Posted by Arabella Moen.
This article from the American Bar Association writes about the considerations that emerging companies need to make when raising capital in a slowing economy. After the record levels of investment in 2021, emerging companies, particularly in the technology sector, have “enjoyed increased valuations driven by greater competition among investors”. With this responsibility, they have been able to gain more access to capital. Yet with market conditions changing in 2022 due to higher interest rates and a tightening of the credit markets, investors are altering their investment strategies. In light of these changes, emerging companies will find that raising capital and securing financing is difficult, so must consider scaling back spending to reduce their “burn rate”, and perhaps their eventual downfall.
As with all startups and emerging companies, there will always be an endless array of issues to be aware of. In terms of financing, one important factor to consider is liquidation preferences, in which holders of preferred shares may receive payments before any amounts are actually paid to the common shareholders, who are typically the founders. In the event that the investor has negotiated a liquidation preference where they receive a multiple of the original purchase price, the investor may walk away with more than they have invested. What the emerging company needs to consider is that the founders themselves, and other common shareholders, may end up with little or no payments. They should look to limit an investor’s liquidation preference where possible. For example, include “a cap on the total amount the investor can receive in the event of a Deemed Liquidation Event.” Through making a compromise that meets both parties’ interests, everybody will be able to benefit.
Another consideration for emerging companies is cumulative dividends. This is something that most people presumably know about, especially those starting up their own business or looking to invest in a company. However, it is not that simple. Dividends tend to be non-cumulative, (paid only as declared by the company’s board of directors) but there are some instances where the investor may deem the investment to be risky, so can insist on cumulative dividends. This is when the dividends increase at a specified rate, “regardless of whether or not the company actually declares dividends on those shares”. They also carry a right to receive those dividends in priority over any other shares. For the emerging company it is vital to carefully consider the impact any cumulative dividends have on future cash flows, along with their effect on distributions in the event of liquidation. Cash burn is a common mistake of emerging companies, so making considerations for cumulative dividends early on will enable them to survive with prosperity in the long run.
These two huge factors are regularly overlooked by startups. With interest rates rising and the possibility that a recession is approaching, emerging companies may have to make tough decisions when raising capital. In addition, they must ensure they understand the terms of any financing documents they agree that will help protect the interests of all stakeholders in the future. After all, emerging companies do not want to be known as ’emerging’ in the long run, they want to be known as a stable, growing, and profitable business that everybody wants to invest in.
https://www.americanbar.org/groups/business_law/publications/blt/2022/10/down-rounds/
Arabella is majoring in finance and technology at the Stillman School of Business, Seton Hall University, Class of 2025.