A turbulent economy spooks everyone, including venture capitalists. Startups and high growth companies used to rely on VCs and their seemingly never-ending pockets for funding. 2022, particularly the latter half of the year, saw a devastating drop in funding, up to 50% year-over-year.
That’s in the U.S. In Canada, both U.S. and international VC funds largely abandoned the market in the latter half of the year.
It’s not looking any rosier for the first quarter of 2023, despite arguments from Decibel Partners founder, Jon Sakoda that the U.S. $290 billion of committed capital to VC firms will act like dry powder and reignite VC firms’ commitment to startups.
Trevor Simpson, Partner, Private Debt at FirePower Capital, confirms that valuations have come down significantly. “The deals are more structured and require more time, not like 2021 where there was much less diligence,” he says. Simpson also says that as interest rates go up, so does the cost of risk capital, which makes VCs more cautious. “Some startups don’t look as great as the VC originally thought, so they’re slower to pull the trigger and are becoming pickier.”
He says there’s a higher probability of success for companies to get funding now if they can produce metrics that show growth and scalability, as opposed to ones that may be figuring that out. The current market makes it much harder to gamble on possibility, so rounds are being delayed until metrics pan out.
Apart from the rising cost of capital, VC funds have to get their money from somewhere. As this article explains, VCs may not have billions of dollars sitting around waiting for the right company to invest in. They get money from pension funds, for example, the Ontario Teachers’ Pension Plan, sovereign wealth funds, family offices and endowments. These investors may also be affected by the economy and might not have the money to hand over for riskier investments.
So, what can business owners who are looking for between $2M and $15M in funding for growth do while they’re waiting for valuations to go back up and VCs to start investing again?
One option is to go to a bank, but as Simpson points out, traditional lenders aren’t a guarantee because there is often an equity requirement to borrow the money against.
“Business owners ideally want to have investors invest when their companies are at their highest valuations – right now, that’s not the case for many industries,” he says.
Another way of keeping their businesses funded to stay in business until valuations go up again and to weather the potential recession and increased interest rate environment, is to look at alternative lenders.
When the macroeconomic climate changes, as we’ve seen, and all those valuations come down, companies still need to find investment to provide runway which doesn’t reprice their valuation lower, often a death sentence for venture-backed companies, says Simpson. That’s probably the motivation behind why they’re turning to debt to give them the extra 12-to-36 months to grow into their previous valuation.
Private lenders can provide funding via private debt to mid-tier companies without diluting their equity or repricing the value of the company from the last round.
One example, explains Simpson, was Ubiweb, a local Canadian company based in Quebec, that came to FirePower after speaking with VCs and PE firms for equity capital valuations. “The valuations they got didn’t make sense for what they wanted,” he explained. “They knew what was best for their business. They decided what the platform would look like, as opposed to having a third-party influence where the company is supposed to grow or what strategic decisions made sense.”
Leveraging private debt, FirePower created a package of approximately $3 million dollars in funding, and it was used to hire more sales and customer success personnel. “They’re a huge presence in Quebec and they’ve now grown to additional provinces.”
Patrick Desrochers of Ubiweb says, “In early 2022, we quickly realized that the landscape had completely changed as it relates to valuations and the market’s general willingness to invest in all types of businesses. For Ubiweb, our relationship with FirePower means that we will be able to continue our triple-digit growth and delay equity dilution through the current market downturn.”
The company got a lower interest rate and has a back-ended exit payment at the end of the term.
Plus, while borrowers will start paying interest from day one, the principal payments can be deferred to the end of the term. The interest payments are smaller, sitting at around 11 – 12% per annum, making it affordable for the company throughout the term of the loan. By the time the principal payment is due, the company is often in a much better position and the principal repayment is actually a smaller, more affordable percentage of the overall value of the company.
And they still retain their equity and control over the company, which is now in a better, more attractive position to gain VC funding.
Simpson says the next year will be tough, especially for tech companies. He predicted layoffs, which we saw from a number of larger tech firms like Meta and Twitter. For anyone looking for funding, he suggests taking a hard look at your company’s offering and finances.
“What does your forecast look like and are you changing pricing or features to provide more value?” he asks. Other things to consider include whether you might expect more churn because clients decide they don’t need your product. Focus on maintaining customers and measured growth throughout the next 12 – 18 months.
Using private debt to buy the extra time you need to weather a downturn and improve your company could not only relieve business pressure, but also put you in a better position when the market rebounds and VCs open up their wallets.