Preparing for a Downturn: A Playbook for Emerging Fund Managers

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:

1. Triage your portfolio into three buckets.

• 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.

2. Until this downturn is over, focus your efforts on your Tier Two companies.
   
   ‍Your next two years should be all about protecting your ownership in your Tier Two companies and helping them succeed without getting massively diluted. Making these companies better on the capital they have is your best line of defense, of course. One investment might be the difference between success and failure for a fund manager. Increase your reserves now for these companies.

3. Be honest and proactive with your Tier Three companies.
   
   ‍As difficult and emotional as it may be to admit it, many of your Tier Three companies will be very hard to save without substantial effort. Have a candid conversation with the Founders immediately about the existential threat and proactive steps they should be taking now, such as immediate exploration of combinations with better funded competitors or strategics, or how to proactively wind down and return remaining capital.
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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:

1. Get connected: Get to know your fellow shareholders that you can work with that are aligned with you. Figure out which shareholders might be the ones with lots of capital who may try to crush you. Get to know the independent board members if you aren’t on the board.

2. Get informed: Make sure you know how to do your own liquidation waterfalls. Don’t rely on Carta. Be able to model new proposed financings yourself in Excel by hand. Otherwise, you won’t understand how a new round of financing impacts you. Also, it's time to read all those investor rights agreements and cap tables. Read them closely.   The details are going to matter. Share information with all the shareholders that are small like you so that you can all know what is happening inside the company and the board. Know what is going on before it's too late.

3. Find an outside corporate litigator: You may think that your fancy fund lawyer at a big traditional venture law firm is going to help you when you are in the middle of a board battle. Think again. They are not the best option. You don’t want to bring a butter knife to a knife fight. Find a litigator with experience with board battles who is not at a big traditional VC fund law firm. While big corporate firms are awesome at many things, representing small shareholders against BIG VC runs counter to their core business.

4. Understand your sources of power:

• 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.

5. 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.
   
   
6. 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.

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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 ben@akkadian.vc if you are interested in such an event.

Read our next article on strategies for managing the business side of a venture capital firm during a downturn.

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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.

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