From our vantage point here at Sapphire Ventures, equity markets are beginning to emerge from the doldrums of 2022, when entrepreneurs and investors often had a particularly hard time squaring their thinking on valuations. The public markets corrected first, with SaaS multiples dropping from highs of more than 10x (or more than 30x for many high-growth SaaS companies) in November 2021 to lows of around 5x (or around 7x for high-growth companies) in mid-2022.
Based on our feel for flows in the market, secondary trading in unicorn private company stock corrected next, in late 2022 and into early 2023, with option holders and early investors (typically sellers) finally starting to agree on prices with late-stage investors (typically buyers), even if at a significant discount compared to the last primary round.
What comes next? We believe that the primary expansion-stage VC markets will open for business in a meaningful way. These markets have almost always been open for good companies, but many participants in the market are finally getting their arms around the new normal in terms of valuation. With companies that raised back in 2020-2021 starting to think about reloading their balance sheets, we expect expansion-stage deals to return to a normal pace in the second half of 2023 and throughout 2024.
At Sapphire, we have signed two term sheets in the past few weeks to lead rounds for new portfolio companies, and we continue to be long-term believers in the SaaS business model. Springtime has sprung for late-stage VC.
Extending Runway: Equity Versus Debt
While many people argue that startups in today’s market should pursue near-term profitability, we think this advice is short-sighted, and instead most should continue to prioritize efficient growth. Yes, that means they will be burning cash until they reach scale. To fund this burn, startups have two main avenues: debt and equity. Each is useful in different situations. We consider equity as the primary mechanism to fund burn until a private company reaches sustainable scale, but debt can be helpful to fund working capital, or as bridge financing for tuck-in acquisitions, or as a short-term runway extender to help a growing company hit one more key milestone required to raise the next equity round.
In 2022 and early 2023, we saw a proliferation of terms and structures in both equity and debt markets which we think attempted to solve for headline sticker shock regarding equity value and interest rate. In our view, entrepreneurs should resist the temptation to preserve headline valuation, and instead seek long-term, value-added investors using financing instruments that have standard “clean” terms.
Standard venture preferred equity and venture debt terms have developed over the years to ensure alignment between investors and entrepreneurs. As companies start to come back to market, our advice on how to think about the next capital infusion is simple: Keep It Clean.
First, a look at equity. If you need growth capital, don’t hesitate to embrace down rounds. (Yes, you heard that right!) Once a venture fund is on your cap table, our interests are aligned to raise the next up round. If that’s not possible, then it’s best for everyone on the cap table to raise a clean venture preferred round at the market clearing price rather than create a tortured financing instrument that gives you the headline value you are looking for, but takes a lot of it back in structure.
It can be painful to explain to engineers that the value of their equity hasn’t increased, and markdowns are no fun for VCs to report to their LPs (limited partners) either, but once you’ve taken the pill, everyone is better positioned and aligned to increase go-forward valuation. On the other hand, if you settle for structure — such as a 2x liquidation preference, a 12% payment-in-kind (PIK) dividend or a guaranteed minimum 1.8x return — there will be boardroom squabbles if things move sideways and founder fortunes lost even in a reasonable M&A scenario. Let me repeat: resist the urge to artificially increase headline equity value.
Can You Raise a Clean Up Round?
Many public SaaS multiples are down 70% to 80% compared to 2021 peaks. Let’s use 70% to do some math. Assuming you raised expansion-stage capital in mid-2021 and are looking to do an up round, when can you raise your next round at the same or higher valuation with clean terms? If you grew 80% for two years, you should be in a position to raise again in the second half of 2023. (Here’s the math: (1-70%) x 1.8²= 2 years.)
If you are growing 50% annually, then you may need to wait until mid-2024. (The math: (1-70%) x 1.5³= 3 years.) If your growth rate has slowed to a still respectable 35%, then you probably can’t grow into your last round’s valuation any time soon. (The math: (1-70%) x 1.35 ⁴= 4 years.) The fundraising environment has undergone a sea change in the past 18 months. The sooner you acknowledge the new normal and get on with raising a clean down round, the sooner you’ll be positioned to get back on track for go-forward valuation appreciation.
Debt Financing Considerations
Turning to debt, let me first say, we are not fans of debt for early-stage companies that have yet to achieve true product-market fit. We believe that’s an equity risk and should be funded with equity. But even for venture-backed companies, debt can be a useful tool to finance growth once product-market fit has been achieved.
If you have around $50 million ARR or more (and show even modest growth), you can probably find available debt financing for at least 1x your ARR levels in this market. That debt can go a long way toward helping you raise the next equity round at a price you’re happy with. But you have to be careful to take the cleanest debt possible that truly extends your runway. Too often, we see companies take on debt that has a lower interest rate but comes with liquidity covenants that may restrict them from drawing capital when they need it most. In other words, be wary of paying for “insurance” that doesn’t actually pay out when you need it.
The other issue we see with debt in this market is the proliferation of structure and equity-like “bells and whistles” that lenders include to lower headline rates, reduce covenants or increase loan size. For example, some crossover funds provide debt combined with a large grant of penny warrants. When you run the math, you will likely find that these instruments come at a cost of more than 20% IRR in an upside case, which feels a lot like equity-level returns!
Alternatively, we have seen debt with prepayment fees, end-of-term fees or restrictive covenants (which can lead to covenant reset fees down the road) – all of which push the cost of debt into the high teens despite a more benign 8-10% headline interest rate. If you are looking to add debt, we think a 10-15% cost of capital is reasonable in this market. Most importantly, make sure you model out cash flows and covenants to ensure that the debt actually extends your runway. At Sapphire, we have a model we use to help our companies understand the all-in cost of debt. If the cost gets too high, or if the debt doesn’t extend runway meaningfully, we advise our portfolio companies to turn back to equity.
Creating Long-Term Alignment
We believe the venture capital business is one of alignment: alignment with founders who expect us to help grow their startup into a Company of Consequence and alignment with LPs who trust us to be a good steward of their capital over the long term. In our view, clean venture preferred stock with a 1x liquidation preference is a great tool to create this alignment. If fundraising at the right valuation proves more difficult, standard participating preferred can also be a good tool to help founders swing for the fences while reaping just rewards for a solid M&A outcome. And as we’ve discussed, clean venture debt has its role as well in extending runway and lowering cost of capital.
We’ve seen this movie before in the last two major market corrections. Resist the urge to add structured equity or debt that aligns interests only in a best-case scenario outcome. Raising capital on clean terms will help move you up and to the right again.
If you are building an expansion-stage Company of Consequence in the enterprise software domain and would like additional information about financing options, you can reach Steve Abbott at [email protected].
Disclaimer: Nothing presented within this article is intended to constitute investment advice, and under no circumstances should any information provided herein be used or considered as an offer to sell or a solicitation of an offer to buy an interest in any investment fund managed by Sapphire Ventures (“Sapphire”). Information provided reflects Sapphires’ views as of a time, whereby such views are subject to change at any point and Sapphire shall not be obligated to provide notice of any change. Companies mentioned in this article are a representative sample of portfolio companies in which Sapphire has invested in which the author believes such companies fit the objective criteria stated in commentary, which do not reflect all investments made by Sapphire. A complete alphabetical list of Sapphire’s investments made by its direct growth and sports investing strategies is available here. No assumptions should be made that investments listed above were or will be profitable. Due to various risks and uncertainties, actual events, results or the actual experience may differ materially from those reflected or contemplated in these statements. Nothing contained in this article may be relied upon as a guarantee or assurance as to the future success of any particular company. Past performance is not indicative of future results.