What not to do at a technology startup falling into financial distress
It is distressing, but technology entrepreneurs should not despair. Until recently, they thrived in a world that was changing fast. Now, moderation has started to kick in. It has suddenly become a tougher, less enthusiastic, and exuberant place to operate in.
Technology companies’ valuations have decreased, a freeze hit IPO markets. And a lot of capital is unspent¹. Venture capital and private equity investors are either more cautious or sit it out for now. As many in the startup world anticipated such a period.
Private companies must make tough decisions about their future. Their operators need to take a hard look at their unprofitable business models. And decide what to do next.
They need to either succeed or go bust. In these scenarios, what does success mean?
Success or failure
There are currently more than a hundred thousand venture capital-backed companies worldwide. Between ten and fifteen percent of all companies go bankrupt before they get bought. Most of them will not be able to secure an exit or up round. Those that are successful can still generate significant value for stakeholders and investors.
Startups that are in financial distress typically have to sell at a discount. Or accept funding at a significantly lower valuation than their previous financing round. If they are unable to do either of these things, the company will likely fail.
We expect the post-coronavirus recession to trigger a period of decreased VC-backed M&A activity. During the last recession in 2008, there was a significant decrease in the number of such deals in the U.S. and worldwide. We already see a decrease in these numbers for the first half of 2022.
How can startup founders or CEOs help themselves when facing financial distress in such market conditions?
As a reminder, technology startups usually finance themselves through preferred equity or equity-like instruments. A close group of insider investors usually held these instruments. They prefer these structures rather than holding complex secured or unsecured debt.
In certain geographies, startups may access economic relief programs or sector-specific subsidies from the government. COVID spread such measures across the board and the globe and increased its uptake. Yet, these state-provided funds can take a long time to access, and even longer to receive.
Usually, entrepreneurs take out of their toolbox the following financing or exit strategies.
A fresh round of funding
As discussed before, current market conditions complicate such deal-making for founders.
Bank credit, bridges, private loans
Raising debt is already tough for technology or internet startups during an expansion. These companies are unique in that they often carry little to no inventory. Intangible assets mainly load their balance sheets. At some stages, they are commonly not profitable and might not earn revenues. Valuation and credit risk models of banks or financial investors require such inputs to be able to lend out.
Many technology companies take on large venture capital investments or issue large amounts of debt to fund research and development. So the startups carry financial ratios, which in theory, are already not attractive for financial institutions in a booming economy.
Sale of assets/divestment
Many technology companies, especially software and internet ones, have no tangible assets. Their only real asset is the team behind all the intellectual property. Yet, this asset is often more worthless than valuable. If the technology running the product is not used by anyone or if nobody buys their service.
With the unique exception of startups owning patent portfolios, small or large. Yet, selling the entire portfolio or just a part of it could lead the company to enter into a life-or-death situation.
Bankruptcy processes
In some geographies, bankruptcy laws provide entrepreneurs with restructuring tools to continue operations. The main operation expenses at technology startups are staff, office leases, and clouds/servers. To keep operations running smoothly, these expenses must be kept current.
As a result, a bankruptcy to restructure liabilities is often unnecessary. Sometimes the best and fastest option for all stakeholders of the statup before going bust…
… is to execute an exit plan
Some investors buy or restructure companies in distress or in special situations. These investors can help startups get back on their feet and continue growing.
The success of such an exit is contingent on an M&A process with them. Yet, it becomes very unlikely if the founder is not already involved in such a process. Finding the right partner and closing the deal can take anywhere from 6 months to one year, or even longer.
More often, founders find themselves moving outside of such a timeframe in financial distress. It is actually not too late if the startup leadership has not made sure that the market knows them and their story. Even if they have no investment banker or they are not best friends then a quick fix still exists. That would be an immediate and right addition to their board.
Ambitious CEOs, we know, recruit ex-bankers or retired insiders from market players in their sector. Often this is one of the cheapest and fastest ways to expand their profile before a potential acquisition. Besides all the other benefits that such board members bring to the table.
For non-financial startup leaders, these processes may feel boring, new or tough. If they have not done that so far or not even trying to consider then they should still enter that process alone.
Options on the table
Dilemma
In most of these distressed M&A deals, the main choice to make is between selling the equity of the company versus selling the assets. Founders also need to manage the conflicting expectations of all stakeholders. Creditors want to receive what they are owed before equity owners.
Each party has its own bias against the deal’s terms and conditions. Yet, all parties would rather receive something back as opposed to zero cents on their initial investment.
Equity Sale (or Merger)
The main benefit of selling equity is the speed of execution. Depending on regulation and internal approvals, it is done either via a stock sale or a merger. The startup and its potential buyers can negotiate confidentially until the transaction closes. This minimizes flight risks from employees, clients, and partners. As well as potential threats from their competition.
Asset Deal
Asset deals offer flexibility for all parties involved. Investors benefits from buying assets while excluding liabilities — and not having to audit them. The main inconvenience is that asset deals tend to be a slow process. Investors need to pick the assets. And then have all stakeholders involved agree to a sale of these assets. In turn, they can be tied to employees for example.
Acquihires
Investors simply hire the whole staff or all of the startups’ key employees. This is usually the case for smaller private companies. Founders have a chance to go through such a sale process when
- Consensus exists between management and team leaving the company and the remaining crew being kept motivated to continue
- Technology or product save costs, increase revenues, or the acquihires generate other synergies at their new employer
- Investors compensate all shareholders and pay up for liquidation costs. And some of the liabilities of the startup, in exchange for which they receive a release of claims.
In all those deals, entrepreneurs need must take into account dozens of other factors too. As well as many risks. The essence in itself of the failure, disruption or distress slows down that process. Startups often developed a product that either did not gain significant traction or are not of great value. Founders then need to speed up the evangelization of these new investors. Thus, they must squeeze long sales cycle (sometimes of several years) into a couple of months long process.
The process
During a distress sale process, investors have significant negotiating leverage over the startup. Both parties are racing against time. Founders must keep their businesses afloat while negotiating. And also be on good terms with all stakeholders with diverging interests.
Startups need to do their homework
This is likely the last time that founders and executives work on a large project together. They should have a “let’s not leave any stone unturned” attitude while tackling this task. Everyone involved should be clear and knowledgeable about all stakeholder relationships and liabilities.
This mindset and knowledge increase the chances to reach a quick outcome in a gruesome M&A process. Maybe it is also time to seek legal counsel.
Consensus is key
Entrepreneurs should get everyone on their board involved as well as as all investors. They need to make sure before going out there pitching where are the group’s red lines such as:
- The sale strategy and valuation ranges to be negotiated with potential acquirers
- The timeline which respects the remaining runway to liquidate the company in due form if everything else fails
These conditions should achieve a consensus. The board and shareholders should validate them in an official mandate given out to the startup team members appointed as negotiators.
Transparency is non-negotiable
The negotiators need to keep the data room updated continuously with all relevant documents. Time is of the essence in these negotiations. Being transparent with new investors will help negotiators arrive at a yes or no decision faster.
They also need to make sure that they correctly measured their financial stress correctly. As technology investors usually look at financial ratios, such as liquidity, profitability, and financial leverage ratios, negotiators need to have these numbers ready at all times.
Founders become hunters, in a pack
If the entrepreneurs are solo founders, they should get a board director involved in all dealings so that their executives and business heads stay fully focused on running the day-to-day and managing increased risks of failure.
Co-founders should work together, even the technical ones who have previously never participated in such deals. Investors usually feel safer if they see the “whole” organization facing them and all parties streamline communication this way.
The negotiators should then draft immediately a list of the first group of potential buyers they need to approach in any way possible.
Targets of the founders’ last pitch
A co-founder, a business partner, or a key employee could at this stage buy out the company. Yet, this case very rarely happens for technology startups. The most natural way for the founding team, and also most efficient one is to approach the stakeholders close to them. In a decreased order of success probability, the negotiator should go after their
- Largest investor(s) on their captable- corporate venture capital funds usually better receive such a proposal than other VCs. Especially, if the investor already invested based on potential strong business synergies. Business angels are sometimes involved in such deals (when they have the financial resources to do so)
- Their Technolog or Commercial Partners- these targets can continue the shared projects in a combined business as it is in their best interest to do so.
- (Largest) supplier(s)- or their competitor(s) excluding moral hazard. Obviously, it is in their suppliers’ best interest to keep the failing company as a customer. Sometimes, suppliers have their own supplier or group of suppliers who rely on that very business to continue.
- Competitor(s)- negotiators should avoid startups at an equivalent stage or close by. These competitors do often not have the resources while facing the same macro risks. Excluding the startup that just came out of a fresh round of funding. Usually, this process is an acquihire.
- Personal and business networks to leverage to find anyone else willing to take over the company- in this case, all internal and external stakeholders should seek out distressed buyers such as private equity or special-situations funds.
- Optional- Online Platforms. Founders can list their company on digital marketplaces to buy and sell startups³.
Keep their team morale high
Technology startups that are experiencing financial difficulties have unique situations. Yet, there are some common value drivers that exist. Some of those include the team and intellectual property. If founders want to sell, then they should move fast. This will help to keep employees from leaving and maintain high team morale. The valuable asset is the team building the intellectual property. Without these key staff members, investors acquire obsolete technology.
The End Game
Entrepreneurs exiting in a special situation face a lot of dilution. They weigh this dilution versus the time and resources invested in their ventures to achieve that outcome. If their technology, product, market, team, clients, or whichever, still motivate them then it is not a hard sell to be an acquihire. Otherwise, founders should not discard taking a cheque, of whichever size.
Choosing one option over another cannot be made by the will of the entrepreneur and its shareholders. The market dictates its terms. Economic rationality prevails in the end. Yet, nothing prevents the startup from following each one of these strategies in parallel, or sequentially.
If all else fails and there is no other available solution. Then the startup having the chance to wind down all operations and liquidate the company in good order, should do so. And also try to stay in the best terms possible with all stakeholders.
Businesses come and go.
The world is a big enough place.
Entrepreneurs know how to move on.
Footnotes:
- Why must technology startup founder not cut costs and not fundraise in the medium term?
- Online marketplaces to buy and sell startups and small businesses (technology, internet, traditional): bizbuysell.com, buyandsellabusiness.com, empireflippers.com, flippa.com, investors.club, microacquire.com, microns.io, tinyacquisitions.com. In our experience, joining these platforms is often not in the best interest of the startup. It can signal to the world that the company is in distress. These platforms are often U.S.-centric and only work well for smaller companies.
Photo Credits (by order of appearance):
Tom Pumford on Unsplash, Palindrome Capital, Anuj Yadav on Unsplash
Information Sources:
CB Insights, Crunchbase, Dealroom, Pitchbook
If you have read so far, thank you for your time! We are PCA Ventures Partners. If you like what you just read then let us know. If you do not like what you just read then also get in touch.
Readers of our last article asked what could or should startups if they are on the brink of collapse. It was on our roadmap to issue such an article. Yet, we wanted to collect more information before answering it. We asked around and we received stories of startups we know which were failing or about to. They cannot raise and are soon running out of cash in these difficult times. This was not a strong signal that we could ignore. Backed by our experience in that matter, we went deep into that distressed rabbit hole. These are no fun times for anyone.
On a more positive note. On the way up from that hole, we discovered Poxi Page and GetValidation. Both are just WOW products and there is a market fit there! We continue to keep faith about great people building great products in all corners of the world.
