Eric Ashman has spent his career partnering with founders and CEOs to navigate the challenges of building great companies. Unlike many consultants who lack practical experience in their field of expertise, Ashman has an enviable resume that has helped to make him a highly sought after advisor for entrepreneurs and business leaders.
Eric Ashman is former President and Chief Operating Officer of Group Nine Media, one of the world’s largest digital-first media companies, the former CFO of the Huffington Post, and most recently President of DTC apparel brand M.M.LaFleur. Eric recently launched a management consulting firm based in Cambridge, Massachusetts, focused on helping venture-backed founders navigate the challenges of growth, scaling and building value.
As economic headwinds for start-up companies begin to blow, Eric’s advice and actionable insights are more relevant than ever.
We recently had the opportunity to connect with Eric Ashman to discuss how business leaders should respond to the down round, as financing terms in the venture capital marketplace are tightening quickly. The following are excerpts from that conversation. The comments and quotations been edited for content and clarity.
“As the economy heads into a recession amidst a period of high inflation, venture capital funding has contracted, particularly for growth stage startups. As a founder looking to raise capital, a path to profitability matters again. You need to focus on how you’ve been trying to scale your business, how carefully you’ve chosen your investors and the impact that external events may have on your business’s trajectory.
So how far is VC funding falling?
According to Crunchbase, “Global venture funding in May 2022 reached $39 billion, marking the first month in more than a year when it dropped below $40 billion. The May figure is also well below the $70 billion peak VC funding reached in November 2021.
VC funding in May fell 14% month over month from $45 billion in April. The largest pullback was in late-stage venture capital, which fell from 2021 monthly averages by close to 40%.”
It’s impossible to predict just how far down funding may fall in the coming months. 2020 saw nine months under $30 billion in funding; one month reached as low as $18 billion. It’s time to consider the possibility of a down round in your future if you must raise capital in the next few months.
It’s important to remember that a down round isn’t necessarily as scary or threatening to your long-term success as you may fear it is.
The Instacart Example
In March of 2021, Instacart was valued at $39 billion. Fast forward one year, and Instacart cut its own valuation by 40%, down to $24 billion. Keep in mind that Instacart was not trying to raise more capital – so why drop their own valuation?
As the economy pulls back, public company market caps and private company valuations both lower. Instacart’s publicly traded competitor, DoorDash, had its market cap fall more than 50% between January 2022 and June 2022, indicating a pullback in its sector.
In early May, Instacart filed a draft registration statement with the SEC for a potential IPO. As a strategic move, they chose to privately slash their own valuation rather than set expectations too high for their stock market debut.
The elective drop in valuation may have been a difficult decision to make but could mean a more impressive stock market debut and a better future outcome.
Typically, valuation compression begins with later-stage startups, but the current economic downturn will lead to valuation compression at earlier and earlier stages.
Valuation is Negotiated
A startup’s valuation is decided upon between founders and investors using revenue and multiplying it by an agreed-upon multiplier based on the startup’s growth rate. Founders and investors work together to determine an appropriate multiplier.
In a strong economy, these multipliers will be high, and in a weak economy, these multipliers will drop. This is when you see market caps and valuations drop.
Because there is a range of acceptable multipliers that are greatly influenced by outside factors, startup founders should focus more on running a successful business and less on their current valuation or market cap.
While a lower valuation can be discouraging, it also offers opportunities, like resetting option prices and positioning your company for the future, as Instacart did.
In a strong market, a down round of fundraising may look like the beginning of the end for a startup. But in a recession or market crash, venture capital investors understand that startups may need the capital infusion to stay alive; it doesn’t necessarily mean they are doomed to fail.
Preserving Valuation Isn’t Everything
In an attempt to avoid a down round, some founders will opt for offering additional preferred stock rights. This can entice investors to invest at a higher valuation, especially existing investors. Investors with many startups in their portfolio may be facing several lower valuations at the same time, and they may prefer to delay some lower valuations if possible.
But as you look to the future and all of the possible outcomes for your startup and your team, you may want to rethink offering additional preferred stock rights. Things like higher liquidation preferences, participation rights, warrant coverage, or anti-dilution protection through the inclusion of ratchets can really cut into your upside in the event of an exit.
Before making that decision, you’ll want to speak with qualified advisors and run the math to determine which course of action is right for you. In many cases, a lower valuation with higher dilution gives you more options in the future.
Consider Pay-to-Play as a Viable Option
Pay-to-Play works by requiring preferred stockholders to invest proportionally (pro rata) in future financing rounds. If the investor chooses not to invest in a funding round, they can be forced to convert their preferred stock into common stock, losing all special privileges and turning them into common stockholders.
Pay-to-Play can benefit both founders and preferred stockholders. For founders, pay-to-play allows you to lean on supportive investors when fundraising is difficult. For investors, pay-to-play ensures that the capitalization table doesn’t fill up with early investors who never show support again. Preferred rights are then reserved for the most loyal of investors.
Remember – when your startup is in danger of going under, you need to leverage all tools at your disposal. Additional funding can be the difference that lets you keep the lights on.
Staying open and transparent with your board and your preferred investors will help to mitigate the negative reactions you may face as you consider a down round or pay-to-play provisions. Don’t hide your plans or the difficulties that your startup is facing; address them head-on so that everyone knows your plan.
Before actively seeking additional funds, cut costs as much as you can. Pivot to profitability, shifting your approach from growth to all costs to proving a path to profitable, scalable growth. Streamline your operations. Adjust your path forward and make this known to your board.
You should know your board and your investors well at this point, and be familiar with who is most aligned with your vision for the company. Build relationships with your allies to ensure that you have support if/when you need to make difficult decisions.
Consider All Options
Sometimes, the best choice is to wind down the business and return any remaining capital. If you come to realize that investors will not have their expectations met, and/or your team will not benefit in an exit scenario, and you cannot raise funds or lower costs quickly enough to continue, it may be time to walk away. There is no shame in that decision. Most startups fail. You can learn a lot from the journey, and apply those lessons to whatever comes next.
Ask yourself: what does success look like for this startup? How long will it take to reach that level of success? And then determine if it makes sense to continue on.
Of course, there is one other option for some startups. You may be able to forego raising capital and focus on being profitable as an operational business. If you’ve got an appealing enough product and still care about your business, slowing down growth and hopping off of the venture path may be the right choice for you.”