First Round Capital published their latest LP letter last Friday. It details how the early stage venture capital firm is anticipating a significant startup market shift and some of the drivers behind this shift. It’s a worthwhile read, if you haven’t seen it yet.
As entrepreneurs and VCs, we have to stay optimistic in order to succeed. It is an essential part of the journey and value creation process to believe in, and plan for, success. Succeeding in the face of all odds, that is what disruption is all about. But – let’s face it – we have to embrace reality. Nobody knows what the real impact of a “down” market will be or how long will it last. I’m not here to make such predictions. What I do know for sure is that behavior has definitely shifted over the first few months of 2016. Much has been written over the last few months on the changing startup landscape. Instead of seeking to simply regurgitate what has already been put out there – the question I am focused on here is “what can we as Canadian entrepreneurs and VCs do about all this?”
I’ve personally worked in the tech sector through two major down cycles – once as an entrepreneur, during the dotcom implosion at the turn of the Millennium, and once as a VC, during the global financial meltdown in 2008. One of my daily reads is Dan Primack’s Term Sheet email newsletter that summarizes new VC funding rounds and exits. I remember seeing this newsletter almost completely devoid of new funding announcements during some of the 2008-2009 timeframe – a stark contrast to the long list of deals that have been announced by that publication on a daily basis over the past few years. My investment portfolio today spans a wide range of startups – recently funded seed companies, profitable later stage companies, companies that are well funded for the foreseeable future, as well as companies who are actively out fundraising or evaluating M&A. These companies are widely geographically disbursed across North America including Montreal, Toronto, Silicon Valley and Boulder.
As entrepreneurs and VCs, we have to stay optimistic in order to succeed. But nobody knows what the real impact of a “down” market will be or how long will it last.
Below are some of the observations I’ve gleaned over the past few weeks, as a VC working primarily out of Canada. These observations are a result of my daily activity working alongside smart entrepreneurs, and from my interactions with my partners at Rho, our co-investors, potential new investors, and various service provider firms across North America. Most importantly, I’ve also included some of my thoughts on what you as a Canadian entrepreneur can do to potentially weather these new realities (provided below in italics).
Deal Overhang
We continue to see deals getting done and announced – but this is mainly because the true impact of a slowing market hasn’t really been felt yet. Deals that signed term sheets (this applies to both new pending financing rounds or M&A transactions) last December / January / February (when market sentiment was better than today) are just now getting closed and announced. We all know that deals take time to clear due diligence, negotiations, and closing, and that this can take many months. Today we are seeing an “overhang” in the market from deals that were negotiated and papered over the past few months. This overhang is skewing the real impact of what is coming for all of us in the entrepreneurial community.
Understand that things will get worse before they get better and tailor your mindset and actions accordingly.
Proof, Not Faith
A co-investor of mine put it very succinctly to me the other day: “VCs, today, are investing ‘in proof’ much more than ‘on faith.’” What this means is that companies that are just getting started, and those that are in-between round categories (meaning those that don’t have clear Series A or Series B metrics in place) are having more difficulty raising money from new investors.
Have a clear idea of where your company stands relative to what VCs are looking for now. If you are caught in between rounds and need money, you may have to look at other sources of capital, becoming cash flow positive and/or M&A as an option (more on these topics below).
Paralyzed By Fear
Some VCs, in both Canada and the US, are just deciding to take a more general ‘wait-and-see’ approach to the changing market. They are unsure of what the near future truly holds or what the true magnitude of a downturn will be. They are (rightly) concerned about their current investments and making sure the companies they have already placed bets on survive a downturn, as opposed to adding new companies to their portfolio. Generalizations are always dangerous because we continue to see some exceptions up here in Canada, but, on the whole, relative to US competitors, Canadian companies are underfunded. From a portfolio management standpoint, US companies with higher burn rates may take up more capital from their existing VCs in order to survive. This means there may be less money available to you as a Canadian entrepreneur. Other VCs are still actively seeking to make new investments but are proceeding with caution and with stricter criteria (more on this below).
Entrepreneurs should recognize that this cautionary, “wait-and-see” VC mindset is out there and could grow more prevalent over the foreseeable future. With respect to capital available from your US-based VC, try to put yourself in their mindset, engage them ASAP in a dialogue about how they are feeling about your company, where it ranks in their portfolio relative to other companies, ask what capital is available to you from them over the short to medium term – and ask whether this has changed over the past few months or may soon change.
The Bar is Rising
Companies with clear Series A or B or C metrics are still getting interest and long looks from VCs – but the bar on metrics has gone way up. As an illustrative hypothetical example, VCs who used to get excited about SaaS companies with $80-100k in monthly revenues are now looking for revenues of $150k+.
Understand that the bar is rising and that it may take you longer to get to a place of clear demonstrable metrics to attract your next potential investor(s). Plan your cash flow runway accordingly – stretch out your runway, close on more money than you originally anticipated, consider raising your round is US dollars to benefit from the favorable exchange rate, keep your funding round open for another few months to allow additional investors to come into the round at a later time and seek out other funding sources than just VCs (more on this below).
Valuations Coming Under Fire
It will be of no surprise to any of you that I am seeing valuations coming down versus the recent past. US VCs are consistently attracted to Canadian opportunities because, put plainly, we have stellar entrepreneurs. However, another key factor is the fact that Canadian companies have recently offered more attractive valuations to Valley and NYC VCs, relative to their local markets. This dynamic is now changing as US companies seek to raise capital at lower valuations.
First of, understand that valuations are, in general, being challenged, so adjust your expectations to face this reality. Also recognize that the deal pricing advantage Canadian companies offered is evaporating. More than ever, your company will have to stand on the attractive unit economics in your business and your market traction, as opposed to your valuation.
M&A as an Option
Companies that are choosing to look at M&A as an option (versus raising a new round of financing or running at cash flow positive) are in for a tougher go than ever relative to the past few years. Literally hundreds, if not, thousands, of companies are out trying to court the various corporate development groups of the larger acquirers. These corporate dev guys are taking their time and being even choosier about what to spend time on. Deals are taking longer to get done. Acquirers know that, in this changing landscape, they have the luxury of time, there is less risk they will lose a given deal to a competitor and that their negotiating power goes up as the cash on a target’s balance sheet goes down. I’ve even heard some recent stories of deals that were “retread” – meaning two companies had finalized negotiations on a merger, only to have the acquiring company change the terms at the last minute before close!
Even in good times, earlier stage Canadian companies have a disadvantage when looking to get acquired by US-based companies. This disadvantage does erode over time.
Even in good times, earlier stage Canadian companies have a disadvantage when looking to get acquired by US-based companies for the simple fact that the talent being acquired is usually geographically separated from the acquirer’s headquarters. Acquirers of early stage companies typically want to be able to assimilate talent under their own roofs. This disadvantage does erode over time as a Canadian company scales and becomes more of a standalone, profitable, entity, that can be run as such post-acquisition.
Recognize that, today, your cash runway needs to support a more elongated and competitive M&A process. If you are using cash on hand or are raising a new interim financing to bridge to an M&A transaction, make sure you over compensate for the cash and time it will actually take to get a deal closed.
Sources of New Capital
In terms of raising new money, many companies in need of capital are still charging ahead looking for new lead investors. As stated above, the ones with clear proof points relevant to their stage are getting long looks, and those that find themselves in-between rounds, without clearly attractable metrics, are mostly getting quick passes from new investors. Many smart entrepreneurs are looking to their “inside” investors (meaning investors who have already previously invested in the company) for new rounds, or doing smaller extension rounds (e.g. Influitive’s recent round) with one, or maybe two, new investors to pad their coffers.
Many smart entrepreneurs are looking to their “inside” investors for new rounds, or doing smaller extension rounds. Recognize that there are many domestic VCs who have capital available.
As stated above, you may be in tougher with getting capital from your existing American VC, but recognize that there are many domestic VCs (my firm included) who have capital available for existing and new companies. Most of us have raised money from our LPs for a stated focus on Canadian companies, meaning that we have a long-term, vested interest in developing the local ecosystem and local companies. Our portfolio returns are more exclusively driven by what happens with the Canadian companies in our portfolio than US VCs, and, thus, we must act in a way that gives us all a chance to maximize these returns.
In terms of other sources of capital – outside of VC – companies continue to look at Angels and high net worth individuals, but also at alternative sources such as strategic investors and crowdfunding (e.g. RentMoola’s latest round). One thing I have not seen dry up in this market is debt availability – the major debt providers (whether via lines of credit, SRED financing, A/R or inventory lines etc.) still seem to be on a good pace to deploy capital. This is likely because they invest on a different risk/return profile and have different criteria and asset claim seniority than equity investors do.
Recognize that you should be broadening your scope of potential cash sources in this market. As a Canadian-based company, remember that Canadian VCs remain an important source of capital for your company. SRED returns and debt pledged against SRED particularly offers Canadian companies a distinct advantage over US competitors, make sure to leverage and explore this option, among others, fully.
Planning for Profitability
Optionality is among an entrepreneur’s best weapon in any market, but particularly in down markets. What I mean by this is that companies that have multiple options available to them (e.g. a range of available funding sources, a broad assortment of potential acquirers who have they have warmed up to) and/or are profitable (or can become profitable relatively quickly) have the best chance to survive and thrive. The best entrepreneurs I know are always thinking hard about optionality for their businesses.
Being cash flow positive often comes at the expense of growth, but, of course, survival is the name of the game in a down market. Companies who are already profitable are planning to continue this trajectory, at least until they have a better handle on what the market downturn truly means. Companies that can be profitable in the near future (say 6-12 months) are laser-focused on making this happen, even sooner than planned. Canadian companies typically have lower burn rates than US competitors, and therefore, have an advantage here. Getting to profitability is always easier said than done, but for Canadian companies it can be relatively, and theoretically, easier.
If profitability is achievable for you, think about the hard steps needed (sell more or cut more!) to get there and becoming cash flow positive… fast!
Lengthening Your Runway
Companies that have recently raised rounds, or who are relatively flush with cash, are looking for ways to stretch out their runways to weather a market downturn. These smart entrepreneurs understand that access to capital is going to be a differentiator going forward, and that new rounds of financing are going to be much harder to close. Most are looking to extend their runways for 18 months; some are planning for even more. This is particularly important for, and being seen in companies, who have, by design, zero (or minimal) revenues right now. Hiring is being slowed, new product launches are being more heavily scrutinized etc.
If you are lucky enough to have a large enough cash cushion on your balance sheet make sure you tighten your spending to ride out the downturn. Don’t assume you will be able to raise another round over the short to medium term.
A/R is Getting Stretched
We are starting to see account receivables (A/R) grow, and the time to actually receive payments, lengthen. In cash-constrained companies, their payables are often the first, and seemingly, easiest sources of capital. You are especially vulnerable if you’re A/R consists of a lot of payables due from other startups.
Canadian-based companies who have most of their revenues in the US have an advantage with the favorable exchange rate right now. Operating with your costs in Canadian dollars and revenues in US dollars can be an important source of differentiation relative to US businesses.
To combat the reality of A/R being stretch and gain advantages over your competitors, make sure to get a good handle on managing your payables and keep a keen eye on any accounts that seem to be drifting time wise past, say, 60 days. Perhaps offer discounts to some of your accounts to entice them to pay off outstanding balances immediately or offer new customers a discount for pre-paying new balances upfront. Think about outsourcing your more “doubtful-to-collect” accounts to an outside collection agency that specializes in such matters. Also, be sure to be more aggressive with discounting your cash collections in your cash flow projections – assume that it will take longer to collect and that, now, more than ever, some customers will not pay you at all.
Good luck! Remember, with keen awareness and smart planning you can be one of the companies that actually thrives in a down market. When the market inevitably starts to upswing again, you will be stronger than ever!