Funding in an Uncertain Market: Using Venture Debt to Bridge the Gap

October 23, 2020

While a handful of tech companies like Zoom and Shopify are enjoying massive gains as a result of COVID-19, that’s obviously not the case for most. Weaker demand, slower sales cycles, and customer insistence on pricing concessions and payment deferrals have conspired to cloud the outlook for many tech companies’ growth.

Compounding these challenges, a lot of tech companies are struggling to raise capital just when they need it most. The data so far suggests that investors, particularly those focused on earlier stage financings, are taking a more cautious approach to new deals and valuations while they wait to see how individual companies perform and which way the economy will go. With the outcome of their planned equity financings uncertain, some tech companies are revisiting their funding strategies and exploring alternative sources of capital to fuel their continued growth.

Forecasting Growth in a Pandemic: A Difficult Job Just Got Harder

For certain businesses, COVID-19’s impact on revenue was immediate. For others, the effects of slower economic activity and tighter budgets surfaced more gradually with deals in the funnel before the pandemic closing in April and May. Either way, in the second half of 2020, technology CFOs face a common challenge: How do you accurately forecast sales when there’s very little consensus around key issues such as when business activity will return to pre-COVID levels and what the long-term effects of the crisis might be?

Unfortunately, navigating this uncertainty is just as daunting a challenge for investors. These days, equity investors’ assessment of a company’s growth potential, and the value they are willing to pay for that growth, aren’t just impacted by their view of the company itself. Equally important is their assumptions about when the economy will recover and what the new normal might look like. This uncertainty can lead to situations where companies and their potential investors have materially different views on valuation.

Longer Funding Cycles, More Investor-Friendly Deals

While the full impact of COVID was felt too late to have a material impact on Q1 deal volumes, recently released data from Pitchbook and the NVCA suggest that 2020 will see a significant decrease in the number of companies funded, possibly by as much 30 percent compared to 2019 among early stage companies. And, while it often takes several months to see evidence of broad trends in investment terms, anecdotal evidence indicates investors are seeking to mitigate risk by demanding additional protective provisions.

While best-in-class tech companies continue to secure investment on attractive terms, for the rest, the process of raising equity is likely to become more challenging in several ways:

  • Term sheets issued prior to COVID have been pulled, put on hold, or changed
  • Negotiations and diligence are taking longer, exposing companies to more execution risk
  • Valuations are under pressure as investors seek to insulate returns
  • Investors may require more aggressive protection provisions

Faced with the prospect of longer processes, uncertain valuations, and less favorable investment terms, many companies are putting their plans to raise equity capital on hold. If you’re the CEO or a board member of a tech company, you’re left with a choice. You can either reduce your need for capital or seek alternative sources of funding.

Cash Is King (Again)

The past decade has been a good one for companies seeking growth financing with seemingly endless capital chasing deals. With so much capital available, many companies took advantage and invested heavily in growth in an effort to rapidly acquire customers and scale their business. Yet faced with slower sales and a more challenging fundraising environment, many are now reassessing their growth strategies and putting renewed focus on their cost structures. They’re eliminating or reducing expenditures where possible, slowing or halting hiring, and prioritizing investment toward activities that will most immediately drive new, or preserve existing, revenue.

While such cost reductions almost invariably come at the expense of growth, companies that have reached critical scale or have highly flexible operating models and can run their business without burning cash will be able to postpone 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 will simply not have reached the scale necessary to operate at break-even. And for those companies that are still growing, albeit at a slower rate than before, there’s a strong argument for continuing to make investments to support customer acquisition and retention. Irrespective of the company’s particular situation, having additional cash on the balance sheet during this period can also serve to increase strategic flexibility (for example, to make opportunistic acquisitions) and improve the company’s ability to withstand continued economic uncertainty.

Using Debt Funding to Bridge the Gap

Given the current environment, many companies and their investors are renewing their focus on potential alternative sources of capital, including using venture debt, a form of debt structured specifically for growth-stage technology companies, to extend their runway and defer raising equity until market conditions normalize. For technology companies that need capital and have a business profile to 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.
  • Avoiding a potential flat — or even down — round. Venture debt can help companies avoid a dilutive financing and defer raising equity until economic conditions — and valuations — have stabilized.
  • Avoiding suboptimal deal terms. These might include veto rights and unfavorable liquidation preferences. Debt financings don’t include such terms and, in contrast to equity, can be refinanced or renegotiated if necessary.

Given the challenges of attracting new investors in the current environment, many companies are turning to existing shareholders for funding. While existing investors may be willing to continue to support the business, they may not be willing or able to meet the company’s capital requirements in full. In situations like these, venture debt can also be used to complement insiders’ investment to help the company secure the full amount of capital it needs and provide insiders confidence that the company has a fully funded plan.

Be Prepared Because It's Not Over Yet

There’s no playbook for managing through a period as unprecedented as the one CEOs and boards of directors find themselves in today. The crisis 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 venture funding will be, what is certain is that companies will continue to face challenges both foreseen and unforeseen. Now more than ever, companies should examine all sources of capital and ensure they are sufficiently funded to emerge from this period stronger than they entered it.

This article was originally published in TechCrunch and authored by Will Hutchins, Managing Director at Espresso Capital. Republished with permission.

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