These are tough times to raise capital. Every VC out there is still saying “we’re open for business.” Really though, most of their mental energy is devoted to assisting the existing portfolio. The No. 1 message VCs have for their founders is to extend cash on hand.
Most CEOs are listening. They are cutting payroll through layoffs and salary reductions. They are narrowing the engineering plan. They are deferring growth spending by canceling advertising and delaying capacity additions.
What if you have done that and still need cash?
You will now find it harder to raise from VCs than before. Companies will need to be more polished and show more progress to raise the same amount of capital. All the steps that we usually recommend for raising capital successfully are more important than ever.
Why? Given the shock to the economy from the COVID-19 crisis, many VCs expect to invest at a slower pace than before. They need to hold more reserves to protect their existing companies. They also want to extend the lifetime of their own funds, in case they have trouble raising cash themselves down the road.
VCs will also be slower to pull the trigger. Many are reluctant to back founders they cannot meet in person, so they will want to conduct extra diligence. They are also hearing anecdotally that valuations are falling, so they may hope to get a better deal if they wait.
All of this makes funding super hard to raise right now.
But three types of deals are still getting closed:
1. Existing relationships. The VCs have already met the founders several times and maybe even signed a term sheet before COVID hit. The honorable VCs are respecting the handshake. Others may renegotiate for a better price, but are still willing to close.
2. Tiny bets. Although many VCs feel cautious right now, if your round feels quite small compared to what they usually invest, they might just go ahead. They are hoping that this gives them the inside track on your next round. In the meantime, they get to show the world that they are still investing.
3. Winners in the new world. These deals might directly play on the public health, work-from-home, and cocooning trends of the moment. Or, they are businesses that can thrive in a recession. They offer enterprise customers cost savings with fast payback. Services like personal beauty or education can succeed in a recession because they help people get an edge in the job market, yet need to be adapted to a world of social distancing. Consumer products can win in a recession if they deliver reliability and simplicity at frugal prices. An example here is the rise of nut-based milks that appeal to the health conscious at a small price premium. Because they are more shelf stable than regular milk, buying nut-based milks in bulk can reduce trips to the grocery store.
If you are lucky enough to receive a term sheet, how hard should you negotiate given the current environment, and how can you still feel good about the deal in hindsight, after the economy recovers down the road.
Start by worrying less than usual about valuation. The highest priority is to raise the cash needed to execute your business plan. Don’t get cute and try to time the markets. Capital markets will rise and fall throughout the life of your venture.
The difference between $1 million at a $9 million pre-money valuation and the same $1 million at a $4 million pre-money valuation looks big, but is actually just 10 percent extra dilution. That 10 percent could be well worth it to ensure you weather a global pandemic and survive to prosper in the future.
Rest assured that it will all even out. Just do your job and get the cash.
What matters most isn’t the price, it’s the person behind the price. Think of it this way: Long after you spend the money, that VC who led the deal will still be a member of your board.
That is why your main goal should be to attract a VC partner you like. Broaden your thinking and mentally prepare to take whatever price and terms you need to take that are within reason. Just make sure you get the VC you want.
Of course, there are some deal terms we consider red flags, and perhaps more investors will propose these due to the uncertain economic environment. Life is just too short to get into business with a partner who intends to exploit you. Just walk away when you see these:
1. Higher liquidation preferences like 2X or 3X. This guarantees the investor earns a double or triple return on investment before the management team earns anything. Although we sometimes see this for a small, short-term bridge loan, it is not a reasonable ask for a long-term equity investment because it puts all the risk on you.
2. A “full ratchet” means that if management raises money at a lower price in the future, then the original investors also get that lower price retroactively. That means management alone bears all of the dilution risk if the company struggles.
3. The lead investor requires sole approval over board or stockholder decisions. In this case, they effectively control the company. Tell them to drop this or just buy the company instead.
4. Super pro-rata rights that allow the current investors to take more than half of the next round. That can make it impossible for you to attract fresh investors.
5. The investment requires that the company turn around and use the cash to buy products or services from the investor.
Ultimately, the best way to improve your negotiating leverage is to secure two or more term sheets. Then you can let the market set the highest price.
Although today’s funding environment is fluid and uncertain, there is capital out there. You can still succeed. Take decisive action to extend your runway now, so you can show more progress, and adapt your business to thrive in the new world.
That will give you the best chance to raise the capital you need, from VCs you like, on acceptable terms. Make it through this pinch point, and you will be leaner and stronger for the good times ahead.