Following a strong start to last year, investors and entrepreneurs were highly optimistic as startups raised nearly $13 billion in the first quarter, making it the fifth-largest quarter for funding; that changed by the end of 2022. Harsh economic conditions tend to dispel investment complacency with hard realities, and we’ll see reality checking in when it comes to funding this year. Amid rising interest rates and a generally negative macroeconomic outlook, the tap will run slowly.
According to Pitchbook, VC activity dropped in all stages and sectors in the first quarter of 2023. Angel and seed rounds saw a steep decline relative to other investment rounds. Angel and seed activity declined to 34% of all deals made in Q1 from around 47% a year earlier.
Sector activity was more broadly distributed, and quarterly shifts were substantial; for example, software deals dropped 22.9% relative to other sectors. But when compared with long-term averages, most sectors were flat or modestly down relative to each other. Notably, commercial products & services increased its share of deals by 2% compared with the 10-year average.
Tech stocks have been pummeled in the past year, which could mean their company’s value has taken a hit since the last time they raised capital, leaving them with the prospect of the dreaded down round. Companies that have gone through their series seed or Series A are seeing down rounds for the next raise of 20 to 50 percent in valuation.
Among traditional investors, 2023’s fundraising has been awful. Just $11.7 billion was raised in Q1. As investors grapple with a liquidity crunch due to a stalled exit environment, they have shied away from larger deals to preserve capital. This has widened the funding gap between startups seeking capital and investors willing to provide it, but it has also put downward pressure on deal pricing.
The types of deals are also changing from what was for seed companies, many SAFE (simple agreement for future equity) investments for their pre-seed rounds; now we’re seeing more convertible notes (debt), sometimes with redemption provisions six or seven years out.
Convertible debt allows investors to get ownership of your company for their investment. It’s a loan with a distinctive characteristic. When your company raises a future Series A round of equity financing, the money loaned to your company via the convertible debt seed round converts into stock (likely preferred) under the terms listed in the term sheet.
You can never have enough cash.
In this market, anyone who wants to invest in your company you should consider it if you desperately need the funds because you don’t know how long this environment will last.
Straight debt can be the best tool to finance a company that has an immediate need for capital to meet its obligations (e.g., making payroll) because it is fast and straightforward. It also may be the only tool available if the company requires shareholder consent to complete financing with an equity component and the company anticipates delays or will be unable to obtain the necessary consent.
Success breeds capital.
Delivering on your milestones and promises can breed more capital. Go back to your existing investor when you have good news. A start-up company with ten users today and a year from now grows to over 100 million users; those who invested at the start will figure out a way to put in more money.
If a fund says it will support you from series seed through exit, there will be no guarantee it will. If the company is failing, investors won’t put good money after bad.
Interact with your investors.
Founders should talk to their investors at least every quarter and seek guidance.
Founders need to listen to people who are invested in their growth but not involved in daily operations. The VC is waiting for the startup’s growth and thus thinks strategically; that’s why a VC might be the best advisor in opening the founder’s eyes to some major moves and not making small problems a big deal.
Raising money takes time.
In this environment, when raising capital, you should expect to spend a year doing it. It’s great if it’s less, but even in a great environment, you should expect it to take a year to raise capital. Seek the advice of those with a general sense of what valuations are doing now and understand the complexities of transactions.
Our Take
It’s a tough market, and we expect it to remain challenging for at least the remainder of 2023. It’s critical to have advisors who understand the market condition and legal landscape to help you get the best deal possible.
A tough economic climate doesn’t mean the power dynamic automatically tips in favor of those with the cash.
Our advice to founders is to know their worth and deliver on their business plan. If you are confident that you have a robust and scalable business and a good term sheet, then you can be bold in your due diligence and go after the investors who will prove mutually beneficial in terms of both hard and soft value.
Raising money, whether you have experience or not, can take time and effort. It’s essential to be armed with the right questions and have solid legal advisors. If you need help or have questions, please drop us a line at +1 212 545 8022 or visit our website – www.rooney.law.
Read more insights from the Rooney Law team here.
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