“It’s going to be a rough period,” says Tammi Smorynski. The Intel Capital managing director has been preparing for a correction in the startup market since 2021, when valuations reached unsustainable levels.
“In the last few years, entrepreneurs really had a lot of ability to drive prices up on the deals to places that we all were recognising was not good from an investment standpoint. And even from a company standpoint, when you set a valuation too high and can’t create enough revenue to support that, it’s not going to be good for the next round, regardless of the market,” she says.
Smorynski has been with Intel Capital for more than 22 years — since before it was called Intel Capital — and has seen the company invest more than $13bn in more than 1,500 startups, and rack up more than 660 exits. She’s been through several downturns, including the dotcom bust in 2000 and the aftermath of the 2008 financial crisis, and is on alert to prep her portfolio for this next difficult period.
Since the middle of last year, the market has gone into a reset. Only 169 companies headquartered in Silicon Valley closed financing rounds in the last quarter of 2022, the lowest number since 2016, according to a recent survey by law firm Fenwick & West. Some 23% of companies that raised financing had to do so at a valuation equal or lower than they had in a previous round. An increasing number of companies are having to contemplate down rounds, says Ian Goldstein, partner at Fenwick & West. Funding deals are increasingly including protective clauses for investors, such as senior liquidation preferences.
Investors such as Dusty Lieb, managing partner at Echo Health Ventures, the investment firm owned by four Blue Cross Blue Shield insurers, are advising their portfolio companies to manage their cash reserves to make it through to at least 2024 or 2025. But the downturn could even be longer.
“I’m not quite sure how long the storm lasts, when this all shakes out,” says Lieb.
So how should corporate investors prepare to manage their portfolios through an economic downturn?
Smorynski, Lieb, and Goldstein shared advice in our webinar Navigating down rounds and managing CVC portfolios through market uncertainty. This is what they told us:
1. Re-educate your portfolio companies
This sounds obvious, but it is worth remembering that new entrepreneurs who came into the market in the past decade will have a skewed view of investment capital, says Lieb.
“A lot of these entrepreneurs have been trained to believe that capital is cheap and that growth at any cost is what drives maximum valuation. It’s a by-product of some of the large growth equity, hedge funds coming into the space and funding a lot of deals with very cheap capital. [New entrepreneurs] were oriented to think about the world that way,” he says. “But now we’re in a very different environment.”
“There’s some ego, there’s pride, there’s confusion.”
This won’t necessarily be easy and will require a great deal of people skills and empathy, says Smorynski.
“It’s not fun,” she says, explaining to a first-time entrepreneur why they can’t raise money at the same valuation they saw a competitor raise at a year ago. “There’s some ego, there’s pride, there’s confusion. It’s a more delicate dance and conversations that you have to have nowadays. But it’s the right conversations and it’s the right time to do it.”
2. It is better to price a company low than to add complicated investor terms
Our webinar panellists all agreed on this: it is better to accept a lower valuation than to keep it high by inserting a lot of protection clauses for investors, such as high senior liquidation preferences. Liquidation preferences can ensure that investors still make a return even when a startup is sold for less than expected, but they make the company look unappealing for any new investors coming in.
“Sometimes people think we’ll keep the valuation high, but we’ll put on all these crazy terms, so that if the exit is bad we can still make out,” says Smorynski. “The problem is that all that does is make [the company] look worse when you raise more money. A new investor is going to look at that and say: ‘that thing looks horrible’.”
Fenwick & West’s recent survey found that the use of senior liquidation preferences jumped significantly in the last quarter of 2022, with half of all the series D and E fundings using them. Goldstein notes that the use of these special rights is “more frequent with more distressed companies and with less sophisticated investors,” he says.
Some investors, Goldstein says, will still try to avoid putting the burden of these requirements on a company. He cites the example of a recent biotech funding round, where the series C valuation was lower than the company had during its series A round.
“Everyone just realised that it was in the best interest of the company to keep this simple. They did the down round, they waived anti-dilution rights, they didn’t add a lot of complexity to the cap table, they kept the A, B and C [investors] flat in terms of liquidation preference. They moved on, and the company is so much more successful. It doesn’t have that weight on its back as they move forward in building their business,” says Goldstein.
3. Keep everything legally watertight
When startups and investors lose money, things can get ugly and people get sued. It is important to keep your lawyers close at hand to make sure you won’t be facing court action from other investors later on.
“You really do have to be mindful of those more complicated down rounds that really wash out smaller investors, common stockholders, employees. There’s a lot of sensitivity. It’s really important to make sure that company counsel is there in the boardroom,” says Goldstein. “There are various risk mitigation tactics that can be used to try to create as much fairness as possible in a deal like that.”
“Sometimes investors naively think that you can just decide to do [a down round]. That’s not usually the way it works.”
Smorynski adds that investors and portfolio companies shouldn’t jump too quickly into doing a lower valuation round. Even if the market conditions look poor and they are not confident of a key investor coming on board, a company needs to show they have explored all options before opting for a down round.
“You can’t just wake up one day and decide that that’s the most expeditious way to do this fundraise. You have to show you’ve tried to do everything else and that you’ve been forced up against the wall,” she says. “Sometimes investors naively think that you can just decide to do [a down round]. That’s not usually the way it works.”
4. Plan ahead — and don’t assume others know what they are doing
Don’t wait until the money has almost run out to negotiate a rescue.
“If you wait until the company has two weeks left of runway, at that point, you’re going to create a mess, and that mess is going to have some risk buried in it,” says Goldstein. Now — before any acute funding shortfall emerges — is the time to have more board meetings and informal board discussions, says Goldstein.
Smorynski adds that even investors who don’t take the lead role and who may just hold a board observer role at the company need to be proactive in spotting early signs of trouble
“Don’t assume that the management team, the board, or the lead investors, actually are paying attention and going to do the right things in these economic environments. You’ve got to roll up your sleeves and start talking to people, don’t sit back and watch the ship hit a wall,” she says.
5. Be clear on your voting policy
When things get tough for a startup, investors and the company are likely to vote in different ways on crucial decisions. Sometimes corporate investors who sit on the startup board can feel conflicted about where their loyalties should lie with, says Lieb, so it is good to have a policy in place for this. Echo Health Ventures, which has invested in 30 companies since 2016, makes it clear that investors who are board members have a duty to vote according to the best interests of the startup, not the interests of the parent company.
“That’s a very useful policy. It’s just always important to ensure that you’re maintaining your duty of loyalty. That’s your first and foremost concern as a board member,” he says.
When Intel Capital has a board seat, says Smorynski, they will have a second person on the team cover the company to represent their rights as a shareholder.
6. Train your team members to deal with tough markets
Smorynski says Intel started to do mock negotiation rounds with its team members in 2021, to prepare them for negotiating with distressed companies.
Lieb, on the other hand, has been training his team on pricing deals correctly. “Where I focus a lot on is training underwriting, ensuring that the deal is priced right and realising that over the past year we’ve been a much higher cost of capital environment.”
Lieb has learned the need for financial rigour the hard way, having in the past pulled out all the stops to support a business that ended losing a major client and being wound down anyway. No amount of term sheet or shareholder rights renegotiation is going to help if the startup’s underlying business is flawed.
“Had I done the calculus up front: is this asset worth going through all of these iterations? The answer to that was probably not,” he says. “So, I’m always trying to do the math on whether the asset really has the underlying strength to turn the corner.”
The upside?
Down rounds will be difficult and disappointing. But there is a silver lining in a market correction. As valuations come down to more realistic levels, many of the corporate investors who have been staying out of deals during the overhyped market of 2021 are seeking to start investing again.
“We’ve been on the sidelines of dealmaking for the last year and a half.”
“We’ve been on the sidelines of dealmaking for the last year and a half,” says Lieb. Echo Ventures typically aims to do between four and eight deals a year but has been holding back. Better valuations will mean getting more deals over the line.
Many other corporates are like Echo Health Ventures, with untapped funds to invest. This is different to the downturn during the financial crisis of 2008.
“Much more than in 2008 we have a significant dry powder overhang. That will probably keep things a little bit more elevated,” says Lieb. Many corporates will see the correction as an opportunity. “The data pretty firmly shows that these vintage years following downturns tend to be outperformance type of years,” he says.
Watch the full webinar session here:
This webinar is part of GCV’s The Next Wave webinar series. See our past episodes here.
The the next in our series will be Automotive Venturing – what’s next? on April 12, with speakers including Tony Cannestra, director of corporate ventures at Denso.
