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How can hypergrowth companies manage risk in a downward valuation cycle?

Venture capital investment in technology startups — which reached an all-time high in 2021, with global investments of more than $621 billion — is cooling down, dropping by more than 19% in the first quarter of 2022, compared to the previous quarter. For tech companies that had become used to successful rounds of financing to retain their growth momentum, this new reality will require tough decisions and introduce new risks.

As venture capital investments slow, growth startups should carefully assess cost-saving decisions

Hypergrowth companies require access to capital to make the big bets needed to fuel growth and they depend on successful rounds of financing to retain growth momentum. And when the cost of capital is low and venture capital firms are eager to invest, these companies may overlook potential investor and management liability risks.

But now venture capital investment in technology startups is cooling down, dropping by more than 19% in the first quarter of 2022, compared to the previous quarter. This new reality will require tough decisions and close scrutiny of typical and new risks.

The impact of cost-saving decisions on risk profile

When finances are tight, businesses often make three decisions that may directly affect their risk profile and increase investor-related risks.

  • Reduce staff. Trimming headcount can deliver short-term financial savings, but may delay the release of new products or services, slow sales of current offerings, or create long-term financial issues. These challenges may prolong your time to profitability and create investor discontent, potentially opening up your company to liability and lawsuits.
  • Attempt to raise money through a “down round”. Raising additional funds through a down round could affect ownership percentages and lead to the company losing market confidence, among other risks, which may also lead to investor-related lawsuits as your business decisions are questioned. 
  • Step up attempts to acquire other companies or seek to be acquired. Whether you are dealing with an acquisition or a move into a new product vertical, quick decisions can create substantial execution risk, especially if entering into regulated service offerings or searching for synergies in transactions.

4 actions for growth-oriented companies to reduce risk in a down valuation cycle

Fiscal tightening, together with macroeconomic and geopolitical challenges, may prolong the difficult capital environment surrounding growth-oriented organizations. Faced with these new challenges to sustained growth, you should consider ways to potentially reduce your risks, including:

1. Rethink your financial priorities. 

As you strive to retain liquidity during a cautious investment period, you should regularly review your evolving risk landscape and prioritize spending to protect your operations and balance sheet. It’s critical to think about the potential repercussions of each cost-cutting and investment action and determine how to effectively use capital to transfer risk.

This might be a good opportunity to carry out a thorough risk quantification exercise or gap analysis to help you better understand the impact that new risk may have on your organization and your business objectives. 

2. Align your risk management and insurance purchasing strategy. 

As you seek new ways to cut costs, you should consider whether investing in specific risk management techniques could help you reduce insurance costs, both through reduced rates and increased confidence in retaining more risk. 

It’s critical to understand your risk appetite and align your insurance program accordingly. Modeling exercises can provide insight into the projected effect of your mitigation strategies and help you determine the adequate level of coverage for your risk.

3. Embed your risk management plan within your organization’s overall operational strategy. 

Carry out an effective evaluation of your risk management plan and consider how decisions surrounding new product verticals or other strategic endeavors, such as acquisitions, can impact your risk profile. 

If you are considering acquiring new entities or merging with another company, review your representations and warranties coverage, which generally protects an insured against financial losses  that may result from breaches of such representations and warranties. 

4. View insurance as a business enabler. 

An effective risk transfer strategy with a robust risk transfer program can significantly mitigate risk and empower critical decision making for your organization. By mitigating downside risk, or appropriately hedging risk, growth companies can increase the likelihood of success by reducing their exposures. 

Explain your risk transfer programs, and the role they play in protecting your company, to your executives to help them understand the importance of continuing to purchase adequate coverage even during times when the company is reviewing its spending.

Growth-oriented companies are facing new risks during a volatile economic cycle that could have an impact on valuations. Whether you are a seed-stage, pre-revenue, or a large publicly traded company, it’s critical to carefully analyze any decisions in the context of your risk profile.

Discuss with your broker or insurance advisor the risk transfer solutions that are best suited for your situation and that can empower you to embark on strategic growth journeys.

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