MGCS Industry Insights – A Pullback by Venture Investors Poses Fundraising Challenges for Startup Companies

Shannon Beeman
April 7, 2016

Flat rounds are taking some of the fizz out of the funding bubble for startup companies. And like flat beer and flat tires, entrepreneurs are finding deflated investor enthusiasm─ and the inability to raise follow-on funding at ever higher valuations ─ an unwelcome change from last year’s unbridled investment exuberance.

David Brophy, Zell Lurie Institute University of Michigan RossThe biggest concern among venture investors right now is exits, says David Brophy, professor of finance and director of the University of Michigan Center for Venture Capital and Private Equity Finance, or CVP. “When investors see the unicorns (startups with private valuations exceeding $1 billion) going public at prices below their last private investment pre-money value, they become cautious about raising the bid on the next funding round or the bridge financing they are putting into their existing portfolio companies,” he explains. “Investors also are a little more skittish now about putting new money into startups [that are not yet part of their portfolios].”

Economic weakness abroad, a strong U.S. dollar and a global flight to safety have pushed investors away from risky bets on equity and into the debt market. “Venture funds and institutional investors are much more enthusiastic about putting their money into private debt than into the equity of new ventures and young companies,” Brophy observes. “The federal regulatory clamp-down on banks has curtailed long-term senior lending, so companies looking to finance acquisitions are turning to private pools of capital offered by venture funds and limited partnerships. In return, these debt investors are receiving a revenue stream from promissory notes, which may be convertible or have warrants that give them debt with equity.”

The upshot, Brophy says, is that in today’s financial market, venture investors with cash are king (or queen), and have the upper hand in negotiating good terms and favorable pricing with entrepreneurial companies seeking to raise growth capital. “The only way a young company can succeed in this environment is to have something really special,” he remarks. “This includes a really good team and a really good value proposition. Not every company has that.”

Brophy offers this advice to entrepreneurs who are trying to weather the current turbulence:

  • Focus on ways to add value to your company by identifying new uses for products and intellectual property, modifying and improving existing technologies, entering new markets and cultivating deeper sales relationships.
  • Redouble your efforts to provide better, cheaper or more effective products and services to your customers and outshine the competition.
  • Take advantage of market weakness to steal market share from other companies that are failing or closing up shop.
  • Increase your free cash flow and manage your working capital.

At the moment, there is no way to cure the bad spirits out in the marketplace,” Brophy cautions. “The big thing is to survive.”

Venture investors also must make tough decisions amid the current market downturn. “As an investor, you have to do triage all the time, and help your portfolio companies get through the tough times,” Brophy advises. “You have an audience of entrepreneurs and limited partners watching you, and your success in pursuing future opportunities will be conditioned on how well you handle your portfolio now. If you demonstrate you can turn bad times to your advantage by finding a new deal and negotiating good terms, then your institutional investors will love you.”

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About the Michigan Growth Capital Symposium (MGCS)

MGCS is the original university-based venture fair, which was first held in 1979. This nationally attended two-day event provides an opportunity for investors to connect with up-and-coming Midwest businesses and learn about emerging technologies. The Symposium offers the opportunity to build relationships with an unparalleled business network of distinguished private equity industry leaders, leading university research faculty, and entrepreneurial business professionals. MGCS is presented by the Center for Venture Capital & Private Equity Finance at the University of Michigan Ross School of Business with support from the Michigan Venture Capital Association.