Deal drought set to break as interest rates peak and investors look for the next big thing

The pause in interest rate rises by the Reserve Bank of Australia and welcome news from America that inflation is being tamed is paving the way for an end to the deal drought. 

But companies seeking pre-Initial Public Offering seed or venture capital may need to consider a rethink in their strategies on how to attract funding in the new economic climate. 

Capital has dried up significantly, as appetite for risk among investors has been dampened by high inflation and rising interest rates. This has driven a decline in IPOs on the ASX from a high of $12.3b in 2011 to $1.1b in 2022.  

The ASX had its busiest year on record in 2021 with 191 IPOs, but this was followed by a 54 per cent fall in 2022 with 87 listings.  

That may be all about to change.  

There is no shortage of major IPOs in the pipeline from household names including Virgin Australia, 7-Eleven, Chemist Warehouse, to data centre AirTrunk. 

But the fate of this growing pipeline rests on the verdict from investors on whether the interest rate cycle is really nearing its peak, or inflation has further to run, increasing the chances of a more severe economic downturn. 

So far it seems interest rates may be peaking, paving the way for a pivot in investment sentiment. 

But in attempting to tap new opportunities companies will find a very different landscape than during the capital raising boom. 

Then unlisted companies could rush to raise capital without considering the bigger picture and their overarching exit strategy.  

A market at its peak can demand aggressive pricing equivalent to the high multiples that listed comparable companies are trading. 

Ina slowing market, when the company goes back to investors to raise subsequent funding rounds, boards are having to pitch at prices well below the previous rounds. This can cause significant shareholder dilution, very unhappy investors, and have a flow-on effect on plans to move to an IPO. 

For example, the Bessemer Cloud Index shows that tech companies could demand as much as 18 times revenue in US capital raisings at the height of the venture capital boom in 2021. In today’s more risk-averse environment it is more common for investors to limit funding to around 10 times revenue.  

Growth for growth’s sake is no longer enough. More than ever, there needs to be substance behind the hype and venture capital companies need to focus on the basics of their business to get in the door of investment institutions. 

Overwhelmingly, successful founders are adhering to business fundamentals like capital efficiency and cost control. 

Recruiting a board with a strong track record is essential. Investors are seeking a board with directors who can demonstrate they have hit significant milestones in previous roles. 

Investors also want board members with skin in the game who can demonstrate they are aligned with shareholders and are earning performance rights or shares when major milestones are hit. 

Often, the first question that is asked in a meeting with institutional investors is how much of the capital raising is being covered by the chairperson and directors. If the board does not have skin in the game, investors are deterred.  

Upside potential in terms of the company’s business model and prospects remains one of the most important elements in attracting investors. 

But the “grow at all costs’’ mentality of 2021 has been replaced by an expectation that growth will be combined with a low cash burn rate. 

Investors are generally expecting a company to double revenues year on year and revenues to stabilise only when the company reaches maturity.   

In today’s climate potential investors will look at the quality of revenue, an ability to sustain reasonable or high margins, and how much money the company needs to spend to raise that revenue before they commit their funds. 

Revenue multiples and financial models such as discounted cash flow, net present value and comparisons with similar companies in the market should be used when calculating a valuation range, rather than plucking numbers out of the air. 

Communication is vital. Companies that keep their investors and shareholders informed tend to be treated more favourably in new funding rounds. 

Another key to successfully raising money is for boards to target potential Institutional cornerstones well in advance of opening a capital raise. 

We see companies getting turned down by institutional investors and fund managers a lot. This is because they have not sought to understand the fund’s investment criteria. In effect, they are pitching a deal that would not even get past the fund’s investment committee. 

When a board aligns the company with a portfolio managers’ mandates it is more likely to receive backing from the fund. 

With more than 50 per cent less deals in 2023 than in 2021, the pendulum has swung back towards investors at the expense of the founders. But there are dangers if the pendulum swings too far. 

The determination of value is a balancing act. When prices are too high, this reduces the upside for potential investors. 

If valuations creep too low, there is a danger it may impact the entrepreneurial drive that made the company valuable in the first place. 

If the founders’ control of their company becomes so diluted that they lose control, investors risk sapping the founder of the incentive to continue in the long-term. 

This could potentially deprive the company of one of the “it’’ factors that made it attractive in the first place.  

But in the end, to put it simply, if it’s a good deal, investors will flock to it.