Hugs down round

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Several media outfits informed Earlier this week, crypto lending platform BlockFi is looking to raise around $100 million in new funding in a round that will value the company at around $1 billion. Remarkably, when BlockFi last raised money from investors — $350 million last March — investors valued the company at $3 billion.

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It’s a pretty breathtaking drop, and in the world of venture capital-backed startups where everyone feels compelled to “kill him” all the time, the price adjustment could be interpreted as a black mark against the company. However, it may be the smartest game ever.

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Indeed, many companies now face Hobson’s choice between trying to maintain the high valuation they’ve set over the past year – regardless of the distortions needed to do so – or pursuing a “bottom round”, funding that results in a lower valuation. And industry experts suggest that the latter often makes more sense.

Brad Feld, a venture capitalist with more than 20 years of experience, is one of those who advocate using a top-down round when a company needs capital and has not yet reached a previously established valuation. Feld says he has been involved in funding rounds for startups so tied to a particular number that they would do anything to keep it. He was also involved in transactions in which the company and its board agreed to go to any lengths and downgrade the company’s valuation.

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Based on both experiences, he says he is “strongly convinced” that “simply doing a clean reset – at any rate, so that everyone is aligned and dealing with reality – is much, much better for the company.”

He is not alone. “Unfortunately, I’ve been in the industry too long to see the problems associated with these terms,” says Frederick Kort, an early-stage founder of London-based firm Felix Capital. “As a young investor in the early 2000s, I spent a lot of time restructuring the capitalization tables” after the dot-com crash, and then he realized that “trying to correct the situation or maintain an artificially high price with structure is a recipe for disaster.” “.

The smartest plans

Rounds down are not the preferred starting point. In the roughly three months since the winds turned in the startup market, the messages for startups have been to cut costs and do it quickly by laying off employees, postponing projects, freezing research and development, and cutting other expenses in order to become more self-sufficient. .

However, after years of chasing growth, many startups won’t be able to shift gears fast enough. They will need to raise more capital, and while the strongest startups can raise new rounds with small terms at an even higher valuation, others will face two options: raise more money at the same valuation, but more and more “structure” in venture capital. language or start over in terms of evaluation.

Right now, says Lauren Kolodny, co-founder of Bay Area venture capital firm Acrew Capital, many teams, both in and out of Acrew’s portfolio, are settling for more structured “flat and extended rounds” – that’s the most common thing we’re seeing in this Because so many of the Series A and Series B stage companies have raised high valuation rounds with little to no impact on product-to-market fit, “they could have fundamental principles and be doing well,” she adds, “but they didn’t have the ability to grow in those scores”, leading to “harder talk of more punitive rounds”.

Why not discuss other options? Kolodny suggests that part of the reason investors use these extra rounds as a starting point is because of their experience. Recapitalization, which essentially describes the fall, “is a muscle that investors have not flexed for a long time,” she says. There are also “a lot of VCs who have never done a debrief before,” she adds, arguing that “part of what we are seeing is a lack of comfort on both sides when it comes to debriefing, so people move on to the discussion.” an overly structured flat round pretty quickly.”

The founders and their investors are also hesitant to reset the valuations because no one knows yet how long the current conditions will last. While Feld is expecting a lengthy correction right now, Michael Sullivan, a startup veteran and venture capital lawyer at Orrick law firm, thinks the correction the market is going through could be relatively mild.

“I tell the young lawyers I work with that I don’t think we’re going to see another 2002,” Sullivan says. “I don’t think the VC downturn will be as severe as it was in 2001 and 2002, when all we did was bury companies.” Michael Torosian, a Baker Botts lawyer who serves as outside general counsel for emerging companies and their investors, echoed Sullivan’s sentiment. “We had all sorts of people worried about the end of the world at the beginning of the pandemic, and after that the market exploded for a few years – and he was already on the run.”

There are many other reasons why founders make deals with venture capitalists that they might otherwise avoid.

The most obvious of these is appearance. No team wants to look weak. “The outright look is much better than the downside,” which is why the founders agree to “all sorts of crazy terms to get there,” says investor Justin Fischner-Wolfson, co-founder of investment firm 137 Ventures.

The founders also worry about a “spiral of morale,” says Sullivan, who describes “a vicious circle where employees learn that [the value of their shares is suddenly far less]which leads to exhaustion, which accelerates the moral problem.”

Problem with Plan B

Such fears are hardly irrational. Perception matters. Naturally, not all startups are in the same boat right now. The terms of the new round depend entirely on how active the startup is in relation to how it performs compared to the rest of the market.

However, when it comes to accepting a well-structured deal to maintain the status quo or taking a valuation hit, the latter scenario often makes more sense than not.

“You can only create a limited structure,” says Kolodny, noting that the term has a steady ripple effect in a market where it’s harder to find a way out. Once the founder agrees with them, “you set a precedent for repeating these conditions over and over again, given that most companies will need to raise a couple, if not more, subsequent rounds of funding,” she says.

The Court says the same thing, explaining that “If you give this [deal term] to the investor now, the next investor will come for him” and demand the same, and “then you create this huge disparity.

Terms can also get surprisingly hairy. Torosyan says he has already seen the introduction of liquidation incentives that ensure investors get three times their invested capital before anyone else sees a dime.

He says other, even more onerous conditions may begin to emerge, including preferred participation conditions, where investors receive back not only the rate they specify to which they are entitled, but also additional dividends based on some predetermined conditions. . (Torosian describes it as “get your cake and eat it,” adding that he “hasn’t seen much, but I think it will if the downtrend continues.”)

When things get too long, other positions begin to emerge. These include provisions to prevent dilution or provisions that allow investors to retain their ownership interest in the event of a new share issue.

By the way, it’s not just wine and roses for venture capitalists. Something else that the startup world hasn’t seen in years, but might very well see again, is the pay-to-play terms that VCs really hate, and for good reason. “Pay to play” means that if a company needs to raise money and uses insiders to do so, those who cannot or do not want to contribute proportionately will see their preferred shares reduced to common stock or some another subset of stocks. justice with fewer rights.

An investor who does not pay may forget that he will be paid before others, or about any other guarantee of the return of all his money. These conditions in exchange for high marks? Gone.

Acceptance of Plan C

Neither term is right for relationship building, which is why people who’ve seen this movie before say that as painful as it is, rounds down – without structure – can quickly become the smartest fundraising option for many startups.

“If you’re just doing finance to survive and the capital in the business is currently worth nothing, it’s better to just deal with reality,” says Feld. This way, “you have a chance to raise additional capital in the future, and the people who work for the future business will be the ones who accumulate value,” he adds. (Because the value of everyone’s equity and the size of their stakes fall in the down round, milestone-based employee grants created during the recapitalization can help.)

Going fast is probably a good idea, too, especially if the startup is “meeting the business plan but not exceeding it, and it could have six months to take off,” says Torosyan.

Right now, he says, even though he remains optimistic about the overall state of VC funding, the founders “should assume that things are going to get worse and that it will take you twice as long to raise half as much money.” . as you are looking for. You never want to be in a position where you’ve been trying to raise money for three months,” he says. “People will smell the blood in the water.”

At the very least, founders can take comfort in the knowledge that some well-known brands are already moving in the same direction. In addition to BlockFi, “buy now, pay later” giant Klarna is reportedly seeking funds to raise money. $30 billion valuationwhich is a significant decrease from the $45.6 billion estimate put in by investors last year.

No outfit can have a choice. Sullivan notes that one of his venture capital clients backed out of a deal six weeks ago when she asked a startup to accept her check at a lower price as public tech stocks plummeted, and it refused.

Her decision was “rational,” Sullivan says, “and I encourage other companies to accept fair valuations, even if they go down, given that today’s downgrade alternative may not materialize at all. “It’s like the old Brazilian saying that I’m probably messing up,” Sullivan says. “If it’s caught in the net, it’s a fish.”

However, there is a silver lining. The more startups that settle for rounds down instead of trying to make harder alternatives work, the better it is for other founders facing the same problems right now.

“As the market starts to change and more and more companies are rounding down, it becomes more socially acceptable to round down,” says Fischner-Wolfson.

He suggests it’s just human nature. “You never want to be the first guy because you get killed in the press. But once 200 companies write articles about how they failed, the next guy doesn’t care, because no one will pay attention to it.

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