With valuations down the drain, equity is becoming increasingly expensive. Funds are also sitting on their cash and transacting more conservatively. How do you, as a founder or CFO navigate this very different world of finance we are in now?
We will examine:
- When is it right to have an equity/VC partner
- What are the challenges to having an equity/VC partner
- What are the alternatives to equity
- What are debt warrants and how do they work
- Do you need to be profitable
- Negotiating debt and equity rounds
Let’s dive in.
Why would a founder want to give up equity?
Whether you believe it or not the business you started is like your child, and no one wants to give it up freely. You must choose your equity partner carefully, and there are some good reasons to go down the equity route.
- Guidance
A good equity partner will guide you on how to grow your business. The oversight they give, if managed correctly gives you the guidance you need to go from scrappy sidekick to superhero.
- The cycle of life
Going from seed to series A, to series B and so on is part of the cycle of life for many tech businesses. If you’re not bootstrapped and are in this cycle, you will likely have to continue.
Why wouldn’t you want to give up equity?
One word, control.
But like all things in life, it’s a bit more complex.
If you’ve chosen a bad VC partner, it’s like choosing a bad life partner. They want you to perform but if they don’t believe in your mission things can get tough. If you want to buy out an investor the road won’t be easy, find out more here.
Valuations are returning to pre-pandemic levels; the deals you are getting now are significantly lower, normally 3-4x revenue or ARR. It’s hard to see when we will return to 10x revenue valuations . If you raised money in the last 2 years this will create extra pressure on early investors and founders. Equity is more expensive now and if you have VCs that are first money out, and at a multiple of their investment, ouch.
With valuations being down you may have to make some changes. Look at other options while you grow your company's value.
How can Private Debt play a role?
The private debt market has been servicing tech businesses for many years, it is a mature market with thousands of funds worldwide. One term you hear often in this business is Venture Debt, it is the yin to Venture Capitals yang. But it is not the only option available to ambitious tech companies.
Private debt funds understand tech businesses more than traditional lenders do. They also have a higher risk appetite making them a great alternative to growth companies.
Depending on your circumstance debt facilities can be arranged for a wide range of uses, from bridging to the next round to expanding internationally.
One of the most attractive points about private debt is you don’t give away control. I’m not saying there won’t be some restrictions on your use of funds. You can’t go out and buy a yacht, but it’s less restrictive than VC funding. Watch ex-VC turned entrepreneur Tom Blah talk about why he won’t take VC money.
What role does debt play when you’re in the VC circle of life?
Private Debt can play a key role during your equity raise, there are 2 main ways in which it can help you on your journey.
- Mixing it up
Mixing debt and equity is a common occurrence, especially when you’re at a Series A or beyond. Having a VC on board also means you can negotiate a better term sheet with the debt fund.
- Plan B
If you’ve been through the VC meat grinder you will know things can get close to the wire. With the VCs being more conservative and sitting on over $2.3tn of funds you need to think outside the box.
Having a plan B and running a debt round at the same time is not just good business sense, it might be what saves your company.
What about warrants?
In the early years, fast-growing tech businesses typically burn cash and take time to turn a profit. For this reason, they’re often considered too risky to attract traditional finance. Debt funds leverage finance warrants as an incentive to take on the risk.
What is a debt warrant?
A warrant in debt is like a stock option. There are two common warrants you should know about:
Call Warrants – This is the lender’s right to buy shares at an agreed price on or before a specified date. The price is what’s known as a ‘strike’ price, and it is agreed upon during the deal negotiations.
Put Warrants – This gives the lender the security to sell a given quantity of shares for an agreed price on or before a date that is agreed upon during negotiations.
To put it another way, let’s say your company takes out a £1m debt loan with a 5% warrant coverage. Here, you give your lender the option to buy £50,000 in shares at an agreed price on the contract date. The warrant represents the equity kicker.
What happens when a lender exercises its loan warrants?
First things first, understand that warrants are typically only exercised on a ‘liquidity event’, such as a trade sale or an IPO.
If we refer to the earlier example, let’s say your company’s share value has increased by 50% and you decide to maximise profit with an exit strategy. Perhaps you plan to IPO or exit via acquisition, your lender can use its warrants finance to buy and sell £50,000 of shares. Now that they’re worth £75,000, they yield an ‘equity kicker.’
What about founder dilution?
Whether you're doing a debt or equity round founder dilution really matters. Funds want the founders to have ‘skin in the game.’ If as a founder you’re heavily diluted you may run into issues, every round dilutes more.
Do you need to be profitable?
No, and it depends. Both VC and debt funds will fund pre-profit companies. But you must have a clear path to profitability. If your business has not yet proven its market fit you may need to look at other routes.
The best time to raise money is when you don’t need it!
Having a good amount of run rate is important. If you’re managing your cash burn properly you will find it easier and cheaper to raise whether it’s debt or equity.
Negotiation
Negotiating the deal is always an art, and you should find a good advisor. Whether it’s debt or equity a good lawyer and or debt advisor is a must.
Conclusions
Your circumstances will determine what is best for you when raising finance. Here are some key takeaways:
- You can lose control of your company with equity finance
- Balance out your equity raises with the application of a debt round
- Have a plan B, and run your equity round at the same time as a debt round.
- If you EBITDA positive or have a path to profitability it will be easier to get finance
- Start your raise just after the last one.
This article was written with the input of our good friends at Mace Legal.
