What you need to know about funding during a recession

Startup founders are used to dealing with challenges—both expected and unexpected. Every day brings something new, from solving a customer problem to dealing with the strains of scaling a business. The challenges from the last three years meant adapting how and where work was done.

Today, new challenges are on the horizon from global economic uncertainties and the threat of a potential recession. Founders looking for funding must change their tactics if they want to succeed. To better understand what founders need to know, we sat down with Shabab Chowdhury, our Senior Associate, Investments and Advisory at the Accelerator Centre.

For many founders, this might be the first time they have raised during a recession. What should they look out for?

My general conviction overall is that fundraising will be difficult. Investors are holding onto their money. When an investor puts money into a startup, they go in with a long-term view. They're looking at a return on their investment over a seven to 10-year horizon. In the ideal world, startup valuation typically keeps rising during this period. The best thing that founders can do at this stage is to stay connected with investors and keep appraising them of progress, in anticipation that when the market turns around, the founders who showed hustle and kept in touch come to the investor's mind first

What can startups do to mitigate these funding challenges?

Startups can reserve their cash. They can cut operational and general administrative expenses to create a longer runway. It would be best if you also had cash in the bank to survive longer than 24 months however, it’s still important to actively raise money.

Raising equity rounds during this phase gives a lot of investors in the earlier rounds—especially pre-seed and seed—the ability to make additional investments into these companies as portfolio support rather than searching for new investments. I think that's what happened during the pandemic. Venture capital investors are looking to make follow-on investments rather than finding deals they aren't familiar with.

Do investors see these follow-on investments as safer bets, or is it that they have trust in the teams?

Venture capital fund economics works like this: let's say we have 100 million dollars. We're going to put that into 20 companies. Our first financing round would be $1-3 million, and we will reserve some cash for some follow-on investments. That means we will invest up to $ 3-5 million into a fewer set of companies in the next few rounds so that our target ownership stays where we want it to be—around 10 to 15%.

Every time a startup raises capital, the investors get diluted. So instead of finding new companies to invest in, they hold on to their current portfolio to grow their equity value.

Will it be more difficult for new startups to find investors for seed rounds?

Yes! Typically, at the pre-seed and seed rounds, investors would have looked for minimal traction, maybe some beta users, and the company could be at a pre-revenue stage. But in a bearish market, investors look for quite a bit of traction and revenue. They want to see that you have a repeatable customer acquisition strategy. Since the risk appetite of investors in a bearish market is low, it behooves the founders to demonstrate more traction, and therefore it will be relatively more difficult for newer startups to attract capital

Would you say startups with their first customers are better positioned to get funding?

It depends on the business. If a SaaS business sells B2C, investors will look at how you're adding subscribers. But adding subscribers during a recession can be difficult. People don't spend money. People will look to conserve cash—and that's what a recession essentially is—people don't spend enough for the economy to keep growing. That could definitely be a problem for B2C startups and B2B startups. Large corporations and corporate clients could be looking to cut down their costs and look at a service as a nice-to-have instead of a must-have.

Is debt funding a good alternative for startups during a recession?

You need to show much more traction, cash flow, and revenue for debt financing. Not everyone qualifies for debt funding, either. You will need approximately 3-5 million dollars in annual recurring revenue, and not many pre-seed and seed startups have that. Even if you go to a bank for a term loan, many banks don't entertain pre-seed and seed companies.

CIBC and RBC are, I think, the only banks that do debt funding, along with Silicon Valley Bank. But they're also looking for much more traction and for the startup to have recently raised an equity round.

What advice do you have for later-stage startups?

The focus should be on getting the product ready to ship and scale while watching out for unit economics. Increase your revenue and sales and try to keep down your cost of acquisition as much as you can. At the same time, try to get your gross margins higher. You must consider restructuring your operations to reduce operational expenses over the next two years.

Are you interested in talking about your fundraising efforts? Contact us today to learn more about joining the Accelerator Centre.