In a tougher venture financing environment, climate tech startups may need to consider strategies for averting a down round (a financing in which the pre-money valuation drops below the post-money valuation from the last round). This article – part one of a series – reviews current market trends and various strategies to avoid a down round. Part 2 of our series addresses how market conditions impact deal terms and Part 3 discusses how to manage an unavoidable down round.
Venture markets continue to face headwinds in 2024. Overall American venture capital deal value fell 29.6% in 2023, and those companies that have been able to secure VC investment are often doing so at less favorable terms than prior years – PitchBook noted that 44% of the priced financings in their 2023 data were flat or down rounds. While climate tech has been a modest bright spot in a struggling venture capital market, the sector is not immune to prevailing market stressors. While climate tech deal value fell by a smaller percentage than the overall market, it still declined by 14.5% in 2023, according to PitchBook’s March 2024 Analyst Note on VC Investment in Climate Tech. Sightline VC’s January 2024 Climate Tech Investment Trends 2023 report highlighted some of the challenges that climate tech companies are continuing to face in 2024, including a contraction in overall investment amounts and declining graduation rates, as fewer companies progress from early-stage seed financing rounds to Series B or higher growth rounds.
Venture-backed climate tech startups that are planning to fundraise in the near term will need to be strategic to survive and thrive in challenging market conditions. One key tactic for avoiding a disheartening down round is to explore alternatives that enable the company to either lock in its current valuation or defer a new valuation until a later date, such as:
Bridge round. One common choice is to hold a modest bridge round. A bridge financing typically involves a small raise from a combination of existing and new investors through the sale of an unpriced equity instrument, such as a convertible note or SAFE, that converts into preferred stock in the company’s next preferred stock financing round, usually at a discount. The goal would be to give the company enough cash runway to delay its next priced round until it is able to command a higher valuation. Sightline VC noted that in 2023, a “higher proportion of ventures are raising bridge rounds from existing investors to extend runway and avoid re-pricing,” an indication that this strategy is a popular choice for those companies that can swing it. Of course, whether this option is viable will depend on the company’s financial position, how amenable its existing investors are, and what the terms of prior financing rounds require in terms of investor consent and participation rights.
Flat extension round. A similar strategy would be to reopen a prior financing round – for example, by doing a Series A extension round on the same terms and at the same price as the initial Series A financing, rather than undertaking a new Series B financing. A flat extension round of this sort would typically involve the participation of some number of existing investors, although new investors could join in as well. At a minimum, the company will need the support of a sizable share of its existing investors – even if not their financial commitment – because investor consent will almost certainly be required to amend the existing financing documents and issue more shares of the given series of preferred stock. Additionally, the investors may have participation rights under the terms of the prior financing that the company will need to either comply with or negotiate to have waived. It will be important to engage legal counsel early in the process to make sure the company is aware of the applicable requirements and has a strategy for dealing with them effectively. However, this approach can ultimately deliver some degree of cost efficiency compared to a full-scale financing, as it is generally a lighter lift to amend the company’s existing financing agreements than it is to draft and negotiate a new set of documents.
Non-dilutive financing. Another option is to seek sources of non-dilutive financing, such as traditional commercial loans, venture debt, or grants from government or private sources. Of course, not all startups will qualify for these options, and the current interest rate environment can make borrowing a tricky financial choice. There may be additional options for companies willing to look off the beaten path – for instance, nonprofits with an impact investment portfolio may be open to making recoverable grants or low-interest loans to for-profit companies with a business objective that aligns with their charitable mission.
FURTHER INFORMATION
For further information about these matters, please contact Samantha Rothberg at srothberg@klavenslawgroup.com or 617-502-6286, Frans Wethly at fwethly@klavenslawgroup.com or 617-502-6285, or Jonathan Klavens at jklavens@klavenslawgroup.com or 617-502-6281.
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