The New Normal: Building Your Business Like You Did in the Old Normal

It’s déjà vu all over again

- Yogi Berra

As we anticipated for quite some time, the public and private equity markets are in the middle of a storm. This is the first real storm we have experienced since the 2008–2009 financial crisis. The rain shower in March 2020 quickly ended after two months followed with more sunshine, although dark clouds were lurking ahead. Inflation has reared its head for the first time in over a decade and it looks to be stubbornly sticky. While inflation remains high, we do believe that a portion of the current inflation is transitory. Nevertheless, governments around the world have responded with significant central bank interest rate hikes to keep core inflation in check. Coupled with continuing supply chain and logistics issues, protectionism, and global conflict, the world is in store for a lot of uncertainty in the near term. As a result, we believe the markets will remain volatile.

In 2021, we modelled our original thinking based on an expected rise of at least 200 basis points in interest rates and the resultant second order impacts of such an increase to market demand, availability of capital, etc. While our modelling was imprecise, we expected to see valuations for growth equity investments decrease by up to 65 per cent from their highs during the pandemic. Well, it is turning out that we underestimated the impact!

First, the 200-basis point increase we used to model the impact to valuations was conservative. Second, we were not sure if such a rise in interest rates might trigger a recession. A recession would certainly further dampen market demand which in turn would further decrease valuation expectations from their highs during the pandemic. We will go out on a limb and declare that we are already in a “technical recession” (the US is expected to formally announce they are in a recession). The only question that remains is whether it will be a mild or severe recession. Using historical comparisons, we would expect a recession to last 18–24 months.

Valuations of public technology-based companies have for the most part been significantly slashed, reverting to the long-term mean. Private company valuations are generally still lagging the public company comparables, but the number of private companies accepting material “down rounds” or structured deals are greatly on the rise particularly for later stage investments. Despite record amounts of dry powder of capital sitting on the sidelines, dramatic decreases in valuation expectations are prevalent throughout all chains of financing.

We wrote this checklist for entrepreneurs to help them weather through the storm. https://ruffoloj.medium.com/top-10-things-to-do-as-an-entrepreneur-in-navigating-the-storm-edf0e532d45f

In this checklist, we discuss the need to keep a tight rein on your cash position. We discuss some of the ways to increase your cash position through either top line growth or through expense reduction. Many entrepreneurs will also look to raise external capital to supplement their cash position.

The raising of external capital in turbulent times requires further examination. In markets like we are in now, entrepreneurs should not be raising any external capital unless they have seriously considered all their opportunities to increase or preserve their cash position. If you have determined you have no choice but to raise capital in this market, then you should consider all types of capital sources, from the cheapest to the most expensive sources of capital. For example, from cheapest to most expensive:

1. Funding from current and future customers through advances

2. Government grants and incentives

3. Friends and family

4. Conventional bank or near-bank debt i.e., lines of credit

5. Angels

6. Mezzanine or venture debt

7. Venture capital or private equity

8. Public equity markets (most expensive from the perspective of valuation expectations)

What I find perplexing is the number of entrepreneurs I meet with that jump to the need to seek venture capital or private equity capital in priority to most other sources of capital despite it being by far the most expensive form of capital. In many cases, I question whether entrepreneurs really need to raise any external capital at all. In several cases I have been involved with, it was clear that the business would be sustainable without raising external capital, but it would mean a reduction in expenses with a corresponding muting of some top line revenue growth. But in almost every case, the reduction in the top line was nowhere near as expected. In fact, the forced cost reductions helped the entrepreneur better understand areas of the business that were delivering little to no return on investment.

Another comment that I have heard many times is that some entrepreneurs feel that raising capital from a venture capital or private equity firm is a validation of the success of the business. We see this all the time when the market celebrates a massive fundraising with no tangible creation of shareholder wealth. Nothing could be further from the truth.

Raising venture capital or private equity certainly makes great sense depending on the circumstances. For example, it might make sense to capture a market very quickly and gain first mover advantage. Your business may require significant upfront start-up costs such as building a pilot test plant (typical of many businesses in the cleantech sector) or those businesses with a very long path to product development (in the case of drug discovery or medical devices sectors). If you decide as an entrepreneur that raising venture or private equity capital makes sense for your business, you need to make sure that the return on investment from that capital exceeds the very high cost of that capital (typically at least in the 25–40 per cent range compounded annually).

The best way to ensure a return on the investment from the investment capital is partner selection. Many entrepreneurs make their investment partner selection decision based on the lowest “perceived” cost of capital — in other words, those that offer the highest valuation. As an entrepreneur, if you are really not looking for anything from your investment partner other than a source of capital, then selecting solely based on pricing makes the most sense. But most entrepreneurs I speak with say that they are looking for an investment partner that provides value to their business far more than the cost of capital.

So, as an entrepreneur, how do you know which investment partner would add the most value to you? Well, it’s like the old joke. How do you know that the person you just met went to Harvard? They tell you. (Yeah, I know, the hate mail from Harvard grads is coming). It’s important you interview the prospective investment partner to better understand how they would serve you. Their job is to serve the entrepreneur and the reward for that service is to potentially earn a significant return on the investment in your business.

You will need to better understand how the investment partner intends to service your organization. In many instances, investment partners have valuation creation experts on their teams who focus in on delivering the service quality. Here is an interesting graphic provided by Mike Lipkin (our leadership coach at Maverix Private Equity).

Where does your current or prospective investment partner stack up in connection with either their actual or aspirational service leadership level? In many, if not most, cases, the investors who provide the top level of leadership do not offer the lowest cost of capital. The cost of capital would of course need to be competitive, but they also realize that the demand for their capital far exceeds its supply.

Now, go out and get’em!!

John Ruffolo,

Founder & Managing Partner, Maverix Private Equity