Investor liquidity issues are putting the squeeze on Canadian startups

Last week, OMERS Ventures companion Laura Lenz mentioned publicly what so many Canadian VCs are discussing privately.

“Recently, I’ve heard of re-pricing by traders between time period sheet signing and ultimate docs signed,” Lenz wrote in a Twitter thread. “I’ve heard of ultimate docs signed and cash not being wired as a result of LPs [limited partners] had been failing to fulfill their capital calls. And shockingly, I’ve heard of cash being wired after which pulled again.”

Lenz shouldn’t be the just one—such gossip is at present rampant amongst Canadian VCs. Since the summer season, a number of sources BetaKit has spoken with have famous cases of capital calls not being honoured by LPs, together with these for 2 outstanding Canadian corporations by US LPs. BetaKit is selecting to not title the particular corporations being mentioned because it has but to independently confirm these claims.

While these liquidity issues are putting the squeeze on some Canadian VCs, the rapid hurt is to Canadian startups that are trying to fundraise—together with those who had closed rounds, solely to by no means see the funds materialize or be clawed again.

While these liquidity issues are putting the squeeze on some Canadian VCs, the rapid hurt is to Canadian startups that are trying to fundraise—together with those who had closed rounds, solely to by no means see the funds materialize or be clawed again.
 

“Over the previous few months now we have heard of those experiences firsthand, in addition to listening to from different traders and founders throughout Canada,” Lenz advised BetaKit. “Collectively, all of us must do higher.”

Sources with direct information of every deal have confirmed to BetaKit that capital issues have affected three completely different startups throughout British Columbia, Ontario, and Québec trying to boost funds. In one occasion, a verbal dedication was revoked following contingent board approval of a spending plan that included layoffs. In one other, a time period sheet was not honoured following professional rata disputes, blowing up the spherical and resulting in layoffs. In the third occasion, funds had been deposited to the startup earlier than traders sought to re-negotiate the phrases, leading to the spherical being re-priced and a portion of the financing returned.

Many of the sources that spoke to BetaKit about ongoing deal challenges did so below the situation of anonymity—some out of worry of reprisals from inside Canadian tech’s tight-knit funding group. For this story, BetaKit is selecting to not title any of the corporations concerned.

“This is excessive for me and an actual shock to what’s taking place in our market,” Lenz mentioned in a phone interview, talking particularly to the behaviour of funding funds being yanked again from startups. “It goes again to how that impacts the firm—this can be a firm that thinks they’ve raised [funds], it’s been wired into their checking account, they constructed a two-year working plan on and possibly employed based mostly on it. And now that cash’s being pulled again.”

Slow down

Lenz mentioned these “founder-unfriendly” strikes could also be defined by the present financial local weather, however aren’t excused by it.

“What behaviour do you need to painting? What relationship do you need to construct?” she requested of VC corporations. “We’re not shopping for a home and making an attempt to get the greatest worth, we’re getting married and we’re going to reside in that home with anyone else for the subsequent seven to 10 years.”

Lenz noticed related behaviour after the dot-com bubble burst in 2001 and through the nice monetary disaster in 2008. While she famous in her Twitter thread that, in the early days of the pandemic, OMERS Ventures thought-about pulling signed time period sheets, “the dialog was lower than 5 minutes as we agreed unanimously that we had been investing in nice corporations no matter market circumstances, and we worth our status.”

These are all examples of founder-unfriendly behaviour by VCs and progress fairness funds. Yes, monetary markets and the geopolitical setting are unsure – as they’ve all the time been. Poor market circumstances don’t excuse poor behaviour.

— Laura Lenz (@LauraLenz) January 18, 2023

It’s value noting that OMERS Ventures advantages on this context by sole-sourcing its enterprise capital from one in all Canada’s prime pension funds; different enterprise corporations and funds draw from a broader (and extra fragile) collective of restricted companions. In each earlier market routs and the present downturn, LPs have been hit by fairness market volatility that’s lowered their liquidity and devalued their portfolios. The result’s an overexposure to enterprise capital—an asset class that’s thought-about larger threat and tends to make up a small sliver of investor portfolios.

“A number of these massive institutional LPs have huge portfolios and VC is a small share,” mentioned one VC about the state of the Canadian market. “LPs are their portfolio and discovering they’re method obese in VC: it was solely imagined to be 5 p.c, and now it’s 10 p.c, they usually’re stopping or pausing their deployment of capital to VC as a result of they don’t need to put any more cash in the sector whereas ready for the public markets.”

Todd Miller, international co-head of personal capital advisory at Jefferies, advised Secondaries Investor that for the first time in a number of years, capital calls are outpacing distributions for LPs. “We suppose that’s going to proceed for some time,” Miller mentioned. “That will put strain on LPs to do extra gross sales, and provide will construct. We count on it to be a really energetic yr.”

According to a number of Canadian VCs BetaKit spoke with, a number of LPs referred to as on enterprise corporations over the summer season to ‘decelerate’ their tempo of investments and capital calls as they sought to rebalance their portfolios. Some VCs listened. Those that didn’t are now going through the penalties.

Call on me

Understanding how Canadian startups are affected by VCs’ relationships with their LPs requires understanding how capital calls are facilitated.

When a VC closes a brand new fund, the greenback quantity—typically in the a whole bunch of hundreds of thousands—isn’t sitting in the agency’s checking account able to deploy. Instead, it represents a dedicated quantity from the VC’s restricted companions. VCs solely ‘name capital’ from their LPs once they want a money infusion to fund an funding deal or cowl administration bills. Firms usually set the anticipated cadence of capital calls—wherever from per deal to per quarter—with their LP traders upfront.

But LPs, whether or not they’re multi-billion greenback pension funds or high-net-worth people, is usually a robust collective to wrangle, and ready on them to wire funds might decelerate—or kill—offers. Calling capital recurrently additionally will increase the wire switch charges traders would wish to pay.

Enter the capital name line of credit score, facilitated between VC corporations and banking establishments to maintain capital and deal stream liquid.

VCs take out these amenities from a number of banks, with every line tied to one in all their funds. The line is usually a portion of the fund’s whole worth—for instance, $10 million on a $100 million fund—with the financial institution receiving a notional curiosity in the fund’s underlying belongings as collateral for the mortgage. Having a capital name line provides VC corporations the liquidity to shortly finance a deal while not having to attend on LPs, and repay the steadiness as soon as the cash rolls in.

There’s additionally a slight monetary incentive for VCs utilizing a capital name line, mentioned Elizabeth Yin, co-founder and normal companion at early-stage enterprise agency Hustle Fund, who’s based mostly in San Francisco. When VCs calculate their inner fee of return, “the clock begins [on that growth rate] once they do a capital name,” she mentioned. Calling capital on a deal that finally ends up getting delayed weeks or months, whereas the cash sits in the fund’s checking account, can have a small affect on the fund’s IRR.

“We gained’t do a capital name till we all know we’re going to deploy cash, however some folks take it a step additional and take out a mortgage [on the capital call line] as a substitute so the clock hasn’t began, put the cash to work every now and then do the name later to get a little bit of a head begin,” Yin mentioned.

One Canadian banker BetaKit spoke to downplayed the significance of IRR juicing, nevertheless. They pegged a capital name line’s notional profit to the IRR at a roughly 40 to 60 foundation level enhance, a modest element of a fund’s total return.

Domino impact or a pink flag parade?

LPs have a robust incentive to not default on their capital calls: to overlook one means dropping the entirety of their stake in the fund. To achieve this additionally passes the hazard downstream: VCs that may’t totally clear their line of credit score in the allotted time-frame (often inside 12 months, typically inside six) are in default, and the fund’s underlying belongings go to the lender. Those underlying belongings? The VC agency’s fairness stake in a startup.

While the penalties are a lot larger for traders who’ve already made a number of capital infusions, Yin mentioned defaults are extra widespread in the early levels of fundraising from LPs who might have purchaser’s regret or low confidence in the fund. Speaking to the US market particularly, she mentioned that is one thing that’s taking place extra in the crypto area.

“Some folks are defaulting on objective as a result of they don’t consider the fund’s value something.”
– Elizabeth Yin,
Hustle Fund
 
 

“You have now VC funds, whose paper value of their fund has dropped possibly even in half or extra—we get a listing of all the late-stage corporations and what they’re value now in comparison with earlier than and the drops are loopy,” Yin mentioned. “They’re throughout 50 p.c cuts in valuation. And so late-stage traders’ portfolios are now … reduce in half or extra.”

“And their traders are in all probability like, ‘that’s horrible. Do I need to proceed doing my capital requires this fund?’” she continued. “Again, some folks are defaulting on objective as a result of they don’t consider the fund’s value something.”

The banker BetaKit spoke with believes that the probability of defaults taking place in Canadian tech is low given the multitude of choices out there to all events. For instance, VCs might both flip to the fund’s present traders to choose up the defaulted LP’s share or promote that dedication on the secondary market (non-public fairness corporations comparable to Harbourvest, Hamilton Lane, and Northleaf all provide secondary funds). They added that with roughly $4 billion of dry powder in the sector, a few of it in secondary funds, a defaulting LP is an annoyance that VC corporations are well-positioned to resolve themselves.

As effectively, a number of VCs advised BetaKit that fund managers are incentivized to play good in a down market. “It’s very delicate,” one VC mentioned. “Nine occasions out of 10 [if an LP asks to slow down] the VC might be going to pay attention, as a result of their enterprise relies upon on getting that cash.”

According to Pitchbook data from the third quarter of 2022, international dry powder throughout funding levels and sectors reached report highs of USD $585.5 billion.

Lenz is of two minds on the difficulty, noting that it’s “a fund’s accountability is to verify they’ve capital to deploy, and monitor and measure on a quarterly foundation what reserves their present portfolio wants versus what web new investments they’ll make.”

But the OMERS Ventures VC was additionally clear that having to name on different LPs to cowl a defaulting investor’s stake “shouldn’t be a very good signal. … It raises potential pink flags [for other LPs] of what’s taking place in the fund or the market.”

VCs BetaKit spoke with famous that these pink flags can have chilling results downstream. Yin mentioned as late-stage corporations maintain off capital calls to keep away from angering LPs, fundraising turns into more difficult for startups at the subsequent stage down. When these corporations flip to their insiders for bridge financing, these traders in flip cease funding new or early-stage corporations.

“Everyone’s centered on making an attempt to repair their very own inner metrics and their portfolio corporations,” Yin mentioned.

“For the founders affected it’s in all probability simply gut-wrenching and might destroy rounds and corporations,” added one early-stage VC BetaKit spoke with. They famous that VCs prioritizing money stream and inner metrics over prior commitments “sows a stage of distrust” inside the investor group.

“There are many VCs whose phrase is their bond—however for these whose phrase isn’t, tales like this make it a much less trusting market, and in the end it makes the whole lot tougher than it ought to be. In different phrases, tales like this erode belief at a time once we can unwell afford it.”

With information from Josh Scott. Feature picture courtesy Shutterstock.