Capital Efficiency is Back
Over the past few days I read two interesting articles and listened to a podcast, all focused on various aspects of our current economy including rising inflation, declining stock values, stalling growth in the real estate market, and collapse of crypto currencies. Some talk about this as an indication that the economy is a mess, and we’re headed for a recession. Others point to low unemployment rates, the impact of measures to address COVID19, the Russian attack on Ukraine, and greed (profit-taking) among virtually all big public companies, especially oil companies, as sources contributing to the problem, and hope that resolution of some of these issues, and tightening of fiscal policy (interest rate hikes by the Fed) will save us from economic collapse.
New York Times, Ezra Klein podcast: “Opinion | The Stock Market Is Faltering. Welcome to the End of the ‘Everything Bubble.’ https://www.nytimes.com/2022/06/17/opinion/ezra-klein-podcast-rana-foroohar.html
The Atlantic: “The End of the Asset Economy” https://www.theatlantic.com/ideas/archive/2022/06/asset-economy-high-interest-rates-inflation/661323/
Pitchbook: “VC market faces rational reality reset” https://pitchbook.com/news/articles/Superventure-venture-capital-market-downturn
I happen to agree with the view that we’ve just been through a decade or so in which money was easy to come by for all asset classes, so the stock market was consistently rising, as were home values, while speculation in crypto currencies drove that market on a similar upward trajectory. The greatest beneficiaries of all this easy money were those who already had great wealth, both individuals and large companies.
At the same time gridlock in the US Congress prevented anything significant from getting done, aside from the few early bills focused on COVID19 relief. The Country missed a great opportunity to take advantage of this highly favorable environment for investment and tackle really big problems such as infrastructure and climate change. We had a chance to create new industries for the future. Now we likely face a grim reality that this opportunity has been missed and such an environment will not likely return anytime soon.
As much as some want to hide their heads in the sand and wish the pandemic over, COVID19 is continuing to have an enormous impact. Many sectors that were shut down have not yet recovered, and large numbers of employees decided this was a good time to re-evaluate personal priorities and quit their jobs. We’re still trying to figure out the new normal for working remotely vs. returning to work in an office, grappling with supply chain obstacles on a global basis, and struggling with lack of capacity in industries that scaled back when there was no demand and are now facing rebound demand at levels they can’t address (e.g., the airlines).
Others are far more qualified to address this debate than am I, although it’s obvious to me that enormous numbers of Americans can no longer afford to pay their mortgage or rent, buy food for their families, or drive to work, so regardless of the cause, it’s hard to be optimistic about a broad recovery in the near future, or to believe that our divided Congress will put aside their differences and come to the rescue. Okay, I’m done ranting about the bleak macro economic environment.
With respect to financing for early stage life science companies, what is obvious to everyone is that public biotech companies have taken a beating over the past 9 months, exit opportunities for late stage biopharma companies have evaporated (unless they have FDA approved drugs that can add top line revenue for acquirers), and valuations are dropping for all stages of private companies. As many of us experienced following the dot com bubble of 2000, and the sub prime loan real estate collapse of 2008, the days of easy fundraising are over. None of us can predict for how long. In the meantime, investors are once again taking much longer to close deals, and when they do, their investments are being made with much more investor friendly terms, and at much more conservative (sober) valuations.
What does this mean for early stage companies trying to raise relatively small amounts of funding? There is plenty of capital sitting on the sidelines in bank accounts of VCs and other institutional investors, but they are being more cautious about deploying it. Due diligence on rounds is likely to take longer. Companies will be forced to show clear plans for how they intend to get to revenue generation in a relatively short timeline, as compared to the past decade where blue sky ideas were getting funded with enormous valuations. With respect to valuations, they have already declined substantially, as all public market comparables have been hammered. As a consequence, funding is likely to be available only at lower valuations, and with more investor protections such as clauses calling for multiple participating preferred stock rights, and stronger anti-dilution protection.
Rather than fret too much over valuations, early stage companies would be wise to focus more on their plans to create value, showing clear indications of progress to date, credible milestones going forward, and near term plans to generate revenue on a capital efficient basis. In a sort of self fulfilling prophecy, plans that are focused more on near term revenue and less on building big infrastructure for long term scaling will likely lead to businesses that can only justify smaller valuations on exit. As a consequence, the lower valuations at investment will prove to have been warranted in retrospect. But this is the reality we are facing at the moment.
My guidance would be to focus less on valuation, and more on developing relationships with strong backers, and just getting your business moving during this challenging time. Funding is available, and investors can’t afford to sit on their capital for too long. They need to deploy it. We’ve been through these cycles before. Some of the best companies get funded in the most difficult financing environments, in part because investors are being so much more careful about where they deploy their funds. Tighten your belts, hang on for a rough ride, be open to financing proposals you may not have considered a year ago, and stay focused on achieving your goals.