Operational and finance tips for early-stage startups in a tough market

Ben Boissevain Contributor

Ben Boissevain is the founder of Ascento Capital, a boutique investment bank that provides advisory services for M&A, capital raises and valuations to technology companies in the U.S. and internationally.

How tough is the market?

This market meltdown is tough on an historical basis:

Venture Capital (VC): Global VC funding in Q2 2023 fell to $65 billion, down 49% compared to Q2 2022.
Private Equity (PE): PE firms deployment is down a similar 49% in Q2 2023 from the quarterly peak reached in Q4 2021.
M&A: The M&A market for VC-backed startups in the U.S. is on its slowest pace since 2013, as the world’s economy was coming out of the Great Recession in 2009.
IPOs: 55 IPOs have been priced so far this year. The last time there were fewer IPOs was 2009 in the Great Recession.

Operational survival tips

For a company in survival mode, cash is king. Review a cash flow report, not a GAAP report, every day. Slow down paying vendors and require payment from customers in 30 or even 15 days. Focus sales efforts on quick wins that bring in cash, not elephants.

Cut expenses to the bone. Think Elon Musk sleeping on a couch. Review every line item. Consult with employees on areas to cut. Even small items like canceling subscriptions will change the corporate mindset from growth at all costs to a path to profitability.

Shifting the goals to a path to profitability fits with the new investor mantra, the Rule of 40 — if a company’s revenue growth rate is added to its profit margin, the total should exceed 40%.

One area to explore is using AI to perform tasks such as creating legal documents, generating key words for SEO, and writing software code. Almost 30% of new GitHub code is now written with AI assistance.

Unfortunately, terminating employees is sometimes necessary for a company’s survival. Be transparent with the employees, management, and the board. Consider furloughing employees and not terminating them to retain talent.

Finally, consider a hard pivot like Amazon in 2000. Listen to the market to determine where the demand is for a company. What other products or services can the company provide and what other market can the company serve?

Corporate finance options

If a company has a limited runway, pursue multiple corporate finance options simultaneously. Do not pursue the next VC round, run out of money, and then try to pursue M&A. The M&A process requires at least six months.

In a tough market, VC firms tend to double down on their winners, which is understandable from their perspective. The interests of VC firms and their portfolio companies are not always aligned, especially in a downturn. For a VC portfolio company that is not a “winner,” it is challenging to raise capital, since if the current investors are not committed to the next round, it is difficult to attract new investors. Portfolio companies should ask their investors if they are committed to the next round and if the answer is lukewarm, then explore other options, including M&A, while they still have a decent runway.

Companies should explore both equity and non-equity financing options as well as M&A.

Equity options

There are many types of rounds of financing.

Flat round: One way to test the commitment of the current investors is a flat round where the valuation, and importantly for efficiency, the legal documents remain largely the same. This provides the portfolio company with more runway and is easy to execute.
Bridge round: Another option is a bridge round, which “bridges” the gap between larger funding rounds. While not always ideal, they can be necessary to keep the company afloat. Bridge rounds are typically structured as convertible debt.
Down round: In down rounds, the valuation is lower than in the previous round. Down rounds nearly quadrupled in number in Q1 2023 compared to a year earlier.
Up round, structured: Founders and investors can be demoralized by down rounds, so structured term sheets are back in vogue. However, “investor-friendly” terms in structured term sheets often come at the expense of early backers. Liquidation preferences demanded by new investors are as high as 4x. Some term sheets even have stipulations that allow new investors to purchase more capital at discounted rates if milestones aren’t reached, which dilutes the early backers and the founders.

Non-equity options

Non-equity options are nondilutive and can extend the runway.

Revenue-based financing: Revenue-based financing is increasingly popular. Investors receive a percentage of the company’s ongoing gross revenues in exchange for the money they invested.
Venture debt: Venture debt financing is a type of loan extended to startups that can provide more flexibility than other types of debt. Venture debt is also popular again despite the collapse of Silicon Valley Bank.
Factoring: Factoring is when a company sells its accounts receivable to a third party, called a factor at a discount.
Small business loan: It is also worth exploring a small business loan from a bank or the Small Business Administration. The new 2023 SBA loan rules make getting a small business loan easier.
Government grants: Explore sector-specific opportunities for government grants — for example, many proptech companies are pursuing grants from the federal government, which is using nearly $1 billion from the Inflation Reduction Act to retrofit federal buildings to clean up the federal government’s own carbon emissions.
Personal loans: Depending on a founder’s personal finances, a personal loan may be possible, but given entrepreneurs’ necessary tendency to be overconfident, this should be approached with caution.
Licensing: Many large companies are hesitant to acquire a company but might be interested in licensing a company’s technology on an exclusive or nonexclusive basis. A large company’s department that is interested in the technology may already have the budget to license without needing approval by the C-suite, which can speed up the process.

Mergers and acquisitions

Most exits are through M&A versus an IPO. According to the National Venture Capital Association, 94% of venture-backed exits in 2022 were through M&A, while only 6% were through IPOs. While it is good to strive for a billion-dollar-plus IPO, it is practical to prepare your startup for a smaller M&A transaction.

Cast a wide net for potential buyers: Review past M&A approaches to the company. Explore buyers in the core sector as well as adjacent sectors. If a company is large enough, approach PE firms as a platform investment since PE firms’ requirements on EBITDA are more flexible lately as they try to deploy more dry powder. If a company is smaller, approach the portfolio companies of PE firms, since PE add-on deals have grown in popularity. Approach both domestic and international buyers to create an international auction process to obtain the highest valuation.
Look for a soft landing: If the M&A market is not receptive, consider selling a company to a friendly buyer or a competitor for an equity swap or even $1 for a soft landing. It is better to have a track record of selling a company than shutting down a company. If anyone asks what the valuation was, just indicate that the terms were not disclosed, which is the case for most M&A deals.

There’s reason to be optimistic

This market will turn around faster than most expect. The Fed is winning its battle against inflation with hopefully the last rate hike of 25 basis points on July 26, 2023. The Nasdaq is up 38.8% in H1 2023. Dry powder is at a record globally with VC funds clocking in at $580 billion of dry powder and PE firms at $1.3 trillion of dry powder. Finally, the technology sector is exciting again with major advances in artificial intelligence, quantum computing and extended reality, technology advances that increase productivity and create new markets.