Preparing for a Downturn: A Playbook for Emerging Fund Managers
By Ben Black, John-Austin Saviano, and Joanna Drake
Pretty much everyone is worried that we are entering a massive downturn, and in recent weeks, we’ve seen VCs deliver a litany of advice to their portfolio companies on how to adapt and survive. We thought that our emerging VCs would appreciate some advice as well, especially since many new managers may have never lived through a big downturn.
Things can get ugly. It's time to get prepared and make some tough decisions about your portfolio.
We have a lot of experience to share here, so we’ve split this into multiple articles. In this first article, we’ll give some suggestions on how downturns may impact portfolios and steps VCs can take now to weather the storm. In our next article, we’ll look at strategies for managing the business side of a venture capital firm during a downturn.
We’ll also be talking about how to deal with downturns at the 2022 RAISE Global Summit on October 20th in San Francisco. Please click here to apply for an invitation.
So, what should emerging managers expect as venture capital contracts?
Companies will likely experience a sea change as the investor community divides itself between investors that have large capital reserves and those that do not. In downturns, these two groups of investors can have divergent interests. As a result, significant conflict can occur between shareholders. Down rounds will occur, and sometimes such a round is not a big deal for small shareholders. Sometimes, however, these rounds are designed to crush investors who do not have the capital to protect their positions.
Which brings us to the dreaded “pay-to-play” - a new round of preferred financing that includes a term that says, in sum, “any investor that does not pony up their pro-rata gets converted to common shares.” Sometimes, these terms are appropriate. If five large funds are in a company, and two want to keep supporting the company and three do not, implementing a “pay-to-play” means that the three slackers don’t get a free ride on the backs of other investors. This term can be fair, appropriate and effective.
For investors that don’t have reserves, but don’t want to get crushed, this term is about the worst you will see. Those investors who don’t participate lose all preferred rights and information rights, get massively diluted, and most importantly, their liquidation preference goes away. Then the company can be sold for less than the preference stack. The big funds will make money, or at least return capital, and the small shareholders will get nothing.
What should you do now?
If you wait until a portfolio company is facing a terrible term sheet, it will be too late. Here are some concrete steps for you to consider:
If an emerging VC doesn’t have sufficient reserves to protect their ownership in their Tier Two Companies, there are a number of ideas about how to fight back:
Again, we’ll be talking about how to deal with downturns at the 2022 RAISE Global Summit on October 20th in San Francisco. Please click here to apply for an invitation.
We are also considering hosting an event open to anyone and everyone in December or January - whether you attend RAISE this year or not - that would go into great detail about how to manage portfolios in tough times. We would like to know if such an event would be of interest to you. Please email email@example.com if you are interested in such an event.
Read our next article on strategies for managing the business side of a venture capital firm during a downturn.
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