As has become clear to all of us, the devastating spread of COVID-19, the disease caused by the novel coronavirus, has created a public health crisis, disrupted the global economy and challenged us to rethink the fundamental considerations of all businesses, especially the economic imperatives for emerging companies.
Startups are facing extreme uncertainty, risk to funding sources, negative growth and workforce disruption in ways not seen since 9/11 or the 2008 recession. These are highly uncertain times, and investors across the spectrum—venture capital firms, corporate venture capital divisions and angel investors—are pulling back at the same time that customers are forced to rethink their own relationships. Tough times are ahead, but we have seen days like this before, and strong companies can survive and thrive if they move swiftly to respond to changing market dynamics.
A Change in Investor Behavior
While 2019 was yet another record year for venture capital fundraising, fundraising activity for some large institutional funds still in the market may slow down even though those funds currently have robust cash reserves. For smaller funds, this period could prove to be more pernicious. As we witnessed during the Great Recession, in pressing economic situations, smaller funds typically increase their investment activities to save existing portfolio companies, and thus see their reserves quickly dry up. As companies are forced to find new investors, it is not unusual to see wash-out rounds that eliminate gains and lead to those funds’ eventual shutdown. There was a sharp decline in the number of funds operating after the 2008 recession. We may well see that again.
Emerging companies will also be faced with the reality that many VCs are more likely to double down on existing superstar portfolio companies, concentrating on follow-on investments rather than making new investments. Forced to choose with limited capital, many VCs will be evaluating some of their less profitable or riskier portfolio companies and may have to make tough calls about which to support and which to let go. In any case, significant portfolio expansion is unlikely during the term of uncertainty and possibly longer. At the same time, great economic stress tends to drive angel investors to the sidelines as they move to preserve personal capital. Funds and individuals with excess capital will push hard on valuations and milestones as part of their more cautious diligence process.
In many ways, this crisis is a double whammy for startups: Not only are funding sources harder to come by, but many businesses around the country and the globe have been shuttered in an attempt to wrestle COVID-19 into submission. As a result, many startups are finding that their customer base has pulled back (or is starting to pull back) from the startup’s products and services, resulting in declines in revenue, hampering the startup’s path to profitability and increasing the need for additional fundraising. For example, companies that sell products for elective surgery are faced with months of zero procedures in front of them, and travel tech companies’ revenue is precipitously going to zero. Meanwhile, companies that are in the businesses of remote work, streaming and food delivery are experiencing their finest hours.
What to Expect When You’re Fundraising
While some bright spots are sure to exist, most startups expecting to raise funds in the next three to six months must now contend with the likelihood that raising additional rounds before Q4 2020 could be challenging. This is especially true for pre-seed or other early-stage startups that are pre- or mid-launch. If you are one of these companies, put your very best foot forward in your pitch; show evidence of why your deal is worth taking a chance on and get focused now on bootstrapping and efficiency.
Fortunately, we see evidence that “eighth inning” deals are still being completed. However, for deals that are earlier in the pipeline, or companies planning to raise money, expect some investors to walk away or to demand more investor-friendly terms, including better preferred returns; funding for their commitments in tranches; milestone-contingent provisions; and, most likely, lower valuations that provide them a greater equity stake. The speed of the deals will likely slow as cautious investors take more time to perform diligence on companies; thus, time between financing rounds may increase. Overall, there will be less competition for deals and, as a result, likely less pressure on investors to fund deals on the fast track that has characterized the past five to seven years. All of this will increase the pressure on startups to do more with less, and for longer periods of time. Learning those skills will pay off for companies in the long term.
Pre-seed or other early-stage startups will have to consider alternative sources of fundraising, like (a return to) friends and family rounds, crowdsourcing, revenue-based financing, and government grants. Some of these sources—particularly crowdsourcing and revenue-based financing—have not been widely tested through an economic downturn. This creates some uncertainty around the viability of those sources in the current environment. On the other hand, the government is likely to make some make-whole funding available to companies in general and to small companies in particular. Congress passed a nearly $2 trillion stimulus package that includes funding for small businesses and gig workers. It is too soon to know the extent to which investor-backed startups will benefit from that stimulus package. For broad-ranging analysis of the bill, head to Manatt’s COVID-19 resources page.
Later-stage companies face the risk of missing critical funding milestones that trigger the infusion of previously committed, if contingent, capital. If, after reassessing runways, companies realize their cash reserves are insufficient to carry them to the next round, they may have to consider alternative sources of funding, like drawing down on existing venture debt facilities or accelerating exit plans where there is a clearer path to value preservation.
A New “Normal,” Looking Forward, Learning From the Past
The “good old days” of founders setting the pace for investors are likely on pause. Investors will become more selective about deal-making and will have many companies from which to choose. As investors gain more bargaining power, founders may have to accept more investor-friendly terms. They must remember that survival of their company is the ultimate goal. While accepting additional dilution or more investor-friendly terms today may not be desirable, it could mean the difference between managing through this crisis to fight another day and needing to take even less desirable and more drastic measures later. The name of the game is staying in the game. Wait to act and your company could end up on the sidelines.
It’s been over a decade since the startup community had to contend with most of these factors—all of which are reminiscent of what took place during the Great Recession. It’s time to dust off the history books and look back at the fundraising experience of 2008–2009. See, for example, “Venture Capital Down 50%. It’s Not Just the Recession, Folks” by Sarah Lacy, TechCrunch, April 17, 2009, and “Venture Capital in the Great Recession,” PitchBook, April 26, 2019 (updated as of March 24, 2020).
Finally, amid the massive startup environment disruption we are about to face, it is worth noting that some of the strongest companies in the world emerged out of periods of economic downturn. Hewlett-Packard rose from the ashes of the Great Depression, Adobe and Cisco soldiered through the 1980s recession, Google and Salesforce.com survived the dot-com bubble in 2001, and Airbnb and Square were founded during the height of the 2008 recession. Household names like Disney, Microsoft and Apple were born in bad economic times. These companies learned how to thrive in periods of economic uncertainty and learned the toughness and resilience to keep them on the map to this day. Thinking smart, optimizing scarce resources and actively reinforcing the resilience of your team are essential in order to prepare your young company for the tough times ahead. Be targeted, spend smartly and be ready to quickly adapt to the changing landscape.