Many start-ups are having trouble raising new funding on favourable terms amid the pandemic, according to new data.

There was a second-quarter jump in the number of start-ups raising down rounds – funding rounds where the share price has dropped compared with the prior round – according to investing platform AngelList, which compiled data on more than 220 start-ups that raised a priced equity funding round from funds or syndicates on its platform during the second quarter of 2020.

About 75 of those companies raised down rounds in the second quarter of the year. That number was about three times as many as typically raised down rounds in prior quarters, said Abe Othman, the head of data science at AngelList. The ratio of down rounds to up rounds was the highest since the second quarter of 2016, Othman said.

AngelList tracked about 2,900 companies in the quarter, up from more than 2,600 companies tracked in the prior quarter.

The increase in down rounds and flat rounds – in which the share price stays the same as the prior round – shows an industry that has seen more start-ups struggling to raise capital, despite some stories of high-flying companies doing well during the pandemic.

The number of up rounds also reached 154 in the second quarter, up from 138 in the prior quarter.

Many founders are loath to raise down rounds because they believe it will send a message to employees, investors and customers that the company is doing poorly or could shut down.

“There’s a large perception that you’re either going to the moon or crashing,” Othman said, adding that start-ups can be doing well while raising a down round.

Many start-ups want additional capital in case fundraising becomes more difficult in the future, and weren’t necessarily on the verge of shutting down, Othman said, citing no significant jump in shutdowns. “This is much more about start-ups paying for optionality,” Othman said. “Start-ups were not sure what will happen in the future.”

More generally, the number of venture deals rebounded in the second quarter after dropping in the first quarter, Othman said.

Meanwhile, the percentage of flat rounds also jumped in the second quarter to 14% of deals, or double the proportion of deals in the first quarter, according to data tracked by law firm Fenwick & West.

This suggests start-ups are doing more inside rounds led by existing investors, either because they can’t find a new investor or do not want to seek a new investor and take on a new share price while fundraising remains volatile in the current environment.

“(Investors) still believe in the fundamentals of the company but believe it’s not the best time to raise funding now,” said Cynthia Clarfield Hess, a partner at Fenwick & West. “They don’t necessarily want to do a down round. They prefer to do a flat round.”

Valuations also took a hit: They increased 51% in the second quarter, a significant drop from a 93% increase in the prior quarter, Fenwick said.

One example of this in the second quarter was scooter start-up Neutron Holdings, which goes by the brand name Lime, according to people familiar with the matter. The company raised funding at a valuation cap that was lower than the valuation of the prior funding round, one of these people said.

“Our last fundraising round helped us weather the worst of Covid-19 and emerge stronger as a company, well positioned to become profitable in 2021,” said a Lime spokesperson.

One result of this negative market sentiment is that it is tougher for newer start-ups with first-time founders to get funded, resulting in less new innovation coming into the market, Hess said. “For first-time founders, I think this is a much harder market to get funding, recruit and launch a company,” added Hess.

Still, companies that survive the pandemic could emerge stronger in the long term, Hess said.

“The work companies did when the pandemic hit to get their houses in order will pay dividends in the future,” said Hess. “Companies are learning to operate differently, without expensive marketing programs and conferences.

“These sorts of changes could benefit companies’ profitability and the way they do business over time.”

Many start-ups don’t disclose their down rounds and often seek to gloss over a down round by saying that they raised an up round on a valuation basis.

In the earlier part of the pandemic, startups faced more challenges, but the market has improved considerably since then, said Derek Colla, partner at law firm Cooley.

“In April and May, there were a whole bunch of down rounds,” Colla said. “Some companies were wiped out and revenue went to zero.”

However, starting in June, a number of Colla’s clients in sectors such as financial services, healthcare and software as a service “completely turned around” as business came back, he said.

Source: Wall Street Journal

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