How banking instability affects the entrepreneurial ecosystem: guidance for managing capital

Managing capital carefully and building a solid business model will assume an increasingly important role for entrepreneurs.

In brief

• VCs will become even more selective about how they deploy capital, focusing on entrepreneurs with sound economics and realistic growth trajectories.
• Startups will need to carefully review business models and manage cash carefully as they plot a course for the rest of 2023 and beyond. 
• Fundraising will continue, but deals will be more investor-friendly and take longer to close than we have seen in recent history. 

Recent banking failures surprised many and left venture investors and entrepreneurs in a difficult and increasingly complex situation. These failures are indicative of a broader, challenging economic environment that has seen record interest rate increases to fight persistent inflation.

Entrepreneurs need to focus on what happens next and how to fortify their companies in an unpredictable environment: the potential impacts of the failures and the strategies they should employ to manage capital as access to new funding becomes increasingly tight. 

Impact on the innovation economy

Even prior to current banking sector tumult, as market conditions have changed, VCs have been proceeding cautiously and taking more time to invest than they did a year ago, focusing on profit potential versus growth at all costs. These recent banking failures will result in an even more conservative approach to deploying capital. Now, deals will be fewer and on more investor-friendly terms, with longer closes. This is a big change from the recent VC bull market.

Guidance for entrepreneurs

We know great companies will emerge from this challenging market, much like we’ve seen in past downturns. But in an environment with tightening capital access, principles from the height of the COVID-19 pandemic should come into play. If you are fundraising, remember the bar is rising. VCs are prioritizing companies with solid management teams, product-market fit, proven unit economics and large addressable markets ripe for innovation.

As investment capital may be harder to source and doesn’t come cheap right now, here are four tips for entrepreneurs to help weather current conditions:

1. Take a step back and re-evaluate your forecasts. Recent banking failures partially resulted from the rapidly rising interest rates intended to tame inflation and avoid a potential recession. While this impacts all businesses, startups’ revenue projections and burn rates are particularly affected. Customers are re-evaluating spend, and startup costs keep creeping up. Companies must take a hard look at their operating plan and work backward to cash flow models to figure out how this impacts their capital needs. Among other things, this means you may need more capital sooner than expected. Entrepreneurs need to develop a realistic operating scenario, determine what they need to execute, and formulate a plan to raise the capital needed to move forward.

2. Explore and exhaust other means of securing capital. Identifying and securing capital will provide crucial flexibility to complement existing and/or new deals with VC backers. This could include:

• Drawing down lines of available credit
• Evaluating debt in all its flavors and considering alternatives to venture debt as it will become increasingly competitive and expensive to secure
• Exploring supplier financing options such as extended payment terms
• Negotiating rent or vendor pay delays
• Restructuring customer financing (some may be willing to prepay for a service or product)
• Reviewing cost savings opportunities through cost takeout programs, controls and a focus on cash throughout the organization

3. Become fluent in your cash burn rate. Many entrepreneurs likely spent the recent bull market focused more on competitive differentiation and go-to-market and less on their back office’s financial fundamentals. Ignoring these necessities will lead to difficult situations in the current market. Entrepreneurs should consider a 13-week direct cash flow forecast to assess their current standing and evaluate options, including:

• Converting as much of the balance sheet to cash as possible
• Having a highly efficient spending policy and control system to better manage how their money is spent, why and who is permitted to approve on said expenses
• Scenario planning for how your company can reach stability in the future. This will make it easier for leadership and employees alike to envision the required steps going forward

4. Don’t be afraid to reach out to partners, backers, financial institutions, or others. This is a sector-wide experience; an entrepreneur’s backers want the company to weather the conditions and come out stronger, just as much as the company itself does. Many stakeholders share interest in your company’s success, and management needs to explore where and how to get extra support

Companies face no shortage of challenges in this market. As macro-economic headwinds keep coming and the banking failures are better understood, entrepreneurs must carefully review their business models to gauge the appropriate next steps. That said, entrepreneurs are known for their resiliency, and those who can adapt to these challenges will emerge stronger and more capable.

The views reflected in this article are the views of the author and do not necessarily reflect the views of Ernst & Young LLP or other members of the global EY organization.