More than 15% of all startups that raised money in the first quarter of 2023 had to do so at a flat or lower valuation than they previously enjoyed. As investor appetite for backing startups remains subdued, many companies are having to revise the sky-high valuations they reached during the 2021 investment frenzy. The era of the down round has begun.
The down round can feel like a painful let-down for both the company and investors, but there are ways to make this process easier. Bill Taranto, president of MSD Global Heath Innovation Fund, the corporate investment arm of pharmaceutical company MSD, shared some advice at the GCVI Symposium in London about how to prepare.
1. Start with an honest appraisal of where you are.
One of the first questions to ask is whether the company worth saving, says Taranto.
“Sometimes, it’s a harsh thing to say but sometimes the best solution is to shut down a company [rather than] funding to build a bridge to nowhere. Sometimes, no matter how much money you put into it, it just can’t get to where they need to be,” he says.
To decide Taranto usually looks for trends in the profit and loss account and for customer reactions. A company can be revenue and cashflow negative but there may be a sales pipeline that is about to kick in. If revenue has been declining flat for a long time, is there any way to turn it positive? Is it the kind of company that will ever grow?
“It’s about being brutally honest about what we see,” says Taranto. Many startup founders will keep saying that a hockey stick-like growth curve is just about to kick in, but at this point, they need to be able to show investors real evidence.
“What’s the tipping point that’s going to show investors that you’ve turned this around? What is that inflection point? If we can’t see that, then we have to make some hard decisions,” he says.
2. Cut costs — but not too much
Assuming the company is worth saving, the next step is to make it as lean and efficient as possible. But bringing the cash burn down is a delicate art.
“You can’t cut too much. There’s a catch 22. You can’t cut so you can’t serve your customers. It’s cutting enough where you’re not burning as much cash but you’re still being able to do the work that you need to do to survive the next year,” says Taranto.
A good rule of thumb is ensuring companies have around 12 months worth of cash. Taranto is predicting that the investment downturn will last until the first quarter of 2024, so companies need to make sure they can last until then.
If you don’t have enough to last until then, start raising immediately. You have less time than you think, as raising a round could take 12 months to pull off.
“Talk quickly. That clock ticks fast,” says Taranto. “Even if you have 12 months of cash, you don’t have 12 months of cash because you need two months of cash just to wind the company down.”
3. Align your syndicate
The key to a smooth down round is knowing all the other investors in the company’s cap table extremely well.
“Do they still believe in the company? Do they have cash to put in the company? Do they even want to fund the company and to what levels? How are they in ability to get new investors in? You have to know all these things,” says Taranto. “But lot of times investors don’t know anything about the other investors.”
MSD Global Health Innovation Fund is usually the lead investor on deals and the team makes a point of understanding how co-investors are thinking.
“The first time we come into a company, we want to know everything about the other investors. It’s a constant communication over the year,” Taranto says. There’s a lot of behind the scenes work and informal conversations involved.
You also have to understand the voting rights of the company — which investors own which classes of stock and what percentage of those classes need to vote to get a decision through.
“You basically need to get probably anywhere from 60 to 80% of the shareholders to vote in a positive way. You don’t need everybody,” says Taranto.
If one shareholder is trying to force the rest into an unpopular move — such as a cram down in which everyone else’s ownership shares are wiped out — it is worth knowing which combination of other shareholders has enough votes to block this. Time spent studying the shareholder agreements is well worth it at this point.
4. Consider all alternatives
This seems obvious, but it is worth having a menu of options to work through, from raising debt to a sale of the company. If one plan doesn’t work — for example if an attempted sale of the company doesn’t go through — investors need to be clear if they are willing to keep funding the company and for how long.
5. Embark with optimism
A down round should be considered a temporary measure.
“The whole idea is to keep the company afloat,” says Taranto. A down round can be relatively small, raising just enough to keep the company going for the next year. Then, if the company is performing well, it can raise another round at a higher valuation and eventually work back up again.
Some 87% of companies that raised a down round between 2008 and 2014 were able to raise capital again in either a flat or up round in their next funding, according to data from Pitchbook. Some 90% of these companies survived.
A down round will not cause a company to close down, Taranto points out, but running out of cash will. Done well, a down round can be a springboard to a company becoming stronger. It can weed out business plans that aren’t working and trim fat to leave a more efficient core.
The key thing is to be prepared and to do it before events overtake you.
Bill Taranto shared these insights at the GCVI Symposium in London.
