Rather Than Mark Valuations With 75-80% ‘Down Rounds’, Startups Buy Time With Convertible Debt

Rather Than Mark Valuations With 75-80% ‘Down Rounds’, Startups Buy Time With Convertible Debt

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As venture capital deals dry up and layoffs mount in Silicon Valley, some leading startups are going into debt to cover costs and avoid a dreaded “down round” — a new funding round that would likely come with a reduced valuation in a changing market environment.

Many private tech companies in the past year faced a funding crunch because of a decline in venture capital deals and a closed market for initial public offerings, Financial Times reported. A growing number are turning to more creative funding arrangements, according to interviews with venture capitalists, entrepreneurs, pension funds and bankers.

Some of the creative funding includes debt-focused deals such as bridge loans, structured equity, convertible notes, participating bonds and generous liquidation preferences. 

These financing alternatives give less favorable terms for founders and early investors, but they also can be used to create an appearance that the company’s valuation was unchanged or even higher, according to Pitchbook, a provider of data on private capital markets.

However, many companies will eventually exhaust those options and have no choice but to raise new capital, likely in a down round. Since valuations aren’t expected to return to their previous highs for a long time, startups that raise capital in 2023 are likely to do so at a lower valuation, according to Pitchbook.

Crunchbase, a provider of data on startups and tech, keeps track of the top 10 funding rounds each week in the U.S. In one week in December, two of the top four rounds were large down rounds and a third came with “restructuring” and layoff news. “Not exactly what you expect when startups raise large rounds, but these are strange times indeed,” Chris Metinko wrote for Crunchbase.

Large debt deals have been relatively uncommon for tech startups. The top companies have been able to tap vast sources of funding from venture capitalists willing to fund young companies even at frothy valuations, where asset prices are notably detached from their true intrinsic value.

New venture capital deals were down 42 percent in 2022 through November to $286 billion compared to the same period last year, according to investment data company Preqin. Silicon Valley law firm Cooley said the total value of late-stage VC deals it advised on was down almost 80 percent this year.

“For a private company to suddenly mark things down by 75 or 80 percent . . . it’s a huge risk,” said Philippe Laffont, founder of Coatue Management, in an FT interview. Traditionally focused on public equity, Coatue started raising funds to invest specifically in structured equity deals with startups earlier in 2022. “We can give you an alternative . . . Capital that gives you more time to build your business.”

To avoid a down round, “Everyone is taking corrective action,” a Silicon Valley investor told FT. Even founders of well-capitalized tech groups are asking, “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 of 2022 is cyber security company Arctic Wolf, which is valued at $4.3 billion and backed by Owl Rock Capital with a $400 million convertible note in October — twice as much as its largest equity financing, FT reported.

Delivery app GoPuff, backed by SoftBank, raised a $1 billion convertible note in March and is looking into borrowing, despite raising more than $2 billion in 2021 which boosted its valuation to $15 billion by mid-2021.

Despite market turmoil and falling valuations, 174 U.S. companies became unicorns in 2022 by raising money at a valuation of at least $1 billion. That means 2022, while down from the record year in 2021, is on track to be one of the biggest years ever for new unicorns.

READ MORE: The Down-Rounding Of Venture Capital And Speculative Private Tech Bubble: 5 Things To Know About ‘Valuation Spook’ Being Over