Navigating Capital Raises in Turbulent Markets
Capital is the life blood of a growing software company. Taking a strategic approach to capital formation is as critical as sales, product development or talent acquisition/development. Today, growth-stage SaaS businesses need to adapt a proactive and intentional planning process to successfully navigate the currently challenging capital markets.
They need to make it a core competency.
The Capital Market Cycle isn’t New, and Neither is Planning
While the recent correction in valuations has been jarring for entrepreneurs, these cycles in the market are historically common. The post dot-com period of 2001-2003 comes to mind, as both hardware and (pre-cloud) software companies struggled to find sufficient capital to survive. The period after the Great Financial Crisis created a similar environment. One way to think about it is that the market is just reverting back to the mean. Raising capital for a growing software concern has always been hard, the buoyant 2021-2022 period aside. Those companies that developed a robust process survived and ultimately thrived as market conditions improved. The process requires discipline, a planning mentality, and prioritization of capital raising as a strategic imperative.
The elements of a successful approach to the capital raising process should include the following:
Routinely Track the Metrics That Matter
Most SaaS companies, particularly those with institutional investors on their boards, are tracking key metrics such as ARR, retention, CAC, ARPU and ACV. Efficient growth and path to profitability have become a priority for investors and lenders in the SaaS space. Progress towards the Rule of 40 (revenue growth rate + EBITDA margin > 40%) and the SaaS “Magic Number” (revenue growth for every dollar spent on sales and marketing) are metrics currently gaining more attention. If your company is burning cash, calculate your remaining months of liquidity (RML) and/or Zero Cash Date. Understand that if you don’t have the liquidity calculations down cold, investors and lenders will be calculating them for you. A detailed monthly dashboard containing these key metrics to share with both internal stakeholders and potential new investors and lenders has become table stakes.
Solving for “X” – Projections are Critical
Understanding how much capital is required to finance your company’s goals is paramount, particularly in the current environment. Raising too much may seem like a high-class problem, but it has the potential to create unnecessary dilution and/or over-leverage the balance sheet in the case of debt. The problem of raising an insufficient amount is self-evident. The best approach to define the optimal amount is to build a detailed projection model. These models should go out 2-3 years, with the first 12 months available on a monthly basis and the remainder quarterly. Build the models on a GAAP three statement basis – income statement, balance sheet and cash flow statement. Investors and particularly lenders are going to want to see this format, so you might as well get started now. Detail the key assumptions with particular focus on tying the revenue forecast to the current pipeline – “hockey stick” top line forecasts without justification will be met with skepticism.
Once a base case model is built, scenario planning is a powerful tool. Analyzing an accelerated growth cash (taking on more capital to expand product capabilities, add sales staff or to make an acquisition) can define the maximum amount of capital needed. Plus, it can justify the requested use of proceeds to investors and lenders. Alternatively, a downside case can define the minimum liquidity requirements as well as assess debt covenant levels if applicable. Scenario planning can help set the upper and lower bounds to the required capital for management to consider.
Many entrepreneurs push back on long term forecasting, arguing that their market is too dynamic to accurately project out multiple years. It is a fair point; however, the perfect should not preempt the good. Make reasonable assumptions, display them clearly and be prepared to justify them. Develop the practice of re-forecasting at least semi-annually to account for changing business conditions (good and bad). Capital raising processes take time, and sharing stale forecasts can be very damaging.
Understand Your Cap Table
As companies grow and take in multiple rounds of capital, the cap table will become more complex. Instruments from seed equity, convertible debt, Series A (and beyond), and venture debt will have varying terms regarding ownership. Warrants, dividends and preferences will differ by investor and can change the fully diluted ownership. Management must understand the potential dilution to existing investors but also the impact on an employee equity pool. Waterfall models are an excellent tool to understand the current fully diluted ownership, but also to game out the impact of a new financing. These models are readily available from a variety of sources (including Carta), and will allow management to articulate the pro forma impacts to all stakeholders and drive alignment behind a particular financing strategy.
Consider All of Your Options
There is no one-size-fits-all when it comes to the appropriate capital structure. Companies at different stages and with different performance characteristics will face different options. Insider rounds that are structured as convertible notes are fairly common at present to avoid a pricing conversation, but there is no free lunch with equity these days. Venture debt has been in focus as it offers the least dilutive option on the table. However, lenders have to be repaid and terms (pricing, amortization, and covenants) can be restrictive. The point is to be flexible and consider all options available. Often a blend of equity and debt can be compelling for growth stage companies. The work done modeling as described above can define the trade-offs and help to arrive at the optimal capital structure.
Be Proactive
A successful entrepreneur once told me that he was “always fund raising.” That may seem fanciful given the long list of priorities facing a management team. However, there is truth to this notion as waiting until a few months before needing capital to launch a process can be disastrous. Dialogue with investors who may be interested in your company (stage, space, prior experience with CEO + team) can never happen early enough. Investors like to follow companies over time before issuing a term sheet in order to assess your space, to see achievement of milestones, and to gauge performance of your management team. Take the same approach with lenders. If you are not currently working with a tech-focused bank, consider moving your depository relationship to one of the established tech banks and even consider establishing a small line of credit. Having an existing relationship (and potentially going through an underwriting process) with a lender can improve the odds of success in a larger financing as well as accelerating the process when timing is critical (acquisition financing for example). Investment bankers are are also great to know. They are excellent sources of market intelligence, and they know both capital providers and potential buyers of your business. It is never too early to cultivate these relationships.
And About That Down Round
There is a stigma associated with “taking a down round.” No one wants to have disappointed investors, concerned employees (with underwater stock options), and the potential bad publicity. And the current math is terrible – valuations for growing SaaS businesses are down 50-60%+ from the heights of 2021-2022. However, valuations are fluid and only a snapshot in time. External factors (macroeconomic, regulatory, sector) can rapidly change multiples, plus transformative growth can radically change the future perception of your company with investors and potential buyers. There are numerous examples of companies that suffered a down round and went on to substantially increase value either in a future financing or a sale. It is difficult to consider, but the long-term view must be taken, and a down round may be a necessary to provide the capital required. Understanding the impact of the dilution on the company and its stakeholders, while considering all options (such as debt when appropriate) via a thorough planning process, can minimize the damage and position your company for future success.
“Plans are nothing, but planning is everything.”
Dwight D. Eisenhower
A successful capital raise, particularly in a challenging capital market, can turn a critical inflection point into a breakthrough. SaaS companies that have turned the capital raising process into a core competency can succeed in any environment. Experienced CEOs, CFOs and board members can lead successful processes; however, companies can also turn to trusted external advisors to leverage their team as needed.
Alan Spurgin, Partner