It is no secret that the funding environment for startups is changing. While money felt very easy and cheap over the last couple of years, 2022 is on a very different trajectory. Given this change in the funding landscape, companies may need to ask themselves, and their investors, questions that they could previously overlook. One of those key questions concerns the availability of reserved capital for their company.
Before we jump ahead, let’s first address what reserves are. When a venture capital (VC) fund invests in a startup, they immediately send the capital to the company. What they also likely do is internally decide how much additional capital they want to reserve for future rounds of investments into the same company.
For example, let’s say I invest $5 million into Company A. I may decide to reserve an additional $5 million to invest in the next round. Every venture fund approaches reserves differently, but a common approach is to reserve $1 for every $1 invested (as noted by Sapphire Ventures).
Why would VCs reserve capital?
Given the strong market environment over the last several years, VCs mainly reserved capital to invest in following rounds to try to preserve their ownership percentage in the company. If a VC doesn’t participate at all in the following rounds, their ownership percentage gets diluted. This can be viewed as an offensive strategy.
If you’re a startup, you probably didn’t care much over the last several years if your existing investors did or did not reserve much capital for you. In all likelihood, it was probably more problematic than anything because you needed to make room for them in your follow-on rounds.
Now, the world is shifting. The stock market is down meaningfully, and some investors are moving to the sidelines. We know venture funding was down in both March and April of 2022 as compared to the same months in 2021. Perhaps more notably, venture funding in April 2022 constituted a 12-month low. What does that mean for you as a startup? You may be entering a bad fundraising environment, in which case, you should definitely care if your investors have reserves to support your business.
If your existing investors have reserved capital, it can help you in three possible ways.
• They can extend your cash runway so that you can potentially raise again in a better environment.
• They can extend your runway long enough for you to create some positive change in the company to make it more attractive for new investors (e.g., increase revenue, launch a new product, etc.).
• They can provide support in your next round to increase the confidence level of your new investor.
In this situation, the VC is using its reserves as a defensive strategy. Said another way, instead of trying to optimize for ownership percentage, they are optimizing for the company’s health and ability to stay solvent.
If your existing investors have not reserved capital for you, your options may become more limited—meaning, you are reliant on a new investor. If you raise from a position of weakness, it could negatively impact your valuation and terms.
Hopefully, it is now clear why you need to know if your investors are in a position to support you with more capital. The sooner you know, the sooner you can make decisions to put your business in the best situation to succeed. For example, if reserves are limited, you may want to begin fundraising earlier than anticipated.
So—here’s the hard question—how do you ask your investors if they have reserves for you?
As is the answer to many questions, the best course of action is full transparency on both sides.
• Step 1: Start by preparing a summary of the company’s current cash position and expected needs. Ideally, show both your current plan as well as a plan that has a reduced cash burn. This illustrates that you have a handle on your business as well as the environment.
• Step 2: Once you feel confident with your options and the trade-offs between the plans, share this information with your investors. Explain in some detail what you will need to give up to reduce burn. For example, you may need to delay hiring your new quota-carrying sales rep or engineers to support new product development.
• Step 3: After you have shared the company’s needs, ask your investors to, in turn, share information about the amount of dry powder that they have and, ideally, the amount that is specifically available to support your company. It is also okay to ask them what progress they may need to see you make before they are willing to commit more capital to your company.
Remember, your investors are aligned with you and also want a successful outcome. Don’t delay this conversation because you think it might be uncomfortable—it’s not taboo. And, don’t assume there will be capital available.
Every fund will be in a different position—some may need to use all available reserves to support struggling companies, and some may not have reserves at all. You need this information to best manage the current environment for your company and your employees.