A common misconception in the startup world is that down-round financing for a private company is a bad omen. After a down round, a company with intrinsic value can be attractive to private equity. Since 2016, 11.5% of company exits were buyouts, and 1 in 5 companies that raised a down round went with private equity.
Raising less than expected can be a lot like losing in the ring to political and economic hard knocks — not even Rocky Balboa could have prevented it.
What happens to companies after a down round?
It’s not hard to see why a disappointing fundraising round is perceived as a sign of trouble: Existing investors facing “write-down” obligations may seek to negotiate the prior round’s price, and accepting a lower valuation can hinder fundraising. Moreover, management may walk away if an agreeable equity negotiation is not reached.
With enduring supply chain woes, high employee turnover, price inflation, rising interest rates, fears of a global recession and ongoing global conflicts converging on us all, losing leadership at a vulnerable time for the company is a downer, indeed. While a round doesn’t take the company out of competition, to move on with a bridge loan or private equity buyout, the financials have to be in top condition, with solid balance sheets demonstrating costs are in check and their business is poised to grow.
Providing adjusted projections and revised plans for expansion will go a long way to help a company find capital from private equity or lenders. According to Trading Economics.com, balance sheets for U.S banks reached an all-time high of $23 trillion.
With the right mindset, guidance and team, a private equity buyout of a down-round financed company has a comeback written all over it.
Lean, mean down-round fighting machines
After a leveraged buyout, the real work begins. When private equity rolls up its restructuring sleeves, investors anticipate that company’s value to recover its historical level or become more valuable in its new form.
Constructing or deconstructing a corporation calls for a deep understanding of the core industry, the external market and internal organizational forces blocking the company from its market share.
Staying in the ring
After a down-round buyout, one of the main challenges becomes the stakeholder shake-up, which loosens invaluable institutional knowledge and longstanding relationships. A loss of confidence in company management is a blow, but a dilution of ownership is downright demoralizing.
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Understandably, down-valued organizations will see some of their best people go. Add to that a reduction in headcount during the early part of a company restructuring and a capacity deficit can emerge. Reorganizing and replacing critical members of the management and operations teams can make or break a company restructuring.
Running out the holding clock
In addition to talent, a timely exit is essential. The pressure GPs feel from limited partners for a return on investment within a reasonable time is significant.
Preqin reported that in the first half of 2022, buyout funds in public-to-private deals totaled $110 billion and buyout funds were still sitting on $873 billion in dry powder as of June, as cited by Yahoo Finance. Historical precedent indicates that increased competition for investment could lengthen the average number of years to exit.
After the financial crisis, the holding period broadened by almost a year. The average holding period had been 4.7 years pre-event; it became 5.8 years post, per The Journal of Alternative Investments.
The final round
Restructuring to exit with private equity can happen even in challenging markets. PE firms have alternative avenues to the public market, like trade sales and secondary buyouts.
In 2022, the US buy-back IPO value of $338 billion was nearly the average between 2017 and 2019 ($400 billion). Despite the lower fundraising and deal numbers, the unspent capital has to find new investment when the time is right.
A key takeaway for private equity VPs
You’ve found the diamond-in-the-rough, down-round opportunities. Now it’s paramount that corporate restructuring results in the treasure you knew was hidden.
Achieving results often requires reorganizing. Remember not to pour salt on the wounded management.
Reducing forces are a part of every restructuring scenario. Even so, it may be more challenging to run lean and mean in a short period of time without talent retention because those invested stakeholders who are down but not out have valuable relationships with the business, insider knowledge and credibility to leverage.
Escalon for a KO
Escalon’s Fractional and outsourced services can help support your companies short- and long-term strategy while providing the expertise needed during a restructuring. Our finance/accounting and HR operations services are tailored to support every stage of our business. To find out more, contact us today.
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