Predatory investors turn screws on startups

Rewind to 2021 – startups needed two oars and a sail to stay atop the lakes of capital they had available to them. As the feeding frenzy subsided and the market cooled over the course of last year, a scary prospect began to emerge: the down round.

The investment climate since roughly mid-2022 has been one that favours investors. A lot of companies that missed the gold rush, needing to raise in the past six to nine months, went into a hostile fundraising environment. The equity markets are tough, the debt markets – particularly on the back of Silicon Valley Bank’s collapse – are even tougher. So what do you do if you need to avoid the appearance of a reduction in the value of your company, but you still need capital? One option that has seen a large spike has been the use of convertible notes.

There are plenty of ways convertibles are used as a flexible financial instrument in the normal course of things, even during good times. Convertible notes are a form of short-term debt that converts into equity in the company. They can be a convenient bridge, or used at the beginning stages of a startup’s life when a valuation can’t yet be agreed on. Some investors also prefer them when starting out as they also tend to sit higher than equity on the liquidation list in case a startup goes belly up, derisking their entry into a startup. During a downturn, however, they are also an effective way to kick the can down.

Over the past six months, roughly speaking, there has been a steady increase in the use of convertibles or similar instruments that would give portfolio companies a bit more runway. Naturally, they have not tended to be nearly as big as regular equity rounds, with founders still holding out hope that macro conditions would improve, but they have come with risks, and have opened startups up to deeply unfavourable terms amidst a worsening negotiating position.

Strapped for cash

Things are much different today than they were at this point last year. Even in late 2022, when the use of convertibles were already on the rise, the terms were not too slanted away from them. In more recent months, anyone with less than 12 months of runway left, according to one CVC, is willing to take on worse terms – even predatory ones – to stretch out their cash through the first half of next year.

In some cases, founders have gone as far as almost doing the investors’ negotiating work for them, volunteering better terms straight out of the gate. “Normally you would get a typical 20% discount rate. Now, in this environment, when I ask what terms they envision, they say how about we do 25%-30% discounts,” says Lukasz Garbowski, investment director at Btomorrow Ventures. 

The maturities on the notes are getting longer, too. What may in the past have been around 18 months, or 24 at a push, are giving way to as far as 36 months, with more startups willing to discuss pushing them out further than that.

Founders are not blind to the fact that they may be harming their long-term prospects by accepting sub-par terms, but you can’t get to the long term without surviving in the short term.

“They do understand that they are potentially giving up too much and accepting terms that are not in the best interest of their long-term viability,” says Garbowksi 

“But one CEO told me: What else can I do? My board and shareholders will not accept a down round, and even if they were to accept it, there is not that much money floating around.”

Some corners of the market are panicking, with startups and VCs alike reverting to survival mode and working to stay afloat, while dilution is taking place across the board – a pill startups are just going to have to swallow. When choosing between dilution and not making payroll, founders will choose the former.

It’s not just the startups that are in panic mode, but the investors whose portfolios they make up. “I think it’s animal instincts. It’s fighting to survive. I don’t just mean the startup, I mean these new VCs that have created these portfolios at lofty valuations. They have to survive as well, they can’t let their portfolios evaporate overnight,” says Michael Mahan, managing director at Stanley Ventures, also noting that there will likely be a natural selection process over the next 18 months that will cull badly-managed startups. 

Taking advantage

When there is blood in the water, sharks will circle. Some investors are getting savvy to the fact that founders are in a weak negotiating position right now and they see an opportunity to squeeze additional value from these notes.

More often than not, it tends to be the new investors – who have to step in to fill out note offerings that insiders did not fully take up – that come in with the stronger demands, but that is not always the case.

If no existing investors are willing to put up cash, startups are left even more at the whims of newcomers and chancers, who cram everyone else down in a note offering and could inadvertently put the startup on worse footing when it comes time for their next round.

One CVC noted how he was at a meeting of shareholders for one portfolio company, where one investor seemed willing to propose taking a larger bite than they should have, floating some exorbitant pricing to see if the other investors would go for it. “Some of the investors tried to take advantage, and they would put forward really punitive interest rates, which in my personal view is wrong. You don’t invest in startups to get rich on the interest rate – 20-25% interest is kind of excessive.”

In this particular case, other investors killed the idea, but similar dynamics are emerging across the market, where interest rates are going up to 15% or more in many cases.

Companies have also had to cut their burn rate – sometimes by up to half –  to extend their runway, which has taken a toll on marketing budgets and headcounts. Under such circumstances, investors can easily make a rod for their own backs if they start asking for too much.

“I’ll be talking to investors and they tell me they’re getting some incredible terms because these companies are so desperate. And I’m thinking to myself, ‘That’s great for you today, but a year from now when that company needs to actually go and raise a real priced round, your note just made it way more difficult for you to do that,’” says Mahan.

“If we’re not careful how we go about our business this year in particular, we could have another rough year next year as a result of all these predatory terms we’re seeing.” 

There is a general feeling in corners of the market that too many new funds have popped up over the past two years and have been throwing their money around unwisely – and to startups that many believe not to have deserved the levels of funding they got – pumping up the valuations and almost inevitably leading to a bubble-type dynamic.

Ultimately, the underlying problem – beyond just the macro environment – may be one of perception.

“It would be really useful if the whole industry would somehow destigmatise down rounds,” says Garbowski.  “It’s almost like we’re living in an Instagram bubble where everything needs to be happy and positive. Life’s not like that, there are ups and downs, and as long as the trajectory is positive, it’s fine. That would really remove a lot of this bullshit.”