Venture Debt Uses – Avoid Setting a Valuation
As an early or growth-stage company, chances are you have undergone a business valuation. A valuation determines the present value of your company using a number of techniques. These techniques include looking at financial projections, the market value of the company’s assets, its capital structure composition, and the management of the business. You need this objective valuation when negotiating with banks or other potential investors for funding. However, there are certain cases where a company may want to avoid setting a valuation.
Let’s say your company is experiencing good performance but is having difficulty raising capital on terms that reflect that performance. Growth may have slowed down compared to previous periods or perhaps the prior round was set at a high valuation. Current investors may use this to have a down round term sheet on the table.
A down round occurs when the pre-money valuation of a fundraising round is lower than the post-money valuation of the previous round. Down rounds may occur due to several reasons:
- Failure to Meet Milestones: The company has failed to meet investors’ earning targets/growth milestones.
- Competitive Environment: New competitors and the expected ability to grab market share will affect valuation.
- Tighter Funding Conditions: Beyond the company’s control, lower valuations can result from lower overall investor appetites for equity deals.
Implications of Down Rounds
The main concern for down rounds is the triggering of anti-dilution protection. Under anti-dilution protection, investors hold a different class of shares from founders and employees. Shares are sold at a lower price than the investor had originally paid for them and will be diluted less than other parties. The more punitive the terms of the financing round are, the harder it is for the company to raise funds due to the following consequences:
- Signalling: Punitive dilution signals to observers and employees the company is desperate for cash and is not doing as well as expected.
- Trust and Confidence: Lost trust and lower confidence among the investors and board may cause them to interfere in operations that may become distracting.
- Less Motivation & Control: Extra dilution may impact founders’ motivation and interest, in addition to losing control in the company.
- Employee Morale: Employee options on common stock are typically the ones that stand to lose the most if the company’s valuations are lowered in time.
Alternatives to a Down Round
When faced with a down round, companies are faced with several alternatives.
- Cutting Costs: The company may put effort into cutting costs to make the money in the bank last longer and postpone the need for an external fundraising.
- Bridge Financing: Bridge financing helps “bridge” the gap between funding rounds.
- Renegotiate with Investors: A close relationship with investors opens the floor for negotiation. Terms of the round can be negotiated or by exchanging rights for other investor perks.
- Shut Down: Too many problems, lost motivation, and losing investor backing may be too big of a problem to fix. It may be better to cut your losses and start over.
Venture Debt to Avoid Setting a Valuation
If you’re stuck in a down round or want to avoid setting a valuation altogether, you can consider venture debt. It is a form of debt financing that involves fixed monthly interest payments and minimal equity dilution so you can access the growth capital you need while avoiding extra dilution or having to give up board seats or control. Venture debt allows you to fund growth initiatives and achieve milestones so that your company is in a better position for valuation at the next equity round.
Venture debt is a form of bridge financing that reduces the dilution you would face with an equity round. This form of debt provides access to growth capital to fund growth initiatives and achieve the milestones set in place by your investors. Postponing the equity round and growing your company with venture debt puts your company in a better position later down the road where you can approach the next equity round with a higher valuation.