Distressed venture is coming to save your orphaned startups

In This Article:

The typical venture model relies on a lot of misses and a few home runs to offset losses elsewhere. But for startups that fail to get follow-on funding, distressed venture offers a chance to rebuild outside of a growth-at-all-costs mindset.

Despite being less common than other funding strategies, distressed venture has been around for decades.

These investors target startups that have raised funding but aren't hitting the necessary growth targets to receive further capital, let alone become a unicorn or achieve a high-profile public listing. Firms like MBM Capital then acquire a majority stake, typically at a steep discount, recapitalize a company and take control of operations alongside founders to put them on a more conservative growth path with the hopes of achieving profitability.

"We're taking companies out of the venture lane and putting them in a private equity lane," said MBM Capital managing partner Lauren Bonner. "We're not trying to kind of pop them back up onto that venture unicorn trajectory. That is not our goal.

"Our goal is to find companies that are fundamentally good businesses with business models that make sense and are revenue-generating. They just need a second chance so that they can grow profitably and sustainably, and then have a meaningful exit for founders and investors."

According to Bonner, the opportunities for distressed ventures are likely to become plentiful with the current downturn.

Traditional VCs need to constantly evaluate their portfolio companies to focus on those with the best potential to deliver outsize returns. With the downturn and the fact that some investors are facing a cash shortage themselves due to LPs reconsidering future commitments to VC, the bar for startups to receive follow-on funding is much higher than during 2021's peak, leaving some "orphaned" and without investor guidance.

"I do think that we'll see more need with [the downturn]," Bonner said. "Founders and investors are used to living on the edge, being able to close that round just in time or get the next convertible note, but the climate is different now. I think distressed venture is going to become a more crowded space."

The downturn may open up a new crop of startups to distressed venture investors, as more companies may find themselves fast running out of cash and with limited hope of raising new funding to extend their runways.

The strategies used to turn these companies around are similar to the ones deployed by distressed private equity investors. Cost-cutting becomes a top priority for startups that have overhired or lost focus on their core activities. Layoffs, replacing sales teams, eliminating certain perks and shuttering non-core divisions are also common steps taken to improve a company's chances of surviving. But reducing overhead is just part of the distressed venture playbook, according to Krista Morgan, general partner at distressed investor Stage.

"It's still venture at the end of the day, so you do need a growth mindset," Morgan said. "You need to think about costs and not overspending, but it's not enough to just come in and pull out costs. Our goal is to get them to a more solid place financially and then strategically invest in the team and the product to get growth."

Distressed venture investors take a hands-on approach to help their portfolio companies grow sustainably, with the goal of reaching profitability and then exiting within a few years. Unlike traditional venture, they don't aim for billion-dollar IPOs, but rather acquisitions and smaller listings for a majority of their portfolio, with smaller expected returns.

Distressed venture has the potential to transform underperforming companies into solid businesses, and Bonner believes that more investors will be paying attention, given the current environment. But it's not for the faint-hearted.

Fundraising, for example, can be difficult. Trying to convince LPs to put their money toward revitalizing startups that other VCs have given up on is not an easy task, especially with returns likely to be lower than when investing in traditional venture. The strategy also requires an enormous amount of time and effort on behalf of the investors to turn a flailing company into a thriving one—and on a much shorter timescale.

A big sticking point can be the founders themselves. Building a business in the context of VC requires a certain mindset, often predominantly focused on hypergrowth, and it's one that is quite different from distressed venture. It can be challenging for a founder to see a new investor come in and make sometimes drastic changes to their startup.

"We're told in venture that you need to consistently raise money at higher valuations and spend a ton of money all the time to be successful, and it can be difficult to change that mindset," Morgan said. "It's a culture shift for founders, but it can be freeing to let go of the stress that comes with constantly raising and thinking about how to grow at all costs. We're giving startups a fresh start to get back to the basics of what they love and build something that will last."

Related read: Investors salivate for distressed debt opportunities

Featured image by metamorworks/Shutterstock

This article originally appeared on PitchBook News