By Girard Miller, Tech Coast Angels Orange County Angel Member and Investor
The collapse of SVB bank has left a huge air-pocket in the startup economy.
Although others will eventually fill the gaps to provide sound funding sources for VCs, it’s already clear that the combination of higher interest rates, tighter money all-around, and sour investor sentiment now require a re-set of expectations and the rules of the road for startup entrepreneurs and angel investors.
Let’s begin with valuations and deal terms.
For context, I can make a cyclical case that exits in 4-6 years from now will most likely face a happier financial marketplace with at least some periods of lower interest rates and the inevitable investor amnesia over the recent crisis. If so, then well-managed startups with extraordinary products might have the potential to produce better ROI and IRRs than those that got funding in the past 5 years. (Tech Coast Angels historical research shows mixed results on that thesis, fyi.) In any event, getting from here to the promised land is now a frightful trek through a desert before reaching paradise.
Cash is now King.
Startups that had confidently expected to raise an A round in 12-24 months without sales or significant technical breakthroughs are now finding little if any interest in providing what is now deemed to be “rescue capital”. Add to that the potential for a national recession by next year — which must be given a 50-50% probability these days — and the risk-capital chasm ahead looks pretty bleak. This requires startup companies to secure ample cash runway to get to a point where follow-on funding is a reasonable expectation. No sensible angel group nowadays is going to throw darts in hopes that everything will just work out. As a result, the lofty valuations of 2018-22 are now history. CEOs who now project exits on the basis of comparables from that era will face mounting skepticism. Going forward, exit valuation metrics of companies will be much more likely to include analysis of the future discounted cash flow of the operation at the time of exit, and not just numbers plucked comfortably from the sky as multiples of something – anything—other than profits. ROI multiples at the seed stage must now be higher for the angel investors, now that risk has escalated and capital is pickier.
Then add into this mix the time value of money, which is no longer free. In case you hadn’t noticed, the national bank prime rate – the rate given to the BEST, established borrowers, not pre-money companies – is now 8 percent. Broker call money for margin accounts is now priced at double-digit interest rates for most accounts, and those are fully collateralized and marked to market daily. Why angels would accept an unsecured note without ample compensation is a question that answers itself: they shouldn’t. So the time period between today and a follow-on round (with its dilution, let’s remember) is an opportunity cost factor for all angels.
In the case of SAFE notes and convertible notes, it is totally senseless for an early-stage company’s investor to now accept anything less than the 8 percent rate that prevailed before the crazy days of cheap money and superabundance of capital chasing shiny new objects. In many cases, it now makes even more sense than ever for angel investors to strongly prefer realistically-priced equity rather than notes – especially when the 5-year post-conversion timelines for QSBS/1202 tax exclusions are considered. Time is money, on both the front end and the back end, for startup ROIs after taxes.
So tip #1 for CEOs is this: don’t even dream of pitching an angel forum with a note that doesn’t carry an interest rate of at least 8 percent, and a discount to conversion of at least 20 percent. Your credibility will sink before you get to the Q&A session. If you want serious interest, pitch equity not notes.
Next, we need to see much better planning by company executives for cash runways. Lean and mean operations have never been more important, and founders must credibly demonstrate why cash raised today will not become orphan capital in two years. Expect to see due diligence teams dig much harder into the cash runway and the work already done by the executive team to line up its next round of funding. It will take more than just name-dropping, as angel groups will start checking those references to probe the level of interest and what it will take to get VC money in coming years. Hope is not a strategy.
To quote Tech Coast Angels’ renowned John Harbison, who’s done yeoman’s research on long-term returns: “Fiscal restraint is today’s reality. Financing risk has moved from the back of the long list of risks (technology risk, competitive risk, market acceptance risk, channel development risk, etc.) and now leads as the most critical of risks to assess and address.”
Quarterly P&L projections, with accompanying Go To Market Strategies, will be scrubbed much more suspiciously by due diligence teams, and med tech companies that expect to exit via a M&A event will have to prove that their mousetrap will offer such lucrative benefits to an acquirer that they will be the top candidate for its portfolio teams. For biopharmaceuticals, the business plan for getting all the way through Stage 2 without crushing dilution has now become a vital concern, and a problem for many.
In some cases, warrants at a reasonable exercise price for early investors may be needed. For companies now facing a cashflow cliff, that may be the only viable menu option. We’ve seen a few deals already that would have cratered without warrant coverage of 2x and 3x, and will probably see more.
Finally, for those companies that are successful in raising the cash they need, your board should adopt a cash management policy to ensure that:
(1) no bank deposits are uninsured, especially during and shortly after a funding round when new capital greatly exceeds the FDIC limits
(2) short-term investments are selected that provide both safety and liquidity, independent of the bank used for operating accounts
(3) management of the cash is performed by somebody experienced with money market securities and not a company’s part-time bookkeepers, and
(4) the board receives regular oversight reports on the cash management program.
Thanks for this Guest Post and its graphics to Girard Miller, Orange County Angel Investor.
Girard Miller is a member of Tech Coast Angels, Orange County and an investor in several local funds including Cove Fund 2, Octane’s Visionary Ventures 1 and 2, and MEDA Angels fund 1. He is a retired past president of two national mutual funds and a published author on pension fund investing, cash management and board governance.
The Author’s opinions here are entirely his own and not necessarily those of TCA, its officers or other members.
Image by Steve Buissinne from Pixabay