Startup Market Swings Call for a More Balanced Fundraising Plan
This article was originally published on The Information’s Forum.
As a founder, the market’s wild mood swings can leave you feeling like no matter what you do, your business is never good enough. In 2021, the market message was that companies weren’t ambitious enough and should be raising more capital to grow faster. If you didn’t, some well-funded competitor could pop out of nowhere and take you down. In 2022, the message has shifted, with investors saying companies are burning too much money and trying to grow too fast. The root of this volatility is an imbalance between prudence and optimism in the startup fundraising process.
Finding balance in our financial systems is already quite prevalent in the public markets. According to an internal analysis, the S&P 500 is financed by about 70% debt and about 30% equity, with similar ratios for private leveraged buy-outs in the private markets. However, this dynamic is virtually non-existent in the venture community, and it’s proving to be a critical inhibitor to the health of the startup ecosystem and the broader economy.
So how do you figure out the right balance of raised capital for your business in the midst of market extremism?
Understand the Incentives Behind Both Debt and Equity Investments
In the startup community, founders are more likely to hear the optimistic voice of an equity investor than the more cautious opinion of a skeptical lender because the venture community was founded to finance risky research and development. As the venture community has massively scaled, the vast majority of its investments are actually financing growth, just like the rest of the private equity market which leverages debt and creates balance as a result.
In a traditional venture portfolio, a few big winners can cover for many losers, so those investors often encourage founders to grow quickly in the hope of hitting a big winner that can bolster their returns. By contrast, lenders have less cushion to absorb losses, and therefore accept a lower return (in the 7-12% range, about 5-10x lower than equity) in exchange for a far higher certainty that they will not lose money.
There’s nothing inherently wrong with the equity model; it has provided crucial capital in the high-risk R&D stage of some of society’s most ambitious companies like Tesla, Genentech, and Apple. The problem is a misalignment of incentives that founders feel most during challenging times.
When a portfolio company’s business goes “off-track,” it can be more profitable for equity investors to shift focus to the likely portfolio winners than to roll up their sleeves to help get the business back on track. Lenders, on the other hand, have more of an incentive to go “all in” alongside a founder to ensure the business is successful from the start. Securing a debt investment requires a rigorous financial model, evidence that your historical performance supports the model’s key assumptions, and quarterly monitoring post-investment to make sure that you stay “on track.” The biggest potential drawback of working with a lender (or any investor whose model does not allow them to lose money) is that a more conservative growth plan can limit a company’s ability to compete for market share against more risk-seeking competitors.
Adding Another Item on a Founders’ to-do List
Because of the relative scarcity of debt investors in the startup world, founders are often left to find the balance themselves. I know firsthand how many responsibilities founders already have on their plates as they work to build a profitable business. It can be discouraging to feel like you also have to become a finance expert to set yourself up for success. Nevertheless, the future of your business relies on your ability to build your own balanced slate of financial advisors. Seek out the smartest lenders and equity investors you can find, then average their advice to get to a sustainable plan that balances prudence and optimism in the right mix for your business.
There’s a clear gap between startups that do this and those that don’t. Companies that were prudently financed (whether debt or equity) in 2021 thrive in the current environment. They are finding lower cost customer acquisition as competitors pull back, and seeing new deal-making opportunities. They are flush with capital from across the bank, sovereign wealth, asset management, and life insurance sectors–which consistently and conservatively allocate large volumes of capital across cycles. Many of the high-flying venture-backed companies of 2021, however, are struggling. They are finding their Total Addressable Markets (TAMs) are smaller than expected, the capital sources they rely on have dried up, and they need a new level of financial rigor to break into the mega capital allocators.
Better Balance, Better Businesses
As the venture community grows up, we must create a more balanced system. Assets under management are expected to surpass $850 billion by 2027, and the funding mix is shifting from the high-risk R&D stage to “scale up” risks. This means founders must take the lead to find balance amongst their capital providers because no investor has the incentive to “fix” this system. The result will be more stability and support for founders, and higher odds of success.
For the broader economy, bringing a more balanced set of stakeholders into the mix will create better businesses that generate wealth and reinvest back into society. Both stability and opportunity cost matter because we’re not just dealing with Monopoly money here: the funds LPs invest out of come from pension funds and other sources that matter for real people. Founders may feel frustrated when realizing they have to find the balance themselves, but being proactive will put them ahead.