Down Rounds, Debt, and Decisions

I understand why people always tend to look for a ‘new normal’ during times of economic and investment turmoil, but in my years of experience, the word ‘normal’ is a bit of a mirage. The last decade has mostly been a time of relatively cheap and highly available capital for high growth firms; whether that is ‘normal’ is beside the point.?

What these conditions did create was a set of widely shared expectations about funding rounds — valuations always go up; when you issue new shares dilution doesn’t matter because the overall valuation has increased disproportionately; and incurring debt as a funding source was unnecessary and too risky. So it was okay to burn money in pursuit of growth, get more equity financing when you need it, assuage existing investors by allowing them to increase their internal marks, and generate a signal to the public markets that the company has real momentum, all at the same time. As a bonus, the increasing valuations made great headlines for the company, the CEO and the existing investors, and in practice became one of first things investors looked at when it was time to raise additional capital, whether through a private round or an IPO.

Normal or not, this is not the current market environment, which creates a fascinating strategic choice for high growth companies.?There’s been some attention lately to convertible notes and other “hybrid” financing sources that are essentially a combination of debt and equity. These come at a significant price to growth companies:?investors are looking for annual returns of high teens up to 20% on these notes, the capital is generally senior to all equity raised to date, and they sometimes carry covenants that constrain what the company can do with cash on its own discretion and without agreement from the financing source.

Why would a growth company take this route? Well, in addition to being marginally less expensive than pure equity, since these notes generate part of their return from a coupon, they generally don’t force existing investors and management to adjust the company’s equity valuation.?So, on the face of it, you can raise new money in a down market without a down round and having to shoulder the inverse of those benefits I talked about above that come with that.?

All finance has costs and benefits, and I think it is important to carefully weigh the trade-offs around convertible notes as a strategic choice for growth companies, particularly if the party providing the financing isn’t providing any real operating or strategic expertise to the management team. First, because I’m not convinced that firms necessarily have to be frightened of a down round - in some circumstances (for example when valuations are really high, and the capital raise is relatively small) it’s really not as bad as the perception.?I understand that employee morale is a potential headwind but on the other hand I’m sure most employees would prefer to get refresh grants at something closer to true market value.?Second, because kicking the can down the road often isn’t worth the effort — hope is not a strategy and a down valuation is going to get realized at some point unless you have firm reasons otherwise. Third, because agreeing to the covenants, the reporting requirements, and the seniority associated with the convertibles’ debt component is a business strategy constraint on management that ought to be looked at with open eyes.?

But the most important reason is that I think in many circumstances there are better choices for growth companies. The first question ought to be about taking a half step back: do I need to raise more capital right now??Or can I use existing cash on the balance sheet, tighten my belt on operations, and become self-funded through an exit event???

Many growth companies don’t need to sell a large percentage of their equity to get to break-even. Instead, it may make better sense to bring in an operationally minded growth investor as a partner who can help management streamline non-core parts of the operation and get to profitability without reducing sales capacity or hamstringing core product development.?It may cost a little more up front (though not, I believe, in the long run) and have a lower headline value than the previous round of funding, but this kind of finance relationship yields better alignment, a better investment partner, and a de minimus impact on the returns of existing investors.?

Every financing decision is one-of-a-kind, and it’s always one of the most important decisions that a growth entrepreneur makes. I encourage CEOs (and investors) to really weigh the trade-offs with open eyes, and to not get stuck in a debate about what’s normal, newly normal, or anything else besides what choice best provides flexible support to build for the long term, regardless of where we are in the business cycle.