Capital Market Climate Change

Hope that you feel this
Feel this way forever
You can plan a pretty picnic
But you can’t predict the weather.
—Outkast, Ms. Jackson

If you run a startup and are currently raising money, you probably planned for a somewhat different fundraising environment than the one you find yourself in today. You probably thought that valuations would be roughly the same as they were the last time you raised money. But they most certainly are not. Perhaps you are caught in the “Series A crunch” or perhaps you are a consumer company and expected that you would be valued on users rather than revenue like the last time. Or maybe you are a lucky enterprise company and are pleasantly surprised—this time.

How could this be? What about the efficient market hypothesis? Aren’t markets rational? Won’t we just return to the “normal” environment that we experienced before? To find out, let’s look at the Price/Earnings (P/E) ratio of all S&P 500 IT companies at various points over the past 18 years. If markets behave rationally, one might expect the ratio of price to earnings to be reasonably stable over the period (click here for complete data set). One would be wrong:

3/31/1995: 21.0
3/29/1996: 22.3
3/31/1997: 23.3
3/31/1998: 30.8
3/31/1999: 49.7
3/31/2000: 73.4
3/30/2001: 26.3
3/29/2002: 82.5
3/31/2003: 44.6
3/31/2004: 31.6
3/31/2005: 22.8
3/31/2006: 22.8
3/30/2007: 22.6
3/31/2008: 19.1
3/31/2009: 14.5
3/31/2010: 18.8
3/31/2011: 15.4
3/30/2012: 15.5

So, the average company on the S&P 500 IT index with $10M in annual earnings would be worth $210M in March of 1995, $820M in March of 2002, $310M in March of 2004 and $155M in March of last year. And those are big companies with real earnings, so you can imagine how a private company’s valuation might fluctuate. If you have no imagination, consider my experience. In June of 2000, I raised money at an $820M post-money valuation. By the end of the year and despite more than doubling bookings, I could not raise money at any price in the private markets and was forced to take the company public at a $560M post-money valuation. Things change. Why do things change? Because markets are not logical; markets are emotional.

Now that we’ve established that climate change is real, what should you do if the current environment is much worse than you expected?

In some sense, you are like the captain of the Titanic. Had he not had the experience of being a ship captain for 25 years and never hit an iceberg, he would have seen the iceberg. Had you not had the experience of raising your last round so easily, you might have seen this round coming. But now is not the time to worry about that. Now is the time to make sure that your lifeboats are in order.

Before we begin doing that, let’s understand the depth of the problem. First, if you did not understand how radically the fundraising environment might change, then there is no chance that your employees would have understood it. In fact, if you are like most companies, your managers probably implied to your employees that your stock price would only rise as long as you were private. They might have said something ridiculous like: “Based on the current price of the preferred stock, your offer is already worth $5M.” As if the price could never go down. As if the common stock were actually the same as preferred stock. Silly them. As a result, if you raise money at a lower price, your people will likely not only freak out, but possibly believe they were lied to. Note that they may very well have been lied to. As Scooby Doo once said, “Ruh roh.”

Now about those lifeboats.

If you are burning cash and running out of money, you are going to have to swallow your pride, face reality and raise money even if it hurts. Hoping that the fundraising climate will change before you die is a bad strategy because a dwindling cash balance will make it even more difficult to raise money than it already is, so even in a steady climate, your prospects will dim. You need to figure out how to stop the bleeding, as it is too late to prevent it from starting. Eating shit is horrible, but is far better than suicide.

When you go to fundraise, you will need to consider the possibility of a valuation lower than the valuation of your last round, i.e., the dreaded down round. Down rounds are bad and hit founders disproportionately hard, but they are not as bad as bankruptcy. Smart investors will want the founders and employees to be properly motivated post-financing, so there may be a way to a reasonable outcome for both you and your people. Make sure that you figure out what kind of deal is better than bankruptcy and be sure to communicate to both your existing and potential new investors what you think makes sense. In this situation, it’s better to start low and get one bidder that may lead to many and the market-clearing price than have no bidders and the dream of a high price.

Once you begin your process, keep in mind that you are looking for a market of one. You don’t need every investor to believe that you can succeed. You only need one. If 20 investors tell you “no”, that does not mean that there is no market for your deal. You just need one to say yes and she will erase all 20 no’s.

After, God willing, you successfully raise your round and it’s a down round or a disappointing round, you will need to explain things to your company. The best thing to do is to tell the truth. Yes, we did a down round. Yes, that kind of sucks. But no, it’s not the end of the world. We can probably re-price your options. If we took too much dilution, we will work with our new investor to make sure that every employee is still highly financially motivated. We are the same company that we were yesterday and if you believed in that company, then you should believe in this one.

If your managers intentionally or accidentally lied, then you will need to address that too. Find out what happened and deal with the damage as best as you can. Do not ignore these things or stick your head in the sand, as you cannot afford to lose any more trust than you have already lost.

If you by some miracle make it through this process, then the most important thing to learn from your experience is this: The only surefire antidote to capital market climate change is positive cash flow. If you generate cash, investors mean nothing. If you do not, then your success will depend upon the kindness of strangers.

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