How to Deal with Foreign Currency Risks when Raising Capital Overseas
Fundraising is an international endeavour for many startups and scale-ups. According to DealRoom.co, 42% of Venture Capital invested in 2022 went to countries other than the VCs’ home market.
Yet most VC investors would rather invest in their own currencies. A US investor, for example, would naturally prefer investing in US dollars. Most US-based accelerators, such as Y Combinator, may even insist on setting up a US-based holding company even if your team comes from abroad.
As a result, dealing with international investors brings more complexity to your eventual finance and accounting needs. In this article, we dwell on the nature of such complexities and risks and what your business can do to mitigate them.
Top 5 tips for planning cashflows across currencies
Many startups that raise funds overseas do nothing about currency exposures and keep the received investment in the original currency until they spend it. At this point, they convert currencies at prevailing rates.
While it may seem at the time like a “quality problem to have”, planning in advance to manage FX costs and risks is rarely done, yet it can easily save hundreds of thousands of dollars in a seven-digit fundraise. More importantly, it can help you protect your cashflows and your “runway” from financial risks you thought you could not control.
FX risks are hard to understand in theory but equally hard to ignore in practice. They are often obscure to the inexperienced eye, and many finance teams learn about them through painful real-life experiences.
These are five main things to remember if you want to learn how to avoid such risks without costly mistakes:
- Currency markets are hard to predict. Periods of relative stability do not imply low FX risks in the future.
- Having committed cash flows in foreign currencies results in financial risks similar to a speculative FX position.
- Having currency mismatches for prolonged periods leads to the highest currency risks.
- Dealing with budget FX rates and having FX Gains & Losses in your income statements are telltale signs of FX risks.
- Speaking to experienced peers can save you time and help you understand your currency mismatch.
Understanding currency mismatch when fundraising in foreign currencies
No matter which currency they raise funds in, a typical startup will spend the raised capital on wages, R&D, professional services, and other costs that are mostly incurred in their local currency.
So when the investment comes in a currency different from the one it will be spent in, there is a currency mismatch. Funding in one currency must be converted into another currency to pay for costs in line with the “burn rate”. Most startups are aware of such currency mismatch when they have it and will convert currencies every so often to ensure they have liquidity to pay their immediate needs:
Such an approach focuses on periodically addressing short-term needs while keeping cash balances in the original funding currency. Unfortunately, this results in ignoring the biggest FX risks — those from cashflows farther in the future.
Any committed cash flow that needs to be converted from one currency to another in the future depends on the exchange rate at that time. If the exchange rate moves unfavourably, this will result in excess cash burden and a higher effective burn rate.
Such potential move can be greater for longer periods of time - as exchange rates have more time to move away from current levels. For example, there is a 10% probability that the GBPUSD exchange rate can move 26% over 100 weeks and only 11% over a shorter, four-week period:
Unfortunately, most startups look at converting currencies for cash management needs and while ignoring financial risk management needs.
Keeping your liquidity in a currency different to the one in which you “burn” can shorten the “runway” for your startup
The above-mentioned FX fluctuations can impact the “runway” unless one manages the currency risks. Consider this hypothetical example:
A UK-based startup raised $5 million in investment. With most of its costs in Pounds Sterling, its financial plan budgets £220K in monthly burn rate. Using the prevailing exchange rate, this equates to $280K per month, giving this startup approximately 18 months of runway.
Unless the startup fixes current exchange rates, either by converting the entirety of the funding into pounds sterling or by entering into FX hedging contracts, they are exposed to the risk that the US dollar weakens.
The risks of such weakness are greatest for the longer-term cash flows: the last 6 months of the 18-month plan are responsible for 45% potential extra “burn” due to currency losses, while the first 6 months - account for a mere 19%:
As a result, there is one in four chance that dollar weakness will wipe out almost two months' worth of runway and a 10% probability it can be as much as 3 months:
How to reduce FX risks from raising capital overseas:
To reduce these risks, most startups have several options:
- Convert the raised capital into their local currency shortly after the investment funds are received.
- Locking exchange rates using hedging instruments such as FX forwards or options.
Learn more about Hedgeflows
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