Introduction
Venture capital is a high-risk, high-reward game. But what happens when that shiny, promising portfolio company starts to trend in the wrong direction? The question for venture capital funds (“VCs”) is not if it will happen, but when, and more importantly, how to respond effectively when it does. The following article explores different strategies that VCs may consider when addressing these challenges and attempting to maximize chances of the most favorable outcome.
Analyzing your hand
Before rushing into a pivotal decision regarding an investment, a VC will often prioritize leveraging the existing governance structure of the company and any investor rights negotiated at the outset of their investment in order to right the ship. This foundational step is crucial for assessing and hopefully mitigating the root cause of poor performance. For instance, VCs may consider a change to the composition of the board of directors or board committees, whether by replacing their own nominee(s) or strategically appointing or approving independent director(s), as a means to bring a fresh perspective to the business strategy. In circumstances where the VC does not have a board seat, or where data has not been shared by management to the board, VCs should not hesitate to lean heavily on their contractual information rights (often drafted in a broad and investor-friendly manner), in order to compel the company to provide the information required to adequately assess the situation before moving forward.
Doubling down
What if it becomes apparent that an immediate cash injection is required? The VC may then consider providing additional funding to their struggling portfolio company through convertible debt or another form of debt financing paired with an equity kicker, such as a warrant. This strategy allows the company to maintain operations while still preserving the potential for a turnaround and future upside for the investor. By tying the repayment terms or equity conversion to future valuation, the VC can continue to align its interests with the company’s long-term success while benefiting from greater downside protection on the new capital injection. It is a vote of confidence as to what the future holds and can aid in weathering an economic downturn or a specific market sector hit. However, adding liabilities to the balance sheet is not without risks. Struggling companies often face cash flow struggles, which can complicate their ability to meet additional debt obligations and complicate negotiations with their existing lenders. To mitigate these risks, repayment terms should be carefully considered, and security interests in favor of the VC should be structured to minimize their financial exposure.
Cutting your losses
Sometimes, a VC faced with an underperforming portfolio company may decide it is simply not worth “throwing good money after bad.” In such cases, the approach will inevitably shift to pursuing a liquidity event in a timely manner in order to mitigate the VC’s loss. Where applicable, VCs should consider invoking clauses under the company’s shareholder agreement such as a put right, drag-along right or forced sales process. These rights must be carefully considered, both from the perspective of being exercised unilaterally or together with other aligned shareholders.
In the absence of the aforementioned liquidity mechanisms, the VC will need to work collaboratively with the other shareholders to identify a strategic buyer or partner. This provides an opportunity to save value, promote synergy within an industry, enable expansion into new markets, or even access new critical resources (such as human capital or technology). Selling or merging a company can be especially beneficial when a buyer sees untapped potential or cohesive alignment with their existing operations triggering a value-add opportunity for their business.
Reshuffling the deck
While often seen as a last resort, restructuring, bankruptcy and insolvency proceedings can help preserve value by protecting and monetizing a portfolio company’s key assets such as intellectual property (“IP”). Proprietary IP such as novel technology, software, or patents, can retain significant monetary value even if the company itself is no longer operational. VCs can leverage their network and contacts to identify buyers or licensees specifically for these IP assets, ensuring their value is maximized. In certain circumstances, this may prove to be an excellent strategy to bolster other companies the VC has a stake in. Such proceedings also provide a structured process for settling debts while protecting valuable assets. VCs may even be in a position to acquire the IP themselves at a discount, keeping it on the sidelines, ready to deploy for future ventures. While this strategy rarely results in a profitable outcome, it does minimize losses and ensure that the portfolio company’s assets are not simply wasted.
Conclusion
By identifying challenges in a timely manner, evaluating options, and acting decisively, VCs can preserve value and position themselves for a gradual recovery despite an initial setback. The strategies outlined above demonstrate that proactive planning and timely, informed decision-making can not only mitigate losses but also unlock new avenues for growth. As the market evolves, VCs who stay agile and act strategically will be best positioned to capitalize on emerging opportunities. Now is the time to assess your portfolio, refine your approach, and take the necessary steps to navigate uncertainty with confidence.
