’s largest and least flexible long-term obligation. When a venture fails, the landlord is often the largest creditor. The first step in addressing this risk is understanding your lease before you sign it, keeping close eye on, and negotiating, favorable early-termination and sub-lease clauses.
If the venture market cools, real estate in tech hubs is likely to suffer a similar downturn. In that situation, landlords are likely to hold ventures to their lease terms, creating burdensome white elephants. Consider shared work spaces, such as WeWork, that host larger teams and provide flexibility to scale square footage up or down.
Suppliers & Customers
Critical to bubble-proofing drill is reviewing the terms of your contracts with suppliers and customers, to understand obligations and ensure maximum flexibility. Ventures should create a database of contract-termination dates and the length of notice required to terminate. Many contracts have automatic renewal clauses that require notice to stop the renewal. The database should also include information about any minimum payment obligations.
Expiring supplier contracts should be reviewed through the prism of a slowdown. If you need to cut expenses significantly, will this contract still make sense? Many suppliers will show significant flexibility, to their good customers, in agreeing to modified terms – reduced prices and minimum purchases, and extended payment terms – to avoid termination.
Especially in their early stages, ventures often sign marginally profitable contracts to bolster their customer roster. Bubble-proofing should include an analysis of the profitability of each customer, and if you’re downsizing your team, make sure the remaining personnel are servicing the most profitable contracts. For the remaining customer base, contracts should be reviewed with an eye on performance obligations, helping you understand your cost of performance and making your runway calculations more precise.
Finally if your customers and/or suppliers include a fair number of growth companies, their continued existence cannot be taken for granted. You should identify second sources to mitigate the risk of supplier failures, become more vigilant about outstanding receivables from at-risk customers, and reject orders from companies whose outstanding balances have grown too large. Now more than ever, ventures should adopt creditworthiness review processes to vet new and renewing customers that are considered at risk. For larger projects, ventures should consider requiring letters of credit from customers to secure payment.
In a downturn, investor disputes become more common, increasing officers’ and directors’ exposure, so review your D&O coverage to verify that coverages are adequate for a company of your size. Maintain a reserve for so-called tail coverage. Failed ventures are generally unable to maintain D&O coverage, so tail coverage is necessary to maintain insurance for officers and directors for decisions made while the company was still alive.
Dror Futter is a partner at McCarter & English, LLP with more than 20 years of high tech and intellectual property legal and business experience. He represents startup, early stage, emerging growth, and middle market technology and tech-enabled enterprises and the investors who support them. 973.639.8492. Biography
McCarter & English, LLP is a firm of approximately 400 lawyers with offices in Boston, Hartford, Stamford, New York, Newark, East Brunswick, Philadelphia, Wilmington and Washington, DC. In continuous business for more than 170 years, we are among the oldest and largest law firms in America. More…