While The Dilution Is Painful, Here’s Why Growth-Stage Companies Should Consider Raising Capital In The Downturn

Growth-stage companies, is waiting out the current market environment before your next raise the best strategy? The answer is, maybe not.

While The Dilution Is Painful, Here’s Why Growth-Stage Companies Should Consider Raising Capital In The Downturn
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Given that capital is becoming more expensive and harder to come by, founders naturally want to extend their cash runway to avoid fundraising. There are two reasons for this: If capital is more expensive, founders will have to take more dilution, and with negative investor sentiment, raising capital will likely take longer, which is a major distraction for management. What founder wants to sign up for a potentially long and painful fundraising process?

So, is waiting out the current market environment before your next raise the best strategy? The answer is, maybe not.

While the NASDAQ is down nearly 30% year to date, market multiples are actually pretty fair relative to the longer-term average. The current trading multiples are down meaningfully from the euphoric levels of 2020 and 2021 but are actually perfectly in line with longer-term averages according to Morgan Stanley Research, Refinitiv and internal data.

What does that mean?

The market might not be at the bottom, and this new environment may persist for a while.

Ask yourself—what is the catalyst for getting back to almost 40x trading multiples? It probably isn’t rising interest rates or inflation. Therefore, companies should consider reevaluating their plans to wait out a bad fundraising environment.

Of course, every situation is different, so let’s discuss how two different companies may think about financing in today’s environment.

• Company No. 1: has 24 months of runway and a relatively low burn rate—let’s call it $10 million per year.
• Company No. 2: has 12 months of runway and a high burn rate—let’s call it $100 million per year.

Company No. 1 appears to be in a great position. It has two years of runway, and in all likelihood, this company recently raised capital at a valuation that it could no longer dictate in this market. It may need these two years and more to grow into its current valuation.

How does a company grow into its current valuation?

For high-growth startup companies, there are typically two inputs that lead investors to the company valuation. That is: The company’s revenue multiplied by a revenue multiple equals the company valuation. As noted earlier, the market was previously applying multiples of up to almost 40x, but, with the market downturn, revenue multiples are closer to approximately 10x.

Let’s assume that Company No. 1 raised a $400 million valuation off of a 40x forward multiple, which implies the forward revenue expectation is $10 million.

Meaning: $10 million of revenue multiplied by a revenue multiple of 40 results in a $400 million company valuation.

Now, given the decrease in market multiples, Company No. 1 may need to raise at a 10x forward multiple. In order to achieve its current valuation of $400M, Company No. 1 needs to generate $40 million of revenue. Said another way, Company No. 1 needs to quadruple its revenue just to get to its current valuation. This is what I mean by “grow into” their valuation. Company No. 1 likely needs multiple years to actually quadruple its revenue.

Company No. 1 is also in a good position regarding its burn rate. In a worsened environment, investors often prefer companies with lower burn rates because they can more easily be funded. In this example, $10 million buys the company another entire year of growth. Existing investors likely have enough reserves to cover $10 million if needed, and new investors may be more willing to invest capital because the quantum required is low.

Company No. 1 likely doesn’t need to proactively raise capital given its current runway and burn rate; however, if it has capital available to it at acceptable terms, it should seriously consider taking it. Either way, it should consider moderating costs wherever possible to extend its runway to grow into its valuation. This will require a review of its existing financial plan and cutting existing costs or delaying future expenses. Many companies are already doing this—hence the recent layoffs. Aside from layoffs, they should look at reductions in travel, conference attendance or real estate expansion.

Company No. 2 is in a different position. It only has one year of runway, and it requires a lot of cash with a burn rate of $100 million. This is a double whammy in the current environment. While fundraising cycles have recently been short, more investors are moving to the sidelines and conserving dollars for their existing companies. That means fundraising will likely take longer. If we assume fundraising takes three to six months going forward, this company needs to start fundraising now.

Why? Because Company No. 2 does not want to raise from a position of weakness. If Company No. 2 waits to raise and only has six months of runway left, investors may be punitive with terms because Company No. 2 is going to run out of cash soon and may not have other options.

Company No. 2 also needs to consider that investors will be wary of its burn rate. At this level of cash outflows, existing investors likely cannot fund the company for very long with their reserves. It is also difficult for a new investor because the amount of conviction required to write a $100 million or more check is enormous.

While we have been in a growth-at-all-costs environment, this is changing and Company No. 2 should consider revisiting its financial plan and cut burn where possible. The burn does not need to meaningfully decrease on Day 1, but investors will want to see a path to a more modest burn rate over time. Burning $100 million to grow revenue by 200% may have been the norm, but Company No. 2 may find that burning $40 million to grow revenue by 100% is more attractive in the current environment.

With both scenarios above, there is one consistent recommendation—reviewing their current financial projections and adjusting. The market environment has changed, and therefore, a financial plan should take that into account. Most startups should consider raising capital if it is available to them. No one has a crystal ball, but it is hard to imagine the environment getting better in the next six to nine months. While the dilution may feel painful, a CEO’s number one objective is to stay solvent and live to fight another day.

This article originally appeared on Forbes