How to fundraise in an economic downturn

“We’re heading for an economic recession.”
“Startup valuations are getting slashed.”
“It’s harder to raise investment.”
You might have seen all of these claims – but what’s actually happening and why?

At SeedLegals, we do the legals for 1 in 6 of all UK early-stage funding rounds and we talk to hundreds of founders every month. Using our data, we can see what’s happening in the market. Here’s our view of what’s changing in startup investment and what you can do to maximise your chances of success.

Contents

• High interest rates change investor behaviour
• Startup valuations are going from bonkers back to normal
• Angel investors are likely to be more risk-averse
• VCs will push for a lower valuation
• Be ready for investment in an economic downturn
• Use agile funding
• Watch video
• Talk to an expert

High interest rates change investor behaviour

First let’s look at the bigger picture. Interest rates have risen which means the cost of capital for an investor has risen. When an investor was getting 0% interest on savings from the bank, they might make more speculative investments. Investors might look for opportunities to make a big investment and they might not be afraid to make riskier investments.

Let’s say interest rates rise to 8%: if investors are earning 8% interest on savings, or if they’re paying 8% interest on their mortgage, then they’re likely to prefer startups that have a higher probability of success.

Also it can take five to seven years to get a return after a funding round – effectively, that money is now costing investors. If it was in the bank instead, it could be earning 8%, but with their money tied up in a startup, investors are earning nothing on it.

With extra pressure on finances, multiplied by the risk of a startup not making it, investors now want startup valuations to be more modest.

Startup valuations are going from bonkers back to normal

For revenue-generating startups in the UK, your company valuation has usually been 6 to 15 times your revenue. (That’s the norm for SaaS businesses – it’s different if you’re a med-tech, making hardware, etc).

If your revenue growth is modest, you might achieve a 6x valuation. If your revenue growth is significant, maybe doubling or tripling year-on-year, then you could command a valuation of 15 times your annual revenue.

But in the USA in 2021, those multiples hit 100x – it was insane. Now, the multiples have come back down again to where they were before, possibly less: maybe 5x to 8x.

So what does this mean for you?

Angel investors are likely to be more risk-averse

If you’re a company looking for a few hundred thousand pounds from angel investors, your company valuation probably hasn’t changed. This is because very early-stage businesses were never valued based on the multiples of revenue – because you don’t yet have revenue. Instead, the valuation was based on future potential.

Usually, angels decide to invest if they like the founders and love what the company is doing, and – importantly – they get SEIS and EIS tax breaks. But angels are changing their investment criteria. If you have some discretionary spending money available, you’ll understand because you’ll probably be changing your own investment decisions.

There are different types of angel investor but all types are probably going to make investment decisions that are more risk-averse. They might have read that startup valuations are generally lower and try to push you for a lower valuation. But there’s not enough evidence for them to justify this – so if this is happening to you, you should push back.

If interest rates are going up and angel investors have mortgages or rent to pay, or there are stresses on their own businesses and salaries that fund their investments, then they’ll cut back on investing. If this happens, the UK startup ecosystem for early-stage investment will be stressed by a reduction in investment. We’re not seeing that yet – but it could happen.

VCs will push for a lower valuation

If you’re a scale-up talking to VCs, you might encounter pressure to lower your valuation. This means if you want to raise a certain amount, you have to either give away more equity, or you need to reduce the amount of investment you aim to raise so you don’t dilute too much.

But actually, if you’re a revenue-generating startup talking to UK VCs, we don’t think much has changed yet. Company valuations in the UK were always more conservative than in the USA – they still are but it’s possible that typical valuations are changing from 6 to 15x to 5 to 8x. If valuations do decrease, then you’ll need to work harder to justify your valuation, or hunt harder to find the right fund.

VCs might scale back investment on new opportunities – instead, they might invest in companies they already invest in, to make sure those companies don’t go out of business. It’s also possible that VCs might become more risk-averse and stick with what they know best – for example, an SaaS fintech with recurring revenue is probably still going to attract VCs who understand that sector, but niche businesses might struggle to find investment.

Be ready for investment in an economic downturn

Whether you’re looking for investment from angels or VCs, there are things you can do to be investment-ready and increase the likelihood that your business raises the money you need to reach the next step.

Have you focused your five-year business plan on raising in more difficult times? Adjusted your revenue projections? And adapted your product to take advantage of the current market? Great. Next, there are two more strategies you can use:

Reduce your burn rate

Watch your costs! It’s obvious but this is especially important if you’re not yet profitable. If you have a burn rate – losing money net each month – then take a close look at your runway. How many months do you have left before your funding runs out?

React rapidly now – make modest to moderate reductions in your burn rate to increase your available runway. Then, if you have difficulty raising investment or you can’t raise at the valuation you want (and therefore end up raising less), your company can continue.

As well as lengthening your runway, when you reduce your burn rate, you’ll also make your company more attractive to investors. They want to see that you won’t need to fundraise again soon after your current funding round.

In the world of investing, this is a fundamental change – before, investors didn’t care so much if you were burning through money at an incredible rate. You’re losing a fortune? That’s fine, you’re going to take over the world! That mentality has largely disappeared for now.

At SeedLegals, we’re hearing that this has been replaced by investors looking for companies that are cash flow positive or have low burn rates. It makes sense: if investors are in ‘survival mode’, they only invest in companies that will be in a better position to survive if things get tough. (I’m sure the ‘spend like crazy’ mentality will be back – these trends are cyclical – but we don’t yet know when.)

When you reduce your burn rate, it’s likely you’ll also reduce growth. Unless you only cut surplus spending that wasn’t generating revenue, when you spend less on development, marketing, sales and so on, your revenue will decrease. In the past, investors (particularly VCs) have been fixated on growth: if your company was achieving less than 2x or 3x year-on-year growth, you’d be less attractive to VCs regardless of your burn rate. Now, investors want to see that you’re watching the bottom line, even if you’re dropping to less than 2x year-on-year.

But what if your growth drops to dramatically less than 2x year-on-year? For many VCs that will be a problem. And that’s where agile funding comes in incredibly useful.

Use agile funding

If you were planning to do a funding round and you can’t raise the amount that you want at the valuation you want, you can opt to raise investment with a SeedFAST or Instant Investment:

Raise before a round with SeedFAST

SeedFAST is our name for an advance subscription agreement. It allows you to raise ahead of a future funding round, at a valuation to be determined later. A SeedFAST will convert at the valuation at your next funding round, minus a discount that you agree with your investor to incentivise them to come in now – usually 10 or 20%.

SeedFASTs are agreements with individual investors – this makes them incredibly speedy because you don’t need to round up several investors.

Do you think your low company valuation is a temporary blip? Or will you increase your valuation because you’ll use the investment to get your product launched? If you think you’ll be able to raise your next funding round at a higher valuation than you can achieve now, then SeedFASTs are a sensible way to raise.

You and your investor(s) can sign the agreement online – one customer tweeted recently to say they’d signed a £250,000 SeedFAST from their sunbed in Tuscany! Traditionally, fundraising slows down in summer, but with SeedFASTs, there’s no need to wait until autumn.

Top up a round with Instant Investment

While SeedFAST works as bridge finance before your next round, you can top up after a round with Instant Investment. When you do a funding round on SeedLegals, you can make it easy to top up after your round by choosing a ‘rolling close’ round.

What is a rolling close? Let’s say you want to raise £500,000 but you could only find £300,000. Great, set the funding round as a rolling close and take the £300,000. Then, anytime within a time you specify (usually 12 months), you can raise up to your pre-agreed amount of money at the same or higher valuation than the funding round.

We designed the rolling close provisions to build in the approvals you need to issue shares to investors who join after your round. To issue shares, you always need shareholder approval and investor consent – but when you do a rolling close round on SeedLegals, in one click you can build in those approvals now.

Even if your last round wasn’t on SeedLegals or you didn’t enable Instant Investment provisions, or you’ve gone over your Instant Investment timeframe, you can still use Instant Investment to top up – on SeedLegals, go to Raise, select Instant Investment and choose the options to quickly generate the additional documents you need.

Watch video: How to fundraise in 2022

Are valuations down? Are investors dropping out? SeedLegals co-founder and CEO Anthony Rose explains what we’re seeing and hearing from the hundreds of startups we work with every month, and how to tune your plans to preserve cash and increase your investability.

Talk to an expert

Times are changing and many companies will need to adapt to survive. But there’s a whole ecosystem to support you. For example, could you claim R&D tax credits to extend your runway? Do you have SEIS/EIS Advance Assurance to make your company more attractive to investors? Are you using a sensible fundraising strategy?

At SeedLegals, we love to help you fundraise faster and better. We designed SeedFAST and Instant Investment to give you more ways to fundraise, and to help you get the money into your account faster. Our team helps hundreds of startups every month – to message us, hit the chat bubble. We’re online seven days a week.