I'm No Economist #6: ?? Down Rounds Are Coming, How To Approach (Re)Valuations

Welcome to another edition of?I'm No Economist.

I'm No Economist?is one of the best ways to get news -?mostly opinions?- on the ???? and ???? markets, startups, and the innovation ecosystem.

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We are seeing the signs of a downturn in the markets. The reasons are many, and I've pointed them out recently in past editions of the I'm No Economist. It is only the beginning, the very early stages of a massive correction.

Although it will eventually end, we don't know when it will happen - if somebody is telling you they know when, they probably can't find their own buttcheeks with both hands - so, be wary.

If you read the last edition of I'm No Economist, institutional investors, in this specific case Family Offices all around the world, with a collective ~$ 500bn AUM, are looking for higher returns opportunities.

The private market is getting more allocation because it's been tough to find opportunities in public equities and fixed income. You know: higher interest rates, inflation, lower valuations yadda, yadda.

It is that time of the cycle (for those who kept cash balances) to look for alpha in alternative asset classes.

While looking for market opportunities, I was very interested in learning more about good businesses that were simply suffering from the ghost of insolvency and looking to cash out - fast and effectively.

I know I'm not the only one looking at it. But there are only a few putting this strategy into place.

Sam Bankman-Fried is one of those people. He's reportedly?buying out companies at more than 90% discount over their last valuations. This is hot, folks. Flaming hot.

Although Pitchbook reported recently that down rounds are still historically low, I believe there are opportunities that are under the radar but will come out sooner or later.

Investing in distressed startups

I found very little information about how to analyze those companies to make the right decision to invest in them.

As an extremely curious person, it made me salivate for the opportunity of learning how to do it, as I know there are tons of opportunities to take advantage of.

I went down the rabbit hole and found a very good?article?on how to invest in distressed startups, but also decided to call in a specialist to shed some light on how to analyze and make the best out of buying a distressed asset.

Especially for this edition of I'm No Economist,?Alex Ball, Managing Partner at?FAA Advisors?was super gentle to spare some of his time to give us some light on how to analyze and make the decision to invest in a distressed startup.

We have been exchanging messages around the past posts on I'm No Economist, and we share a similar point of view:

"A strategic investor will be looking at her options as interest rates rise and may not take the risk with startups. The LPs will be more demanding of their VC partners but will also search for high returns as inflation continues to rise.

It will be a challenging time as the era of cheap money and blind cheques may for now, be over."

Alex Ball - FAA Advisors

Before we go on, I want to be super clear this is not a sponsored post. This content is purely educational and has no intention of being a piece of investment advice.

My intention is to generate educational value for the audience. Plain and simple to explain the state of the markets and the investment opportunities that are out there.

Now let's get to it.

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When do startups need more money?

Startups are highly risky businesses, it's in their nature. I'm not getting into how you should pick the right investment from the beginning - so that they don't become distressed businesses.

But I thought it would be a good idea to recap the concepts of why most startups fail.

This infographic from CB Insights sums it up well.

In addition to that, in the current scenario (described in edition #3 of this newsletter), running out of cash and/or raising new capital is going to be the number one reason for startups that are going to be failing going forward:

If you think about it, almost every other problem shown above can be solved by?raising new capital. Finding a new market, challenging your competition, and changing your business models can be solved with a little (or a lot) more runway.

In some of these cases, it means?Mo' money, less problems.

That's where companies such as FAA Advisors come into play. They can help these startups restructure their debts, renegotiate contracts and support them to their next funding round. They are the startups'?cutmen.

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The in's and out's of investing in a distressed startup

1. (Re)Valuation

"Startups will burn cash quicker or need to be more conservative. This means that VCs will have less patience and a keener eye on valuations, cashflow and chance of success."

Alex Ball - FAA Advisors

Besides asking for Alex his point of view on valuations, I had to ask the guru for this one.

Aswath Damodaran?lays out a?step by step?to deal with distressed companies’ valuations.

Here are some of the steps he advises taking when evaluating distressed businesses:

Step 1: Value the firm as a going concern:

You can value a firm as a going concern, by looking at the expected cashflows it will have if it follows the path back to financial health. The costs of equity and capital will also reflect this path. In particular, as the firm becomes healthier, the debt ratio (which is high at the time of the distress) will converge to more normal levels. This, in turn, will lead to lower costs of equity and debt. Most discounted cashflow valuations, in my view, are implicitly going concern valuations.

Step 2: Estimate the probability of distress:

We need to estimate a cumulative probability of distress over the lifetime of the DCF analysis - often 10 years.

There are three ways in which we can estimate the probability of distress:

• Use the bond rating to estimate the cumulative probability of distress over 10 years
• Estimate the probability of distress with a?probit
• Estimate the probability of distress by looking at market value of bonds.

Step 3: Estimating Distress Sale Value:

If a firm can claim the present value of its expected future cashflows from assets in place and growth assets as the distress sale proceeds, there is really no reason why we would need to consider distress separately.

The distress sale value of equity can be estimated

• As a percent of book value (and this value will be lower if the economy is doing badly and there are other firms in the same business also in distress).
• As a percent of the DCF value, estimated as a going concern

Step 4: Valuing Global Crossing with Distress:

To put it simply,?traditional valuation models, discounted cash flow, or others, have to be adapted to incorporate the effects of distress. A negotiated discount over the last valuation seems to me to be the simplest solution.

2. Raising Inside vs Outside Money

"Outside investors can greatly reduce the risk of a business in the short term. Owners and founders can preserve their own capital and eliminate taking unnecessary risks in the short term.

A liquidity event can also be beneficial to founders as they get to realize some value while still being commited to the venture. If the outside investor has experience within the sector that the startup is involved in, then it's a win-win."

Alex Ball - FAA Advisors

This is a great point from Alex. By having new money, founders can have a liquidity event that may put them in a more comfortable personal cash-in-hand situation. Incentives then realign in favor of the ideators of the business to keep working hard towards their business goals.

However, if you are a new investor in the company, you have to be aware of the current cap table and shareholders’ incentives. Usually, distressed companies only go out for new investors when their current ones are not willing to continue funding their operations.

From the insider's perspective, it makes more sense to continue investing in the business. Otherwise, to accept new money is to accept more dilution and the loss of securities seniority (e.g.: converting preferred stock to common stock).

Nevertheless, apparently, at the time I write this piece, there are some lead VCs that are not willing to follow-on on their startups and this opens the door for other portfolio managers to help these companies:

3. Recapitalization

From an investment perspective, there are a few things that are advisable. Some are less advisable than others. From less to most advisable, these are the kinds of securities you're likely going to be taking a look at:

• Common Stock: in the case of an urgent liquidity event, the owners of this kind of stock are the last to be paid out, since other - more senior securities owners - are going to receive the first proceeds of the company sale;
• Convertible Notes?(unsecured debt): in very few cases startups have tangible assets to be used as warrants. No matter how high the interest rates, it's very unlikely that you're going to get any money back if the startup fails for good;
• Preferred Stock?and?Convertible Debt: these types of securities are highly customizable and it's a matter of negotiating with the company how they're going to be handled. Besides, in the case of preferred stock, the shareholders have a higher claim on dividends payment and receiving the money on a liquidity event over common stock shareholders.

4. Getting to work post-restructure

Needless to say that each case is very subjective and the reasons for a company to be in distress are many. Factoring in that they may need senior professionals to help them make decisions and execute the ideas is of utmost importance.

Therefore, be prepared to get in the trenches and work should-to-shoulder with the executives of the distressed company to make sure you maximize the probability of success after this difficult moment.

Not to mention that employees of the distressed company need a clear company recovery plan, especially the ones that sacrificed cash bonuses for equity compensation as an incentive to retain them as top talent.

"It's important to remember that every business will face challenges regardless of the economic situation. The business that realize that what we may face in the coming decade is different from the previous one will do well.

We have entered into a global financial tightening with high inflation. No startup founder or VC investor has dealt with this unless they're over 60. So for us this paradigm shift, the business pivot may happen on several occasions, as the cost of capital, workers and products increase."

Alex Ball - FAA Advisors

Investors that decide to invest in distressed companies must have experience in turning companies around successfully.

This is no easy job.

I hope we helped shed some light on this challenge.

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L.