by Dror Futter
Remember all those articles about whether venture was overvalued? With blinding speed, they now seem quaint. Bluntly stated, most venture backed companies are in a fight for survival. Although certain areas of life sciences may do somewhat better, I think the impact will be widely felt. Complicating the fight is the fact that no one can predict how long it will last and what the immediate post-Corona economy will look like.
To survive entrepreneurs need to focus on actions within their control. 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 the Corona Crash. First, the article discusses how the current situation is likely to impact your venture and your key stakeholders — investors, customers, and suppliers. Then it highlights the levers you can deploy to lengthen your runway and increase your flexibility.
How The Corona Crash Will Impact Your Venture
• Your Runway is Much Shorter Than You Think. Ventures have a natural tendency towards optimism when forecasting sales. When liquidity is good, this is normally a harmless offense (within reason) since additional fundraising can bridge the gap. The Corona Crash is creating demand destruction across most sectors of the economy. Revenues will drop dramatically, especially among ventures where other startups constitute a significant part of the customer base. It is essential to conduct a detailed and very candid review of existing customers and your sales pipeline to set realistic revenue expectations. Expenses will then need to be adjusted.
• Tougher Terms. If you thought fundraising had gotten tougher recently, you ain’t seen nothing yet. The time to fundraise will increase dramatically. 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. You may even see investors demand full ratchet anti-dilution protection. Dividend provisions will migrate from “when and if” to “accruing.” For companies that have outstanding Convertible Notes and SAFEs, down rounds will result in conversion below the cap and often at a discount, creating even more founder dilution.
• Investor Tensions. You are likely to start seeing splits among your investors between those willing to continue funding and those unwilling or unable. Even if your deal documents do not include a pay-to-play provision, VCs 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 the shareholder base, and create tensions among investors.
• New Metrics. “Growth at All Costs” was already on its way to being so 2018. That focus will accelerate — dramatically. 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 downturn, 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. As a result, the list of investors on your cap table is not likely to increase. Most of your funding for the foreseeable future is likely to be insider.
There are a lot of stories highlighting the vast amounts of “dry powder” in the venture market. This should not be a great source of comfort. This “dry powder” is supporting a much greater number of ventures and much higher valuations than in the past. With venture returns likely to significantly fall, investor allocations to the venture space are likely to drop as well, making future VC fundraising more difficult. As a result, funds will be much more careful about deploying their cash and will do so over a longer period of time.
• 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 experienced significant losses in their investments and businesses. This also will be their first experience with a slowdown in the venture segment and the resulting damage to business prospects and valuations. Based on prior cycles, it would not be surprising to see many reduce or even stop their venture investing.
• Exit Valuations Drop, Lowering Valuations Overall. There will be a significant drop in M&A activity, and no one can guess when the IPO market will reopen. This will increase the time it takes 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 cash. Runways are generally shorter than most entrepreneurs think. In theory, bankruptcy is an option to avoid paying most obligations, but for reputational and liability 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, in addition to legally required tax and wage payments.
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. If you have not raised funds recently, consider accelerating your fundraising timetable, and establish credit lines if you can. Don’t over-negotiate deal terms. 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.
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 your 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, sexual orientation, and other factors. The best defense for discrimination claims typically is documented evidence of poor performance, so develop sound processes for formal employee feedback and reviews. Unfortunately, in the short term, layoffs may require terminating solid performers. Adding headcount during this period, if at all, should be limited to very high value-add hires. However, there is likely to be a lot of available talent that presents an opportunity for upgrading personnel.
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. Offering equity instead of wages is not an option. Also, employees generally have more termination rights abroad, especially in Western Europe, so consult local counsel.
Terminating employees, especially solid performers, is never easy. Have a well thought out process for delivering the unfortunate news and providing the impacted employees with as much support and resources as you can.
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 and negotiating favorable early-termination and sub-lease clauses. If you are in an existing lease, approach the landlord about potential concessions and do so early; they are likely to receive many requests.
The challenge for ventures is that the real estate market is experiencing its own downturn at this time. In this situation, landlords are more likely to hold ventures to their lease terms, creating burdensome white elephants. Even once the current quarantines terminate, ventures should be slow to increase their real estate commitments and the soft market should allow ventures to negotiate more flexible termination and sub-lease clauses in new leases.
Suppliers & Customers
Critical to minimizing the impact of the current crisis 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 the 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. Your response to this crisis 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.
If your customers and/or suppliers include a fair number of startup 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.
Finally, establish lines of communication with critical customers and suppliers. With plenty of bad news in the air, there is a natural tendency to keep the news “in the family.” In the current environment, everyone is hurting and bad news is very understandable. Communicating with these stakeholders will help recalibrate your expectations from them, allow them to recalibrate their expectations from you and minimize surprises. This will enhance the contingency planning abilities of all involved and reduce the potential for future disputes.
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.
Preserve Your Reputation
Although it may not feel like it at times, there will be a tomorrow. The venture world is relatively small and when this all passes, how you conduct yourself during these trying time will be remembered. Everyone is stressed and confronting difficult choices. Many of these choices will be made in an environment where there are no other options. If you conduct yourself with candor and sensitivity, people will appreciate it and remember when you re-engage with them. Opaqueness and selfishness will also be remembered, but in a less positive light. Doing the right thing usually has the added advantage of being good business.
Dror Futter is a New Jersey-based partner at the Rimon PC law firm. His practice focuses on representing start-up companies, small and medium size businesses, and their investors. He serves as the external general counsel to several growth stage companies. He is a graduate of Princeton University and Columbia Law School and serves as a mentor at Princeton’s Keller Center and the venture center at the Stevens Institute of Technology. He can be reached at email@example.com