Capital markets are all connected in some way. Whether we’re talking about discounting using interest rates, or the consequences of asset allocation, they all work together throughout economic cycles. Sometimes, movements and changes in valuation happen with astounding speed, and other times (like NOW) price changes seem to take forever. At the current moment, spreads between buyers and sellers are very wide.
Asset owners are loath to take a hit on their assets despite big changes in their financial modeling, and buyers are certainly not in a hurry to overpay for assets they believe they can have cheaper with a little bit of patience. That said, some companies, particularly those in venture capital, are expected to burn cash in their early days.
Because of cash burn and the associated risks, early investors usually get the best terms that any partner gets over the lifecycle of the company. That is of course unless economic conditions worsen at the same time that the company gets short on cash.
With credit conditions tightening, this is exactly where many small companies find themselves. Increased interest rates and tightening of lending standards at small banks have meant that some of these companies need to be super creative to ensure their short-term survival without taking super expensive equity capital from additional investors.
This situation is called a “down round”. What that means, is that a company raises capital at a lower valuation than their seed capital, thus diluting their earlier supporters heavily. Investors naturally hate this. So, many venture backed companies are taking other types of deals to prevent the down round…but that does not mean seed capital providers are happy about it.
Historically, seed or Series A investors protect against downticks in valuation with a clause that suggests that their terms are “pari passu” or on equal footing with future investors, but given the current market conditions, more predatory investors are asking for stacked preferences that give them something better. Unfortunately for the earliest investors, they often have to relent to the new terms to protect their investment… It’s ugly and uncomfortable.
But, with uncomfortable situations come innovation and growth of the venture debt and preferred equity markets where the original seed capital may not get their ownership diluted, but the capitalization table just got a whole lot less attractive. This turmoil has led to a ton of investor uncertainty and kept spreads wide. But there is also opportunity in this chaos and fortunes will be made.