Three Strategies to Mitigate Dilution Impact During a Downturn
Raising capital during an economic downturn can be a challenging endeavour, as the fear of dilution and the need for financial stability become paramount. Attempting to raise during a downturn presents various hurdles including longer timelines, risk-averse investors, and downward shifts in the company valuation.
During an economic downturn, particularly after years of euphoria in the market, the pendulum of power swings from entrepreneurs to investors. Founders who had planned to raise capital during this period now face the challenge of raising funds during a downturn, compounded by the reality that doing so will result in additional levels of dilution not previously planned for or modelled.
Given most startups are not generating enough free cash flow to grow organically during the seed and growth phase, founders usually need access to outside or investor capital to grow their business. Each round of financing raised through a SAFE, Convertible Note, or Priced Preferred Round will result in dilution of a founder’s ownership in the company. The big difference during a downturn is not only diluting the percentage of ownership, but also the value of that ownership, which results from a down round (pricing the current round below the value of the prior round).
Fortunately, there are a few strategies to employ that help a founder manage the degree of impact of a raise during a downturn: aggressively manage your burn rate and build a path to profitability, take advantage of the relationships you have built with your existing investors, and leverage relationships with your network of customers and vendors.
Aggressively manage your burn rate
By effectively managing your cash flow, you may be able to decrease the amount of funds needed dramatically, as well as delay the need for additional financing. This becomes time sensitive and critical when the market turns.
Look at every expense item and determine what can be reduced or delayed. Remember throughout this process that while every single dollar counts, this process is nuanced, and blindly cutting costs can create huge future problems, even though it offers a short-term fix.
While it is very challenging, it may be necessary to reduce headcount to survive. You can also evaluate remaining senior management salaries and determine if those can be reduced short or long term so that everyone is carrying a share of the cut. As a founder, you must balance the depth and breadth of these cuts with the need to continue to grow revenue and develop a realistic path to profitability. Existing and new investors will want to understand when the company turns profitable, which usually does not happen from cutting costs alone. These challenging decisions may be the difference in your startup surviving or not.
Invest time and energy into your investor relationships
The best people to turn to during these challenging economic times are your existing investors – they have a lot at stake in you and your success. You should always aim to build strong working relationships with investors from the moment they invest. It is through consistent and transparent communication, regular sharing of financial information, traction, progress, and challenges that you build this trust. Existing investors can support you in figuring out how to bridge in the most cost-effective, least-dilutive way to get to the other side of the round. Existing investors are your most reliable lifeline and the best source of short-term capital.
Keep in mind that engaging with new investors during a downturn presents a massive challenge. Your existing investors should play a critical role in the process. Seeking funding from a new investor if your existing investors are not leading or participating in the new round is a red flag that may impact your ability to raise the new round.
Leverage your long-term vendors and loyal customer base
If you have customers who are loyal fans of your product or service, chances are they genuinely want you to succeed. Lean into these relationships, strengthening them at every opportunity, and what you might find is a willingness on their part to prepay for products or pay on a shorter timeline, which can aid in cash flow management.
In addition, look for other creative ways to preserve cash flow such as negotiating a lower or deferred rent payment with your landlord, cutting back on services, or technology, and negotiating payment plans with other vendors with whom you have an ongoing relationship. You may even identify opportunities to delay capital expenditures or purchases that aren’t essential to your business in the short-term. The impact of these efforts can add up quickly, easing pain points in your cash flow and reducing or delaying your capital raising needs.
The startup ecosystem is dealing with a landscape that requires founders to consider multiple avenues for extending runway. The best plan of attack is to always think long-term, and devise a plan that extends your runway 18-24 months if possible. As you cut or delay expenses, take a realistic look at revenue growth and determine when you cross into profitability. Even in a downturn, reaching this milestone returns significant power back to the founders.
This is the time to exhaust every creative opportunity to manage cash flow and extend your runway. If you tightly manage your burn rate, continue to collaborate with your existing investors, and lean into the support of your customer base and vendor network, you will be able to mitigate the dilutive impact of raising capital during a downturn.