Silicon Valley start-ups race for debt deals in funding crunch

Tech startups that have traditionally relied on wealthy Silicon Valley investors to finance ambitious growth plans are being forced to accept alternative financing arrangements to sustain their businesses and avoid drastic valuation cuts.

a sharp to refuse in venture capital trading, coupled with a closed market for initial public offerings, has resulted in a funding crisis for many private tech companies over the past year.

Leading startups have been aggressively cutting costs, creating a wave of layoffs across the tech sector. Still, a growing number of companies are running out of cash and seeking more creative financing arrangements, according to interviews with venture capitalists, entrepreneurs, pension funds and bankers.

The company’s founders have entered into debt-focused deals such as bridge loans, structured shares, convertible notes, participating bonds and generous liquidation preferences. These moves are designed to prevent a dreaded “round to the downside” – accepting funds at a much lower valuation than a company had previously obtained.

“Everyone is taking corrective action,” said an investor based on Sand Hill Road, the California thoroughfare that is home to many of Silicon Valley’s top venture capital groups, from Sequoia Capital to Andreessen Horowitz.

With the market slide looking set to continue into next year, this person said that even the founders of well-capitalized tech groups have had to ask themselves: “What are the adjustments? [we need] so that we can live longer, how can we allocate funding from next year to 2024?

Among the biggest debt deals this year is Arctic Wolf, a $4.3bn cybersecurity firm backed by Owl Rock Capital, which raised a $400m convertible note in October, double its biggest funding capital.

SoftBank-backed delivery app Gopuff raised a $1 billion convertible note in March and has explored plans to borrow more since then, despite raising more than $2 billion last year, which increased its valuation to $15 billion by mid-2021.

These deals come with a conversion premium, allowing their backers to convert shares at a higher price than an eventual IPO. Such deals represent a bet that the company will trade higher after it goes public.

Convertibles “leave the hassle in the road,” said Chris Evdaimon, a private-venture investor in Baillie Gifford. “They are mostly being led by existing investors who say we don’t want to get into this nasty valuation discussion right now either.”

Coatue Management and Viking Global Investors, which have traditionally focused on public equities, began raising funds to invest specifically in equity structured deals with start-ups earlier this year.

Coatue is targeting $2 billion for his fund. “For a private company to suddenly downgrade things by 75 or 80 percent. . . it is a great risk”, the founder of the firm Philippe Laffont told the Financial Times. “We can give you an alternative. . . Capital that gives you more time to build your business.”

Such large debt deals have been relatively rare for tech startups, the best of which have been able to tap into the vast amounts of funding from venture capitalists, who have been willing to fund young companies even with frothy valuations over the last decade. decade.

However, new venture capital deals fell 42 percent in the first 11 months of this year to $286 billion, compared with the same period last year, according to investment data firm Preqin. Silicon Valley law firm Cooley said the total value of late-stage venture capital deals it advised on has plummeted nearly 80 percent this year.

That trend has been fueled by a drop in technology stocks, an uncertain macroeconomic environment and rising interest rates. Meanwhile, initial public offerings have fallen to their lowest level since 2009, cutting off a key source of fundraising for mature private companies and their backers.

“Next year is when everything comes back home,” said Ravi Viswanathan, founder of California-based New View Capital. “There will come a point where even companies with capital of 18 to 24 months will have to raise. There will be a lot of pain.”

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Up and down Sand Hill Road, VC funds have reviewed their portfolios and warned founders to assume the capital markets may be closed for another year and to shift their strategies from growth to survival.

The companies struggling the most to raise new funding are unprofitable groups in capital-intensive sectors like battery manufacturing or robotics.

“We just got out of a borderline crazy environment,” said one institutional tech investor. “If you had raised an outstanding amount at a valuation that didn’t deserve it, you felt you had done very well as a founder or management team. Now it’s coming back to bite you.”

Pursuing creative financial options to protect a company’s valuation is an “old playbook,” said an investment manager at a large pension fund that invests heavily in technology. “But it has been a long time since the sums have been this large and it is affecting everyone.”

Some companies are persuading existing investors to put up more capital at the same valuation as their previous fundraiser, known as a “side round,” but with underlying economic terms that are much less favorable to the company.

Where companies are receiving desperate “dirty” term sheets — deals that on the face of it accept a company’s existing valuation but have terms that could prove more beneficial to new investors — are making the rounds, one investment banker said.

“Investors say we’ll buy at the same price, but we want seniority and to be at the top of the stack in case of liquidity,” Kroll’s Silicon Valley leader Glen Kernick said, adding that he had seen a number of deals signed. that provide for investors to double their investment before other shareholders in the event of a sale or bankruptcy.

Tonal Systems, which develops smart fitness devices, reached such a financing deal earlier this year, according to corporate documents first reported by the Wall Street Journal.

This structure can be brutal for shareholders further down the seniority ladder, such as employees who hold stock options, if a company’s value were to fall. It’s a trade-off between accepting a valuation shock or accepting punitive terms that risk creating conflict in a company’s shareholder base, or even removing value from employees.

Some companies are repricing their own equity to enhance the growth potential of employee stock. Delivery app Instacart cut its internal valuation for the third time to $13 billion in October, down from $39 billion in 2021. Similarly, Checkout.com, Europe’s most valuable tech startup, chopped up its internal valuation to about $11 billion, after it raised a valuation to $40 billion in January.

Drastically lowering internal valuation, which is independent of the investor-determined price of a group’s preferred stock, benefits staff by lowering the company’s cost of stock. This gives employees scope for higher profits in the event of future deals, such as an initial public offering.

“We are telling our portfolio companies not to get too entrenched in a valuation that they had a couple of years ago when the market was abnormally inflated,” said the investment manager at Sand Hill Road. “It’s better to take your medicine now.”