Hi, it’s Victor Cheng here from SaasCEO.com. Today, I want to talk to you about capital markets and how they change in a recession. If you’re an accounting-oriented person, you recognize that the balance sheet has two forms of capital: debt and equity. Equity is raising venture capital, angel investors, and selling stock in your company. Debt is getting a loan, line of credit, or a credit card — financing to run your operations. Those categories of capital will often change, and sometimes quite dramatically, in a recession. I want to give you some historical perspective on what tends to change, what to look out for, and what to do in case certain changes happen.
When the stock market crashes, as it is in March of 2020, the private equity investors — private equity being private equity firms, PE firms, or venture capitalists — their perception of what they can sell a business for changes. The public markets set the IPO valuation for a particular amount of cash flow and that becomes a reference point for how private companies are valued. If stock markets value companies very highly, then private equity investors, owners of stock in private companies, they tend to value business higher because that becomes a reference point. The idea also is that you can either take your company public, or you can sell your business and sell your cash flow to a public company, and then that cash will be valued at the multiple of the public equity markets.
When the public equity valuations change, it dramatically changes the perception of valuations for private investors. I know I have not raised capital in the last 14 days just because the markets changed so quickly. But, you can expect that valuations will go down, perception of market risk will go up, perception of financial operating risk will go up, which then suppresses market valuations. The bottom line: it’s harder to get equity capital. If you can get it, it’s usually less and on worse terms than in a good market. So, you need to be prepared for that. That’s on the equity side.
On the debt side, the thing to look out for is lenders getting extremely nervous about the amount of credit they’ve extended to you. One of the things that happened in 2008 was, a lot of small, medium, and large companies had lines of credit. These are for businesses that are seasonal. They finance operating expenses in the slowest season, and they pay back in the peak season. Or they just need a lot of operating cash flow, they sell to big companies, big companies take maybe three to six months to pay their bills, and so, you use the line of credit to cover your expenses while you’re waiting to be paid by your customers. That’s a very common use for debt capital. In the venture-backed startups world or the SaaS world, there’s a lot of debt used to fund expansion, growth capital, in some cases, the venture capital to start a business up. That’s kind of the range of what debt is used for in the kinds of companies I talk to.
Now, one of the things you want to be careful of is that you want to actually read your line of credit documents. This is a great time to actually read the contracts. You want to figure out if the amount of credit you’ve been extended can be reduced without warning by your lender. Maybe they lent you half a million, a million, or five million dollars in a line of credit. Can they dial that back when they want to? One of the things that happened in 2008 was that the stock market crashed about 35%. I think it was in one day. So, it was brutal. The smart, financially-savvy CEOs, the SaaS companies that had a good CFO, they looked at their line of credit. They realized they’re only using 10% of the line of credit. A lot of them just maxed out the entire line of credit. Maybe they had a $5 million line, they were only using a million, they immediately withdrew $4 million against the line and got up to 100% of the line utilization immediately.
The thinking, which turned out to be correct in that year, was that the banks are going to freak out, the market is imploding, especially the debt markets that year because of the subprime mortgage crisis. Banks are going to reevaluate the risks of their portfolio of loans. They’re going to decide that they’re overexposed, have too much risk, and want to take it down. They take it down by doing one of two things. One is, they don’t issue any more new loans so their portfolio doesn’t get bigger. And then, for the lines of credit that have been extended to have a variable amount of money that can be lent out, they dial back the credit limit as a way to cap their risk in case your business has problems and goes under. That’s their mentality. So, smart CEOs, smart CFOs just took all the capital and just withdrew it within 24 hours of the stock market crash because they knew it was going to happen.
I don’t if know that’s happening right now, to be honest. I would certainly be worried about it. I would certainly go and read my lending agreements to see if they have the ability to do that. Really think about it. Can you afford the interest expense? Drawing that line might be a smart thing to do if you need liquidity to run your operations. One of the things I’ve been emphasizing with my clients, with my portfolio companies is, “Do not expect that you can raise capital.” I’ve been saying this for several years now, “Yeah, you’ve got capital, great. But, you cannot assume that more capital is available. You have to operate your business and your cash management as if you can’t raise more capital, and plan accordingly.” CEOs and founders are just inherently very optimistic. I’m always the most pessimistic person on a board. But, there’s a reason I share that point of view. It’s to be an offset to CEOs that are more optimistic.
Now it’s come to a situation where who knows what capital is available now? Things are changing so dramatically, so significantly. It is unclear what equity capital is available, under what terms, and what kind of debt capital is available, and again, under what terms. There’s a lot of uncertainty. I wanted to paint that picture of what that looks like, what to look out for, and some options of how you can respond to that so that you have some historical familiarity with what happens to the capital markets and the changing macroenvironment. That’s my thought for today. Best of luck running your business and stay tuned for other videos on how to thrive in an uncertain economic time. Thanks, everyone. Have a great day.