For the past decade, we have been in the midst of the biggest economic expansion in American history with unemployment at a historic low of 3.6%.
Naturally, during periods of economic expansion, raising capital for a startup or new business is easier. Investors are incentivized to plow capital into nascent businesses because both the prospect of return is higher in comparison to other investment opportunities and the downside risk is lessened because of target customer spending and capital replenishment. If the “times are good,” investors generally know that even if founders make mistakes, they will have ample chances and opportunities to correct them.
But what happens when the market turns and we enter a recession? Or something unexpected, a so-called, “Black Swan” event like the Coronavirus upends global markets? How do entrepreneurs raise capital in when this happens?
This is a good question since most of the articles you will read about raising capital were written during times of economic expansion. Most likely, during the past decade. Admittedly, even my own experience raising capital dates to just the past 10 years. I was too young to experience the Dot Com Bubble and was insulated at law school during the Great Recession. More importantly, many of the entrepreneurs raising capital today have never experienced a recession either because they are too young or because it’s been quite some time since we’ve had one here in the United States.
To say that most entrepreneurs may be unprepared for this eventuality is an understatement. Last week, I was sitting down with an entrepreneur whose valuation was aggressively high, even by the standards of 2019’s booming economy. When I asked him about his plans for the next round, he admitted that his future valuation in successive rounds was based on a strong economy and that “downside protection wasn’t necessary — I just can’t see the point in dwelling on it.”
I disagree. Strongly.
Entrepreneurs need to prepare for a recession and need to know how to raise capital in a down market. One of the best ways to do so is to prepare beforehand. When the economy is strong, you have the most options. Exploit them.
Even if you are prepared, raising capital in a down market can be incredibly challenging and even confusing. First, entrepreneurs need to prepare beforehand by establishing a clear defensive moat around their business metrics with a strong focus on profitability. Investors respond positively to this in down periods given that so many of their other portfolio companies face significant threats.
Second, entrepreneurs should be flexible on terms and valuations understanding one important fact: capital is more important than anything else. Even if entrepreneurs need to take a lower valuation with more dilution than they anticipated, it shouldn’t matter.
Be proactive. Prepare beforehand. Focus on profitability.
At my company’s Demo Day five years ago, an over-eager investor came up to me asking, “What are the hot companies? I will write the check now.” I pointed to a company that now has a significant television presence. The investor immediately went over and invested $100,000.
No diligence. No conversation. Nothing.
Although this is an aberration, it illustrates an important point: when the economy is strong, raising capital can be incredibly easy.
But in a recession, it can get tough. That’s why the best thing to do is to shore up your position when the economy is roaring so that you are best prepared.
The first thing to do is to ensure that you have a strong cash position with clear runway to ride out a storm. Be relentless in your focus on cutting costs and streamlining operations. Eliminate side projects, new ventures, or other under-performing business units that are not contributing to the core value of your company’s product. Restructure personnel so you can focus all of your colleagues to perform at the top of their profession or license. Additionally, understanding whether you are “default alive” or “default dead” is another good way to measure the health and liquidity of your company.
Secondly, you should seek to get to profitability — by any means possible. In strong economic times, profitability is prized by investors because it indicates the health of a business with or without venture investment. In a down economy, when growth and profitability are ever more scarce, having a business in the black can place you in a very small elite set of entrepreneurs.
There are numerous ways of reaching profitability. One particular focus should be on the margins of the cost of delivery of your product. Take a hard look at the unit cost of delivery of your product or service and make adjustments as necessary. Further, you can cut sales and marketing expenditures in order to immediately put your business in the black. While you may be sacrificing growth by cutting marketing expenses, the decision may be warranted given the nature of the economy and what’s best for your business.
Accept more dilution to survive
When raising capital, entrepreneurs and investors often negotiate over the valuation of the business. Investors are trying to minimize the valuation in order to maximize their percentage ownership while entrepreneurs are trying to maximize valuation in order to minimize their relative dilution.
In a strong economy, entrepreneurs usually have the upper hand as valuations are being driven up across the board and investors have less power in negotiations. Conversely, in a down economy, investors often have the upper hand as there is less capital swirling through the market.
Entrepreneurs need to get comfortable with accepting a lower valuation, and thus more ownership dilution, in a recession. This is especially acute when a business has a short runway of capital and needs an infusion of investment to survive. In this predicament, entrepreneurs will usually take whatever lifeline they can get.
What entrepreneurs need to focus on is the end goal; the survival and eventual successful exit of their business. Recessions are cyclical by nature and entrepreneurs can make up for lost value at successive rounds once the economy improves. More importantly, the discipline taught during these periods can make for massive financial returns down the road.
If you can’t raise capital today, do what you can to survive till tomorrow
During a recession, raising venture capital becomes significantly more challenging. If you find yourself in a position where you need to raise capital in a down market, there are a few key lessons you can take to heart. First, you should do whatever you can to cut costs and preserve liquidity in your company. Second, you should focus on achieving profitability. Lastly, you should be comfortable accepting more dilution in ownership.
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