Silicon Valley start-ups race for debt deals in funding crunch

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Tech start-ups that have traditionally relied on deep-pocketed Silicon Valley investors to fund ambitious growth plans are being forced into alternative financing deals to sustain their businesses and avoid drastic cuts in valuation.

A sharp decline in venture capital (VC) dealmaking, alongside a closed market for initial public offerings (IPOs), has resulted in a funding crunch for many private technology companies over the past year.

Leading start-ups have been cutting costs aggressively, creating a wave of layoffs across the tech sector. Still, a growing number of companies are running out of cash and are seeking more creative funding arrangements, according to interviews with VCs, entrepreneurs, pension funds and bankers.

Company founders have entered into debt-focused deals such as bridge loans, structured equity, convertible notes, participating bonds and generous liquidation preferences. These moves are designed to avoid a dreaded “down round” – accepting funding at a far lower valuation than a company had previously secured.

“Everyone is taking corrective action,” says one investor in Sand Hill Road, the Californian thoroughfare that’s home to many of Silicon Valley’s top VC groups from Sequoia Capital to Andreessen Horowitz.

As the market rout looks set to continue into next year, this person said that even founders of well-capitalized tech groups have had to ask: “What are the adjustments [we need] so we can live longer? How can we punt financing from next year into 2024?”

Among the largest debt deals this year is Arctic Wolf Networks, a cybersecurity company valued at US$4.3-billion and backed by Owl Rock Capital Corp., which raised a US$400-million convertible note in October – twice as much as its largest equity financing.

SoftBank Capital-backed delivery app Gopuff raised a US$1-billion convertible note in March and has explored plans to borrow more since then despite raising more than US$2-billion last year, which had boosted its valuation to US$15-billion by mid-2021.

These deals come with a conversion premium, which allows their backers to convert shares at a higher price than an eventual IPO. Such deals represent a bet that the company will trade higher after going public.

Convertibles “kick the can down the road,” says Chris Evdaimon, a private companies investor at Baillie Gifford. “They are mostly being led by existing investors who are saying we also don’t want to get into this unpleasant valuation discussion right now.”

Coatue Management LLC and Viking Global Investors, which were both traditionally focused on public equity, started raising funds to invest specifically in structured equity deals with start-ups earlier this year.

Coatue is targeting US$2-billion for its fund. “For a private company to suddenly mark things down by 75 or 80 per cent ... it’s a huge risk,” the firm’s founder Philippe Laffont tells the Financial Times. “We can give you an alternative ... capital that gives you more time to build your business.”

Such large debt deals have been relatively uncommon for tech start-ups, the best of which have been able to tap the huge amounts of funding from venture capitalists, which have been willing to fund young companies even at frothy valuations over the past decade.

However, new VC deals fell 42 per cent in the first 11 months of this year to US$286-billion compared with the same period last year, according to investment data company Preqin. Silicon Valley law firm Cooley LLP says the total value of late-stage VC deals it advised on had slumped almost 80 per cent this year.

That trend has been driven by a rout in technology stocks, an uncertain macroeconomic environment and rising interest rates. Meanwhile, IPOs have dropped to their lowest level since 2009, cutting off a key source of fundraising for mature private companies and their backers.

“Next year is when it all comes home to roost,” says Ravi Viswanathan, founder of Burlingame, Calif.-based NewView Capital. “There will come a point where even companies with 18 to 24 months’ capital have to raise. There’s going to be a lot of pain.”

Up and down Sand Hill Road, VC funds have reviewed their portfolios and warned founders to assume that capital markets may be shut for another year and to shift their strategies from growth to survival.

The companies that are most struggling to raise new funding are unprofitable groups in capital-intensive sectors like battery making or robotics.

“We have just come off a borderline insanity environment,” says an institutional tech investor. “If you had raised an outstanding amount at an undeserving valuation, you felt you had done very well as a founder or a management team. Now, it is coming back to bite you.”

Hunting for creative financing options to protect a company’s valuation is an “old playbook,” says an investment manager at a large pension fund that invests heavily in tech. “But it’s been a long time since the sums have been this big and it’s affecting everyone.”

Some companies are persuading existing investors to put up more capital at the same valuation as their previous fundraising – known as a “sideways round” – but with underlying economic terms that are far less favourable to the company.

Where companies are getting desperate, “dirty” term sheets – deals that on their face accept a company’s existing valuation, but have conditions that could prove more beneficial to new investors – are circulating, says one investment banker.

“Investors are saying we will buy at the same price, but we want seniority and to be at the top of the stack in case of liquidity,” says Kroll Inc.’s Silicon Valley leader Glen Kernick, adding that he had seen a number of deals signed which provide for investors to make two times their investment before other shareholders in the event of a sale or bankruptcy.

Tonal Systems, which develops smart fitness devices, reached such a funding deal earlier this year, according to corporate filings that were first reported by the Wall Street Journal.

This structure can prove brutal for shareholders further down the seniority ladder – such as employees holding stock options – if a company’s value were to fall. It’s a trade-off between accepting a hit to valuation or accepting punishing terms that risk creating conflicts in a company’s shareholder base, or even wiping out employee value.

Some companies are repricing their own equity to improve the upside potential for employees’ shares. Delivery app Instacart cut its internal valuation for a third time to US$13-billion in October, down from US$39-billion in 2021. Similarly, Checkout.com, Europe’s most valuable tech start-up, slashed its internal valuation to about US$11-billion after it raised a US$40-billion valuation in January.

Slashing internal valuation – which is separate from the investor-determined price of a group’s preferred equity – benefits staff by reducing the cost of their company shares. This gives employees scope for further gains in the case of future deals such as an IPO.

“We are telling our portfolio companies you shouldn’t get overly anchored on a valuation you had a couple of years ago when the market was abnormally inflated,” says the investment manager on Sand Hill Road. “It is best to take your medicine now.”

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