The recent turmoil in the global stock markets has caused me (and others apparently) to reflect on the potential adverse impact on seed, angel, and venture capital financing.
Since a startup entrepreneur should be most focused on building a great business, I’m going to condense two decades (translation: 20 years) of stock market experience into my CliffsNotes® version to educate readers, especially startup entrepreneurs, ways to navigate the volatility of the financial markets.
How Markets Work
- Companies raise money to pay for things in three ways:
- (1) operations, i.e. selling goods & services for more than it costs to provide those goods & services;
- (2) borrowing, i.e. taking loans (selling bonds which are sellings promises to pay more tomorrow for cash today); or
- (3) selling equity (selling a stake in the business with the hope that the stake can be sold at a later date at a higher price)
- Sometimes, holders of the above Item #2 (“bonds”) or Item #3 (“stocks”) want to transfer the item. Those holders access the financial markets to facilitate those transfers.
- The general rule is that you want to sell something for more than you paid for it. Unlike everyday necessities like food that “shouldn’t be” resold after use and thus are worth less than before they were used, stocks and bonds (also collectively known as securities) can gain value, i.e. appreciate, and lose value , i.e. depreciate over various times intervals. So back to the general rule, participants in financial markets are battling each other to buy stocks and bonds for lower prices than they can sell them. It’s that simple. Anyone telling you that it’s more complicated than that may be attempting to justify their compensation.
Why it matters to Startup Entrepreneurs & Other Growing Corporations
- Most startups are not able to pay the bills through operations so they must borrow cash (issue bonds) or sell equity (issue stock). Hopefully, the startup is able to cover its expenses after issuing bonds or stock until the startup is generating enough cash to pay the bills through operations. But often, a startup is testing out its business model which takes time -time that can get bought by raising more cash through additional issuances.
- The recipients of those issuances are typically also participants in the financial markets, who – back to the general rule – want to sell something for more than they paid for it. The likelihood of the recipient being able to sell a holding (bond or stock) for more than its cost is affected in large part by risk, defined by Merriam-Webster as the “possibility that something bad or unpleasant (such as an injury or a loss) will happen.” Investors, i.e. the buyers of startup bonds and stocks use various analytical tools to ascertain risk specific to a particular startup when deciding the likelihood of avoiding “something bad or unpleasant.”
- Investors normally find things that can be sold easier less risky than things that cannot be sold as easy. The relative ease of sale is referred to its liquidity. Therefore, investors tend to reduce risk by investing in more liquid securities. Since startups and emerging growth companies tend to be “private” (i.e. there is no general market to which holders can sell the company’s bonds or stocks) their securities tend to be far less liquid than a company that is “public” (i.e. selling its bonds or stocks can be done whenever the financial markets are open).
- Many people, including startup entrepreneurs, neglect to consider the impact of market risk (possibility something bad or unpleasant happening to the overall markets) on an investor’s decision-making matrix. If market risk shifts dramatically, investors will refrain from buying bonds or stocks that they perceive to be more risky, which means:
- investors will likely avoid illiquid securities such as the bonds and stocks of startups and emerging growth companies; and
- startups will have a significantly harder time raising needed funds to run, let alone grow, their businesses.
What Should You Do Now?
- Consult attorneys and legal counsel to review all material agreements (e.g. vendor contracts, financing agreements) to find the key clauses that may be triggered by events such as missed payments or “down rounds” so that the company can effectively strategize to protect the business that you’ll toiled so hard to build.
- Review internal financials to look for ways to reduce the company’s cash burn rate.
- Consult with attorneys and consultants to develop alternative exit strategies beyond the standard initial public offering in the event the financial markets become severely depressed.