How private companies are navigating today’s turbulent capital markets

With the current headwinds in the capital markets, private companies and their key stakeholders are facing significant and rapidly evolving funding challenges. As IPO, SPAC and merger activity remains subdued, companies that are turning to the private capital markets are finding greater selectivity from capital providers, meaningful shifts in investor priorities, valuation resets and the revival of structural protections for investors.

A panel led by EY IPO and Private Transactions Advisory leaders in the Financial Accounting Advisory Services practice shared insight from banking, legal and investor perspectives during a recent National Venture Capital Association (NVCA) webinar. The panelists examined how companies are navigating the realities of today’s private markets, the key issues they are facing and their outlook for capital markets for the remainder of 2023 and beyond.

Early-stage companies and disruptive technologies are attracting investors, while late-stage growth investments present more challenges

Recent market conditions have proven challenging to private companies seeking capital. A combination of valuation resets, cost structure reassessments and more stringent structural terms demanded by investors have made it difficult to secure financing. Many investors shifted their focus to portfolio company management during this time vs. capital deployment into new opportunities, said panelist Stephen Lambrix, EY Private Transactions Advisory Leader in Financial Accounting Advisory Services.

When investors have decided to back new management teams, companies in the seed to Series A stages and companies with disruptive technologies have been most appealing, Lambrix said, adding, late-stage growth deals “are tough in this environment where your return profile hinges on the exit opportunity via IPO, M&A or otherwise. Earlier is easier.” Growth rounds are getting done in this environment but far less than early-stage companies.

It’s also clear that companies with compelling unit economics that can demonstrate a path to profitability have a leg up in this financing environment. “Focusing on unit economics is fundamental to building a good business,” said panelist Nicole Quinn, a partner at Lightspeed Venture Partners. “Building a generational business is the approach and the mindset a founder needs to have.”

Climate tech and biotech are two industries generating interest. But the hottest industry right now is generative artificial intelligence (AI). An economic downturn is often fertile ground for emerging industries and businesses, as it provides founders an opportunity to aggressively prepare for the needs of the market and the growth they expect to achieve, Quinn said.

“We’re going through a significant technological wave, just as we did with disruptive technology like the internet and mobile,” she said. “We’re excited to see what these AI companies can do.”

Quinn believes there are a lot of good companies that have filed their S-1 forms and are ready to do an IPO. While many were hopeful IPOs would pick up again this spring, that hasn’t happened. Macroeconomic factors like inflation and high interest rates still need to improve before we can expect to see the IPO markets return. As a result, M&A activity has been limited as well.

“It's never been more expensive to acquire a customer, competition is fierce and we’re going into a recession,” Quinn said. “So, a lot of these bigger companies, they need to stabilize their own ship. When they have done that, then I think they will look to make acquisitions. But I also think they’re not in a hurry until the IPO window opens up.”

As deal terms trend in favor of investors, both VCs and companies remain cautious

Investors who have money and are willing to invest it have increasingly turned to bridge financing structures with convertible notes, said panelist Danielle Lauzon, a partner at Goodwin Procter, often with the promise of a certain discount on the back end.

“The discount, valuation caps and other components have perhaps been more investor-favorable than we’ve seen in prior years,” Lauzon said. “There is a realization that valuations in 2020 and 2021 were a bit inflated, and now there is some pressure testing of those valuations, which has led to a number of flat rounds as well.” If there is an opportunity to take a meaningful down round, that’s OK, provided it’s with a clean structure, she added. Companies can come back from a low valuation. Terms with heavy structure that benefit investors over founders, however, stay on the cap table and carry on to future rounds. 

On the company side, pay-to-play provisions that require existing investors to participate in subsequent funding rounds is leading to hard conversations. “If an existing investor is willing to step up and put in the cash, that investor wants to know others are going to participate,” she said.

From a legal standpoint, multiples on liquidation preferences and participation rights are easy to put into a charter. But companies must also consider the pressure that is put on their management team depending on how large a liquidation stack is, who gets paid out and what future M&A deal volumes need to look like to keep the team motivated during more distressed times.

Four things private companies need to keep in mind: