Our cash is running out and our shareholders don’t have the funds. What can we do?

Our business is not yet cashflow breakeven, despite a substantial equity raising two years ago. Cash is running out and we need a further injection to make it through to profitability. Our existing shareholders don’t have the funds to follow on and the only deal on the table is offering us a much lower valuation than our previous round. This will significantly dilute the existing shareholders who have taken on a far higher risk. What can we do?

The cruel reality of early stage investing is that there is no credit for past investment… there is only credit for business performance.

In essence this is the flip side of the risk/reward equation. The earlier one invests the higher the risk of loss and the higher the potential rewards. The bit people often miss is that if you cannot continue to participate in future capital raisings, you will be diluted by those who do.

From the perspective of the new investors this is only fair… based on the business in front of them, they are the ones prepared to risk more capital.

Most shareholder agreements provide existing investors with rights to participate in further capital raisings. This right ensures that they have the option of at least maintaining their proportional ownership of the company. Choosing not to exercise that right could justifiably be viewed as a loss of confidence in the company’s prospects.

In your case the lack of participation appears to be based on no further financial capacity. This raises an interesting question with regard to the initial investment scenario. One of the most important pieces of analysis in any deal is that of capital risk going forward, ie. how much money is the company likely to need to reach positive net cash flow?

Applying the standard rule of thumb that a business will cost twice as much and take twice as long as you thought to reach breakeven – did you have enough to embark on the journey?

In these cases the situation for executive versus non-executive shareholders can differ.

Often new investors may be prepared to top up the equity of executive shareholders through an executive share option plan (ESOP). Astute investors understand that well-motivated management is critical to success. Washing management out in a down round can be very de-motivating so this mechanism is used to restore a reasonable equity interest.

Non-executive shareholders simply have to pay to play… if they don’t have the money then perhaps they will think twice about getting involved in future high risk start up deals. If they choose not to invest then they have formed the view that the business is no longer worthy and they would rather not put good money after bad.

In the absence of a competitive market for your business, the only investor at the table has the negotiating power other than to the extent that he will still require a capable management team… hence the ESOP mechanism.

The final point to note is that it generally doesn’t matter at what valuation you start… what matters is at what valuation you finish. Those that maintain continuous commitment to the business – either through funding or executive talent – will ultimately reap the greatest reward.

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 Doron Ben-Meir has been an active venture capital manager for the last eight years. He founded Prescient Venture Capital and prior to that was a consulting investment director of Momentum Funds Management. He was a serial entrepreneur over a 12 year period, co-founding five new technology-based businesses.

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