Reality bites for private company funding

You always need a tough constitution for angel investing and crowdfunding. But in 2022 private company funding and valuation is more painful than ever.

As an investor in a portfolio of unlisted startups, you must hope you’ve backed a few big winners to make it worthwhile – because many of your other investments will sour.

In fact, plenty of firms you back will end up worth approximately nothing.

And things can go that way very quickly.

This is true of all venture capital (VC) investing. But it’s especially true for us private investors looking for winners in the heavily land-mined arena of crowdfunding.

Despite the fluffy promotion about missions to change the world and all the rest of it, adverse selection looms large.

Put simply, if company founders come to us for crowdfunding, they’ve often already discovered that nobody who does this for a living will give them any money.

Doesn’t exactly inspire confidence, does it?

Everyone up to their necks in denial

At least in a year like 2022 those professional VCs are taking it on the chin, too.

Private company funding and valuations have collapsed, whether or not founders and investors are admitting it.

The Financial Times recently wrote that:

The venture capital world is in the grip of a silent crash.

Unlike the stock market, there are no daily market indices to broadcast the pain, and no individual share prices for anxious tech employees to watch as their personal wealth evaporates.

In fact, for many of the investors and entrepreneurs who have just lived through a historic boom in venture investing, it is even possible to pretend a crash isn’t happening at all. Loose rules that require only sporadic writedowns, the estimated value of private companies, have made it easy for many to turn the other way.

Josh Wolfe, co-founder of Lux Capital, likens the response to “the classic five stages of grief”. “We’re probably somewhere between anger and bargaining,” he says, referring to the emotions that follow denial.

Yet investors and company founders, Wolfe adds, are still resisting the full implications of a market downturn that will have a profound effect on the start-up economy.

Financial Times, 1 August 2022

Many money-losing firms may already be dead men walking.

Some should be properly valued at zero.

Live and let die

Others will secure funding and live to see another day, but not without someone taking a lot of pain.

The bleeding might come from previous investors or the founders and employees – or both.

Down rounds and heavy dilution are in my view inevitable, as insiders and existing investors in unprofitable companies give up more of their ownership in exchange for life-preserving cash. 

It’s all good reason to be gloomy if you’ve made investments in this area.

But on a brighter note, I think it’s probably an okay time to be a startup who’s hit profitability.

For one thing it will get easier to hire good people as other firms cut back or fold.

And, ironically, you will be more likely to get funding when you’re less desperate for it in today’s market.

Professional VCs who must put money to work would always rather double down on their winners.

But this instinct is amplified when everyone fears their firms might run out of cash.

So the strong will get stronger, and the weak will fall by the wayside or be acquired.

Private company funding with a gun to your head

As an example from the front line, I was surprised – but hardly shocked – to get an email recently from one of my unlisted companies which revealed its valuation had cratered by 95%.

For those slow with maths: it was now priced at one-twentieth of its most recent funding valuation.

Galling – especially as it had only completed that round in late 2021!

Surprised – because the company is a beneficiary of post-Covid ‘unlocking’ and its revenues have risen 300% in the past 12 months.

But not shocked – because it’s burning cash for growth and was always planning more rounds. Which, as we’ve discussed, is exactly where you don’t want to be right now.

And having warned just a few weeks ago that everyone needs to get realistic about the new climate for private company funding and valuation, I can hardly cry crocodile tears.

As I wrote:

Valuations still seem fanciful, given that the multiples paid by public stock market investors – where, crucially, everyone can see what everyone else is paying – have crashed.

A fast-growing unlisted fintech that valued itself at, say, 80-100x revenues in mid-2021 should not expect the same valuation multiple in 2022.

Possibly not even the same order of magnitude.

Still, I had no inkling that this particular company would see its valuation plunge to this extent.

And while I heavily discount all my crowdfunded shares, I do not value them at nothing.

Some private investors I know do.

Maybe I should?

One for all and all for one

In the end I actually put a little bit more money into this company at the shiny new giveaway pricing.

You see, the firm decided it had no choice but to raise funding via a ‘pay-to-play’ round – a typically euphemistic bit of jargon that means existing investors either put extra money in at a heavily discounted valuation or else see their ongoing stake diluted into peanuts.

This forced funding was the justification for the low valuation I mentioned.

And it’s arguably a reason for hope for any shareholders who did decide to put new money in.

To recap, the company was unable to get the funding it needed in 2022’s hostile environment for optimism at anything like its previous valuation.

Given that it needs money to pay staff and keep the lights on, this was… a problem.

Hence the pay-for-play round, which restricts new investment to existing shareholders.

If the company can indeed use this fresh capital to become cash-flow positive as planned, then this desperate cut-price round will seem – in retrospect – artificially cheap and shareholders who stumped up the cash will be rewarded.

Of course that’s a very enormous ‘if’.

And if it fails I’m just throwing good money after bad.

Alternatively, if nobody puts in any money, the company will go bust and everyone loses everything.1

This kind of game theory just doesn’t happen in the public markets.

It’s kind of fun for an investing nut like me, but to reiterate what I always say with this stuff you definitely do not need to be involved – and you probably should not be – to reach your financial goals.

Private company funding and valuation in 2022

A final question is what should I now value this company as worth in my records?

Am I discounting enough? Should I have seen this crunch coming and reflected it in my valuation? Might I now be optimistic and write the value back up, since it hopefully has the cash to survive?

And what does this episode imply for my other unlisted holdings?

I won’t try to answer for this specific firm. This post is already of niche interest!

Instead, I’ll be back soon to cover valuing unlisted holdings much more broadly.

Investing in unlisted companies is full of surprises. Whether you’re an angel investor, an employee granted shares or options in your employer, or an investor in often-sketchy crowdfunding start-ups, you should expect the unexpected.

Yet there are steps we can take to try to ensure more nice surprises than sucker punches.

Hopefully my upcoming deep dive will be of value to private investors, as opposed to professionals. There is little on valuing private companies written with the likes of us in mind.

In the meantime, let’s be careful out there.

Interested in crowdfunding despite the risks to your capital? Sign-up via our affiliate link to Seedrs and you can get a free £50 investment credit when you invest £500 or more in your first 30 days.

1. Although in this case I already knew the company had secured several million pounds on condition of existing investors being faced with the pay-to-play round. That did de-risk things for me somewhat. [↩]