What Lenders and Equity Holders Should Consider in Challenged Circumstances
Factors Causing Stress in the SaaS and Software Sectors
Whether you believe a SaaS (or software) apocalypse is upon us or we are just looking at an inevitable correction driven by AI, SaaS and other venture-backed private software companies are facing the reality of aging cap tables, challenged valuations, and fundraising limits.
While all of that is difficult enough, the shareholders in the cap table — holders with aging positions, misaligned expectations, and unrealistic valuation demands — are creating high-risk situations by acting in conflict with their company’s senior debt lenders. The lenders are holding loans that are starting to amortize and are coming due. The borrowers are struggling to refinance or “take out” the lenders before they run out of cash, or worse, run out of options. Many lenders have already restructured, given covenant relief, or extended interest periods by the time the equity investors holding aging positions pose a real threat.
Given the continued sluggishness of the public and private equity markets, including the recent devaluation of many publicly traded SaaS and software companies, prospects for exit valuations for SaaS and software companies proposed a year ago (or even at the last round price) are difficult to come by. While many software companies will find a path forward, others will not due to lack of adequate capital, vision, disruption at the board level, or harmful cost-cutting. This is compounded by the deployment of capital and debt away from more traditional software and SaaS into AI companies. These factors are also causing stress and misalignment with the founder and management ranks who hold equity at the bottom of the waterfall, likely underwater and in an environment they cannot control.
Who are the Zombies, and Why Are They in the Cap Table?
Emerging companies raise money at different stages based on need. They bring on equity investors who are right for the moment but may not be right for the future. These investors obtain board positions, control rights and have other influence that may be misaligned later in the company’s growth. This is compounded when such investors cannot or will not continue to fund the company due to their internal fund limitations (lack of available capital, rebalancing of portfolio assets, or change of decisions makers) or changes in the company’s prospects.
With respect to the former, these may be funds that have an early stage focus, are family offices or high-net-worth investors with limited allocations, or conversely, larger funds that are consolidating bandwidth around perceived portfolio “winners.” As to the latter, not every venture-backed company will succeed, and changes in the marketplace — including technology disruptions – may cause existing investors to decline continuing engagement. Any or all of the investors that are not actively engaged with the company (or not acting realistically about the company’s prospects) are the “zombies” in the cap table — taking up valuable space in the capital stack but contributing little to the company’s current needs to support growth or exit.
The real challenge for zombie shareholders is to accept the falling valuation and exit prospects of the portfolio company they invested in years ago, often at valuations that cannot be supported now. This creates tremendous tension when such investors will not fund the company to a turnaround (if one can be planned) and at the same time will not accept disappointing valuations and lack of a robust or full returns. Hence, the zombie shareholders exercise rights and influence but do not cooperate with other holders in the capital stack or with the company’s senior lender. Since they are resistant to pressures from the senior lender, they create long periods of indecision by the board and voting shareholders, which leads to further erosion of the business. These zombie holders are typically loath to cede control to the lender, but ignoring the lender’s rights creates significant risk to the entire capital stack.
Senior Lenders – Zombie Slayers or Saviors?
In fairness to the shareholders, they made an investment and want their capital plus a return on the investment. They likely have duties to their own investors or simply want to maintain their own return objectives. They may also be closing out older funds and need to distribute assets or find a way to continue the funds. Nonetheless in challenged situations, they sit behind senior debt holders who have similar goals but also hold unilateral rights and remedies in conflict with the equity ranks.
However, while the interests between equity holders and debt providers may be in conflict, it doesn’t mean the interests are at odds. Stated differently, working with the senior lender can yield reasonable results for the equity ranks, while resisting the senior lender’s rights entirely could yield a complete wipeout of the equity capital. It is also a reality that the board must maintain engagement with the founder and management teams who have no incentive to stay around through protracted negotiations, litigation, or bankruptcy.
In many instances, if a sale process is undertaken and a plan is in place to bridge to exit, the senior lenders may provide further payment relief or even bridge the capital if no one else will. While these accommodations may come at an economic price to the equity, that price has to be weighed against the risks and costs of litigation, losing control of the assets, quickly pulling together equity in a down-round environment, or filing a bankruptcy (which creates further costs and uncertainties and likely extinguishes the value of the equity classes). The lenders will not tolerate and are not required to sustain significant reductions in the debt and returns to due to them – they too want their capital and interest paid (and are entitled to that ahead of the equity). However, a lender may tolerate some modification or conversion of debt obligations to equity if all stakeholders agree on a comprehensive strategy.
While senior lenders have no board-level fiduciary duties to the shareholders of their borrowers, lenders do have an economic and reputational need to work with borrowers to achieve positive outcomes. As such, a lender has no duty to save the equity ranks, but a positive outcome for the equity is possible through a cooperative strategy among the board, the lender, and the zombie holders. This requires all the stakeholders, zombies included, to evaluate the realistic possible outcomes and let go of outdated valuations.
The Upshot
The valuations of SaaS and software companies are under pressure as AI companies rapidly capture a greater share of venture equity and debt capital deployment. Related, the valuations and prospects of aging SaaS and software companies are legitimately challenged by emerging technologies driven or enhanced by AI (or other similar companies that are performing to higher benchmarks). While the aging “zombie” holders and lenders may conflict on potential outcomes, cooperation between and among the stakeholders, and finding ways to move the zombies from inaction and resistance to action and alignment is key to executing viable exits outside of foreclosure, bankruptcy or other distressed liquidation led by senior lenders. Senior lenders can and should bring pressure on all stakeholders, and especially the zombie holders, to recognize operational and capital limitations to hasten productive negotiations and bring alignment for a positive, if not perfect, outcome.
