Preparing for the Downturn: A Playbook for Emerging Fund Managers
Originally published by RAISE, June 11,2022
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:
- Tier One: If the company is growing greater than 100% a year, with solid unit economics, they have hundreds of millions in the bank, and a great management team, they will do just fine. Don’t worry about them.
- Tier Two: These are companies that look like they might have a business, but it’s not proven out yet. There are still significant risks and questions. And you have a big ownership stake that represents a large portion of your unrealized NAV. You need to ensure that they can raise money in the next 2–3 years.
- Tier Three: These are companies that have not hit their plans, have incomplete management teams, and still haven’t figured out their business model. They will need to raise capital in the next two years and will also absorb an inordinate amount of energy and attention that you can’t afford, especially if your ownership stake is small.
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:
- Get involved: Treat your Tier Two companies’ fundraising like it’s your own. When faced with a terrible term sheet, it’s up to you to create a better option for your portfolio company. You can form an access fund with your LPs to participate in down rounds and pay-to-plays. Don’t charge fees and carry. As an industry, we have created thousands of SPVs to increase our exposure to our best companies. We have all played offense with SPVs. Now it is time to play defense.
- Get a mentor: There are experienced venture capitalists out there who lived through 2000–2002 and 2008–2010. You need one now to be your friend. They have been through these events before and can coach you through tough situations.
- Independent board members: They are required to represent all the shareholders who are not the major VCs.
- Corporate governance law: The Board has a fiduciary responsibility to all shareholders, not just the big VCs.
- Reputation: VCs hate to look bad publicly. That is a source of power for small shareholders. Call out bad behavior. Use the press if you absolutely have to.
- Blocking rights: If enough small shareholders band together to control a share class that has to approve new rounds, they may be able to block dilutive financings, if they have the votes. If a big investor wants to try to sell a company, even common shareholders can block it if more than 50% of common shareholders vote against a deal. We have seen this happen! Refuse to approve new share issuances to stop transactions or extract concessions.
- Time: This downturn will be rough for the next 2–3 years. Focus on helping all your companies get through this time without getting your positions crushed.
Disclaimer The Tipping Point Series, including Featured at RAISE articles, (“Tipping Point”) is a collection of interviews with fund managers who (a) have previously raised a venture capital fund and (b) are providing advice and insights into the formation and management of venture capital funds (the “Presentations”). Tipping Point is not an offer to sell or a solicitation of an offer to buy any security issued by any venture capital fund, including without limitation, any venture capital fund managed by Tipping Point’s speakers, presenters, or producers. The Presentations do not (a) provide investment advice with respect to any security or (b) make any claim as to the past, current, or future performance of any security or venture capital fund, and Tipping Point expressly disclaims the use of the Presentations for such purposes. The Presentations are not intended to constitute legal, tax, accounting, or other advice or an investment recommendation. Prospective fund managers should consult their own advisors about such matters with regard to their venture capital funds. Raising a venture capital fund involves significant risk of loss of income and capital, including loss of the full amount raised and invested, which may occur as a result of identified or unidentified risks. Tipping Point is produced by Raise Conferences, LLC (“Raise”). Raise is a private invite-only venture capital conference, which provides a forum for venture capital funds to network with and present to potential venture capital investors. Although Raise produces Tipping Point, the Presentations are independent of Raise’s conference and do not provide any forum for the Tipping Point speakers, presenters, or producers to solicit the sale of any securities.
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.
Watch for our next article on strategies for managing the business side of a venture capital firm during a downturn coming soon.