Structured Deals in Challenging Financial Landscapes: Raising Capital when Capital is Dear

16 March 2023

By Zachary Cefaratti, Founder of Dalma Capital

 

The first quarter of 2023 has proven to be one of the most difficult financing environments in decades. With the gulf region being a notable exception, raising equity in private and public markets has become extremely challenging. Many companies that had planned to IPO in 2022 and 2023 have had to defer their IPO plans.

It has become particularly hard to finance growth companies, even those which continue to grow robustly. Investors are heavily discounting future cashflows given the uncertain outlook, in addition to substantial increases in nominal rates. As a result, valuations have dropped aggressively — greatly amplifying the dilutive effect of equity fundraising. This has resulted in a bid:ask spread between issuers and investors that result in deadlock in any financing discussions, and thus giving rise to structured deals.

Structured deals, such as convertible notes and preferred equity, have gained prominence in the world of private company financing, particularly when faced with difficult financing conditions, risk-averse investors, or divergent views on equity valuations. I will share the advantages of structured deals in these challenging environments and explore the unique investor universe and approaches that differ from those of traditional equity investors.

 

Advantages of Structured Deals in Challenging Financial Environments

Bridging valuation gaps

One of the most significant advantages of structured deals is the ability to mitigate valuation disagreements between companies and investors. Convertible notes, for example, allow both parties to defer valuation discussions until a later funding round (or IPO), when more information is available or when growth targets have been achieved to establish a fair valuation. Preferred equity, on the other hand, offers investors downside protection through liquidation preferences and dividend rights, making valuation discussions less contentious. We find in 2023 that the less focus on valuation, the better which has led to convertible notes being more popular compared to preferred equity.

Customization potential

Structured equity deals allow for the adaptation of terms and provisions to cater to the particular requirements and risk profiles of both companies and investors. This adaptability is beneficial in unstable markets or when investor risk appetites vary.

Reinforced investor protection

Structured deals offer investors safeguards, such as liquidation preferences and dividend rights in preferred equity, and potential equity appreciation in convertible notes. These attributes can be especially appealing to investors in turbulent financial situations where safeguarding their investments is crucial.

Speed and Efficiency

Structured deals can expedite the fundraising process, as they require less negotiation compared to traditional equity financing. Companies can close deals more quickly, allowing them to focus on growth and operations. For investors, this efficiency typically translates to reduced due diligence costs and a streamlined investment process — however it should be noted that in 2023, we are seeing substantially increased due diligence on structured deals to what we would have seen in years prior.

Flexibility

In uncertain market conditions, structured deals offer flexibility to both companies and investors. The terms of convertible notes and preferred equity can be customized to address the specific needs and risk preferences of both parties, creating a more tailored financing solution. This flexibility is particularly valuable when navigating volatile markets or when risk tolerance varies among investors.

Enhanced Risk Mitigation

Structured deals provide risk mitigation for investors in challenging financial environments. Convertible notes align the interests of investors and the company, as both parties benefit from the company’s growth, while the conversion feature offers potential upside for investors. Preferred equity, with its liquidation preferences and dividend rights, protects investors’ capital by prioritizing their claims in the event of a liquidation

Double-edged Swords of structured equity in 2023

Dealing with growth:profit transition and shifting from equity to debt

Companies that have been historically focused on growth, such as was the case with most tech companies prior to 2023, often find that during their transition financing can be challenging. Companies may be on the cusp of profitability, or profitable but still be burning through cash. That shift in focus can put them into what seems like a financing no-mans land, where they are not achieving or likely to achieve sufficiently credible growth to justify high equity valuations, but also are not sufficiently profitable to raise conventional debt. This transition also raises questions on where exactly the company may land when complete, or if they will be successful in making the jump at all. In 2023, we see many companies making this transition aggressively, with notable successes such as AirBNB. While raising convertible debt can help deal with this transition, some companies will find that as they tap into debt markets — investors demands for their focus on profitability (which are particularly aggressive in 2023) may cause misalignment of interests between investors and companies. The distinct features of structured deals make investors focus on their own returns and downside protection, rather than the companies long-term growth. They may require companies to cut more costs than they would like, and may make them feel that the business becomes too focused on the short term.

Dilution dilemma

The dilution dilemma is a critical concern in structured equity deals. While these instruments can facilitate capital raising in unfavorable financing situations, they can also lead to ownership dilution for founders and existing shareholders upon debt conversion or preferred share issuance. While structured deals are typically a solution to reduce dilutive impact on companies compared to re-pricing equity, if the company fails to reach targets in growth or valuation in subsequent rounds the dilutive impact of conversion can be exacerbated.

Disadvantages of structured equity deals in challenging financing environments

Complexity concerns

In difficult financing situations, companies may already be grappling with operational and financial issues. The added complexity of structured equity deals, with their elaborate terms and provisions, can impose further strain on a company’s resources, including legal and administrative expenses. This can be particularly challenging in dealing with covenants related to those facilities, which companies may find to be very restrictive and could breach. In 2023, we are seeing covenant breaches becoming more common, and also being responded to more aggressively.

Hurdles in exiting

When companies seek to exit during challenging financial circumstances, the various terms and conditions tied to structured equity deals, such as convertible notes or preferred equity, must be addressed and negotiated with potential buyers or underwriters. This can result in complications and delays in the exit process. This can be particularly challenging when the path to exit is IPO.

The Investor Universe and Approach

Diverse Investor Base

Structured deals attract a diverse range of investors, from venture capital firms, hedge funds, private debt and private equity funds to family offices, angel investors, and high-net-worth individuals. This diverse investor base allows companies to access a wider pool of capital, while investors benefit from the opportunity to participate in private company financing with different risk and reward profiles. Structured deals also offer an opportunity for existing investors who may have invested at lower valuations to increase their investment in the company in a structure that may improve their overall risk/return profile and may help avoid markdowns to their existing investment.

Risk-Adjusted Investment Strategies

Investors in structured deals employ risk-adjusted investment strategies that differ from those of traditional equity investors. These strategies focus on achieving a balance between risk and reward by incorporating downside protection mechanisms and potential equity upside. Investors may evaluate opportunities based on factors such as the company’s growth prospects, market conditions, management team, and the specific terms of the structured deal.

Final Thoughts

Structured deals like convertible notes and preferred equity offer a compelling alternative to traditional equity financing, particularly in challenging financial environments. With their ability to reduce valuation disagreements, enhance risk mitigation, and provide flexibility, structured deals have become increasingly popular among private companies and a diverse range of investors. By understanding the unique advantages and investment approaches associated with structured deals, both companies and investors can better navigate difficult financing conditions and unlock new opportunities for growth and success.

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