What to Expect in Your Next Funding Round: 5 Things to Focus on
- Apr 13, 2020
- John Pennett
The last two years have been banner years for venture capital funding in the technology space – reminding us of the “dot.com” era funding period of the late 1990s. As 2019 was coming to a close, management teams and investors were planning for growth and expanded financings in 2020, with IPO and M&A planning discussions taking center stage at most board meetings.
Of course, with the COVID-19 crisis, the technology industry entrepreneurs’ world has been turned upside down in the last two months, as management teams have focused on workforce issues, supply-chain disruption, liquidity concerns and COVID-19 funding programs under the CARES Act.
But eventually (and probably very shortly), management teams are going to have to raise additional funding to stabilize the business and keep some of the planned initiatives moving forward. We have all read that VC and PE funds are holding back significant funds to support their existing investments (at the expense of making new investments). So what should technology executives expect when they engage in discussions with investors about additional financings?
The question of valuation of the business will be a challenging one. Should we look at the recent events as a six-month bump in the road? Twelve-month month bump? Or have the business fundamentals really changed? Will the demand for the product still exist in the forecasted manner or will the products/services be consumed in a different manner?
It is likely that convertible debt bridge loans may take center stage as is usually the case where valuation is uncertain. There will be some tricky negotiating points to consider –
- Will you need to provide collateral?
- Will interest rates be above the fairly low traditional rates?
- Will warrants or other sweeteners be required to entice the investor to provide the financing?
- And the question of maturity date becomes really critical – it would seem unwise to “assume” that, at the maturity date, either the debt would be extended or converted to equity. So the investor may have gained protections that really put them in control of the collateral and perhaps the company as a whole.
Series Next Equity Financing
If the investor and company agree to an equity investment, it is possible that the valuation may be lower than expected and perhaps even lower than previous rounds. “Down-rounds,” as they are called, often cause a cascading effect on other instruments, such as warrants/convertible debt and stock with ratchet provisions. Non-cash P&L charges are just the tip of the iceberg, as the real issue is the re-distribution of the fully-diluted ownership of the company. Again, the investors could be gaining a more significant control stake.
Operational Goals, for Tranche Rounds of Financing
We are also expecting that investors will be providing funding, regardless of the form, in small tranche rounds. Investors would likely want to see:
- Specific operational goals,
- Detailed cash flow projections, perhaps under a few different scenarios, and
- Careful monitoring of results, and actions taken in response to results.
Then the next tranche could be discussed, based in large part on the updated cash flow projections, business prospects, and achievement of goals. Management teams will have enormous pressure on them to really understand the business, to explain and forecast expectations and then execute the agreed plan. And the agreed plan will require supreme detail on the cash flow forecast and monitoring of actual results against such plan.
As it relates to the operational goals, we are expecting that the topic of workforce will be an area challenged by investors. Investors generally don’t know the workforce, so their continued employment is a “numbers game” based upon the priority of business initiatives and expected cash flows. Management teams may have difficult emotional decisions to make and challenging discussions to have with board members (many of whom are investors).
Management teams need to craft detailed projections (using a couple of different assumptions), have systems and processes to track activities daily for maximization of cash flows, and be well prepared for challenging discussions with potential investors. Improving accounting systems and liquidity planning can only help, as well.
To sum, up technology entrepreneurs should be laser-focused on five things:
- Determination of acceptable valuation of the company.
- What kind of capital is needed, and available, and when (e.g., convertible debt).
- Cash flow projections, for at least six months, with a tool for constant update and monitoring.
- Operational goals – detailed and specific.
- Workforce levels based upon prioritization of initiatives, funding available and operational goals.
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John Pennett is the Partner-in-Charge of the National Technology and Life Sciences Group and works closely with our IPO clients and their circle of legal and underwriting advisors to take an IPO from concept to close.
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