Market clearing prices have moved a long way -- and fast. If you try to fight for last year’s terms, you risk disaster.
Here is a composite of several early 2016 board meetings of startups that need to raise money. The management team often talks about expected valuation for the financing: “Last year we would have gotten a valuation of over $100 million, and of course the market has come down some, but we still think $85 million is a fair value, because we’ve made great progress in the business”. They usually have made great progress.
Markets have moods, much like the people that drive them, and moods can change quickly. Last year’s mood was exuberance, however strained towards the end. This year’s mood is caution and regret for the excesses of the last few years. A potential new investor told one company: “We’re going to be really tough on valuations this year, because we overpaid in the recent past ...” [And now they need to make up for it and think they have the market power to do so.] When moods change, market prices can change suddenly and discontinuously.
But asset owners’ mind-sets often change slower. You can see this in the residential housing market: when prices drop, people hold out for the price they thought their house was worth [the house has not changed], the house stays on the market for a long time, buyers begin to think there must be something wrong with the house, and this goes on until the owner’s mind-set adjusts to a much lower value, or s/he is forced to sell by circumstances.
My partner Scott taught me the phrase “don’t try to catch a falling knife.” What he meant is: when a market starts to correct downwards, don’t fight it. The correction will happen and find a new equilibrium, most buyers will stay on the sidelines until they see where the market settles, and sellers who adjust to the new reality will find buyers first.
Recently, I’ve seen several ambitious campaigns to raise a new, outside-led rounds of financing turn into a small, inside, pass-the-hat rounds because a company [or its bankers, often] communicated price expectations that were too high, buyers stayed away because they had better prospects elsewhere and no desire to wrangle the price, the company became “shopped”, and it had to pull back and hit new milestones before it could go to market again. This danger is doubly acute in a down market.
And I have seen a new kind of “toxic term sheet”. Some investors will offer a valuation that is not far off the 2015 valuations. But the deal is loaded with terms like 2 to 3 times liquidation preference and strong investor control; these terms hollow out the valuation and create mis-aligned interests that can cause big trouble in the future.
There's a subtle risk that the company will pay lip service to these issues but fail to change its price signals and spending plans enough. I'm seeing a lot of companies get this wrong. They are fighting the market, and too many will get speared by the falling knife.
Accept that the market has changed quickly. Adjust to the new reality of lower prices and smaller financings, which will of course be painful. Make a deal with the right investment partner for the right reason. And move ahead.
