Naturally, during periods of economic expansion, raising capital for a startup or new business is easier. Investors are incentivized to plow capital into nascent businesses because both the prospect of return is higher in comparison to other investment opportunities and the downside risk is lessened because of target customer spending and capital replenishment. If the “times are good,” investors generally know that even if founders make mistakes, they will have ample chances and opportunities to correct them.
But what happens when the market turns and we enter a recession? Or something unexpected, a so-called, “Black Swan” event like the Coronavirus upends global markets? How do entrepreneurs raise capital in when this happens?
This is a good question since most of the articles you will read about raising capital were written during times of economic expansion. Most likely, during the past decade. Admittedly, even my own experience raising capital dates to just the past 10 years. I was too young to experience the Dot Com Bubble and was insulated at law school during the Great Recession. More importantly, many of the entrepreneurs raising capital today have never experienced a recession either because they are too young or because it’s been quite some time since we’ve had one here in the United States.
To say that most entrepreneurs may be unprepared for this eventuality is an understatement. Last week, I was sitting down with an entrepreneur whose valuation was aggressively high, even by the standards of 2019’s booming economy. When I asked him about his plans for the next round, he admitted that his future valuation in successive rounds was based on a strong economy and that “downside protection wasn’t necessary — I just can’t see the point in dwelling on it.”
I disagree. Strongly.
Entrepreneurs need to prepare for a recession and need to know how to raise capital in a down market. One of the best ways to do so is to prepare beforehand. When the economy is strong, you have the most options. Exploit them.
Even if you are prepared, raising capital in a down market can be incredibly challenging and even confusing. First, entrepreneurs need to prepare beforehand by establishing a clear defensive moat around their business metrics with a strong focus on profitability. Investors respond positively to this in down periods given that so many of their other portfolio companies face significant threats.