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About King & Wood

King & Wood is a legal services company based out of Beijing, China.

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40th Floor, Tower A, Fortune Plaza 7 Dongsanhuan Zhonglu, Chaoyang

Beijing, Beijing, 100020,

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Swimming with sharks: Tech founders change tack to avoid predatory VCs

Aug 8, 2022

Aussie tech start-ups have grown rapidly, backed by an abundance of VCs with friendly terms – but as the market tightens founders are looking to avoid bad deals. Share Jason Hosking, the co-founder and chief executive of Sydney-based retail technology start-up Hivery, knows he is one of the lucky local tech entrepreneurs to have closed a big recent funding round on favourable terms. Even with a $US30 million ($43 million) cheque in his back pocket from a round led by New York-based Tiger Global, he has had a taste of the swift and sometimes painful shift in the private capital markets that has driven venture capitalists to slash the value of their investments and forced many company founders to quickly cut costs and reassess their growth ambitions. Jason Hosking says he has been advised by his backers that raising money will be more difficult in the near to medium term. Dominic Lorrimer Hivery started raising its series-B round in February, with the team riding the last remaining momentum from 2021 to sign term sheets in early April at “a significantly higher” valuation than its earlier rounds. By the time his deal closed in early July, Hosking says the mood in the market had changed dramatically, and his investors told him the money would need to last for twice as long, even if that meant growing more slowly. “The market has changed so much across that time that I think we were one of the fortunate ones. Even though the deal closed in the first week of July, we just squeezed in before everything went south in terms of valuations,” Hosking tells The Australian Financial Review. Advertisement “It hasn’t happened to us, but I have heard stories of deals dying after term sheets have been signed or terms being changed because the market conditions have changed so much.” Locally, VCs have marked down tech darling Canva by 36 per cent to $US25.6 billion, wiping $US14.4 billion of its value, and less dramatic but significant write-downs are happening across the industry. Hosking says he has been advised by his backers that raising money will be more difficult in the near to medium term, and to be prepared for other VCs to keep their powder dry, while they look to keep existing portfolio companies afloat, rather than taking on new investments. Double your runway “The main message that is coming from investors is that you need to double your runway. If having just closed a round, you were planning for that investment to last 18 months before your next raise, make it last for three years,” Hosking says. The company has adjusted its spending plans to adapt to the new reality, including delaying “non-core hires”. Advertisement “When you’ve got that sort of access to a free flowing capital market and you’re able to tap into that way quickly … you bring forward a lot of those investments,” he says. Jonathan Barouch, the founder and chief executive of Local Measure, has previously described his company’s near-death experience during COVID , and says that period has served as a dress rehearsal for the current market uncertainty. Jonathan Barouch, CEO and founder of Local Measure, says COVID chaos was a good dress rehearsal for the current tech wreck. Edwina Pickles Avoiding down rounds Towards the end of 2021, Barouch says his chairman Kim Jacobs pushed him to raise funds earlier than planned, and he closed a $5 million round in July at a similar valuation to its previous round. “From the investors that we were speaking to it just almost felt like there was a freeze like it was just very difficult for them to make decisions. So things that normally would take one or two weeks took six weeks or 10 weeks,” Barouch says. Advertisement “There was a very noticeable shift in attitude very, very quickly and it felt exactly the same as what happened like in March 2020 at the beginning of COVID.” The founder says he is now confident Local Measure has a sufficient runway to weather the storm, but has put payment terms and expenses under the microscope, downsizing offices to reduce rent, culling unused software subscriptions and only hiring in the areas they need. Lose leverage “Our revenue grew by 500 per cent last year, so we do still need to hire, but we can deploy the funds in the place that have the biggest ROI,” he says. “I think this kind of market forces you to look at absolutely everything, which I think is super healthy.” The end of easy money has further tipped the power imbalance in the VCs’ favour, meaning founders will need to pay close attention to highly structured terms and conditions that are cropping up, advisors warn. Advertisement Joe Patrick, the founder of advisory firm Astral Ventures, says he has advised on $100 million worth of deals in the past 12 months, and that he is now urging his clients to start thinking about raising capital sooner than they have in the past. “Ultimately, you want to avoid a situation where you’re raising with only a few months of runway left. That’s a situation where you lose all leverage in those discussions,” Patrick says. Patrick says company founders should be wary of “overly structured” term sheets, even if that means taking a down round, where the valuation of the business is lower than that of a previous raise. “In the market we are in at the moment, the power has never been more skewed in favour of the VC. I think a lot of them can smell blood in the water with these businesses and their capital investment is required for a lot of these businesses to stay alive,” he says. “One of the key messages that I’m trying to convey to founders is to not necessarily be afraid of a down round because often the alternative can be worse. Advertisement “Which is essentially trying to maintain an overly inflated price, or even a flat round, at the expense of VCs using much more arduous terms in the term sheets.” These tougher terms can include commercial mechanisms that protect a VC’s investment such as rising liquidation preferences, anti-dilution provisions, accrued dividends and participating preferred terms. Kicking the can down the road Patrick says accepting a lower valuation in 2022 wasn’t necessarily an indicator that the business was underperforming. “I think what’s actually happening here – and to give founders peace of mind – is that they’re actually victim to macro environment changes rather than micro environment change,” he says. “We have been going through a period of overinflated prices, and it’s really important for founders to understand the fair value of their own business because I think that that is something that we’ve become disconnected from over the last few years.” Advertisement Start-ups unwilling or unable to put off funding rounds are turning to convertible notes or VC debt (if they have the revenue to service the loan) to tide them over until the market changes. Anthony Boogert, a partner at King & Wood Mallesons who advises start-ups on financing, says convertible notes are a useful way to avoid placing emphasis on a company’s valuation. “The companies now don’t want to admit they’ve got lower valuations,” Boogert says. “So they’re using convertible notes, some with warrants, which give more investor protection but they’re able to put off that valuation discussion.” Generally, convertible notes allow investors to buy shares at a discount at the next capital raise. The standard discount is around 15 per cent. Advertisement They differ from normal equity rounds in that they must be repaid, like a normal loan, if they’re not converted before the maturity date. A sweetener for convertible note-holders is they are generally repaid ahead of shareholders if the company gets into financial difficulty. Last week, financial services start-up Spaceship alerted its investors it was issuing a convertible note following its inability to launch a series C fundraising round. Spaceship hopes to bank $12 million, and the maturity date is set at around the next capital raise when the company is hoping to re-establish its valuation away from the doom and gloom of depressed market sentiment. “People are basically putting off a discussion about valuation to try and hopefully raise enough money to wait until things turn and everyone’s really positive on these companies again,” Boogert says. Tess Bennett is a technology reporter with The Australian Financial Review, based in the Brisbane newsroom. She was previously the work & careers reporter. Connect with Tess on Twitter . Email Tess at tess.bennett@afr.com Jessica Sier writes on technology, internet culture, cryptocurrencies and software from our Sydney newsroom. She has previously covered global capital markets and economics. Connect with Jessica on Twitter . Email Jessica at jessica.sier@afr.com Save

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    King & Wood's headquarters is located at 40th Floor, Tower A, Fortune Plaza, Beijing.

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