Covid19 has hit everyone quite badly and due to their fragile nature startups are especially in danger during this time of uncertainty (running out of money is actually one of the major reasons reason startups fail). Experiences from the 2008 financial crisis have shown that VC activity slows down significantly during and after an economic crisis (e.g. Block, Vries & Sander, 2010), so the natural question arises: which investors are still actively investing during this time? In a great move this list was started by Phil Wilkinson in order to understand which funds are still actively looking for investments. If you scroll through the list, you get the impression that investors have not changed their behavior at all and that you can go out fundraising now as well as ever.
But let’s face reality here: no fund has the incentive to openly admit that they are not planning on investing due to the current economic circumstances. For one, that would make them seem very risk-averse (not really a great sign for an investor in this highly risky asset class) and secondly, the possibility still exists that they might just miss out on great deal (remember: investors are driven by an incredibly high degree of fomo).
Talking to people in the ecosystem you hear a completely different picture from what Wilkinson’s list might tell you: many investors already had to stop their investment activities and a majority is taking a more passive approach to new investments until at least some of the uncertainty has passed. This means that while you might still be able to pitch to investors, the likelihood of actually closing a deal is pretty slim.
Let me give you a few insights to explain my point as to why you should in fact not start fundraising and what you can do instead to increase your runway.
The Venture Capital industry is suffering from this crisis in more ways than one.
For one, consumers and companies have less money to spend and may postpone purchases into an uncertain future due to the lock-down and historically high rates of unemployment right now, but the real worry is that a recession will follow which will exacerbate the current problem by a yet unknown factor. While some industries are currently more affected than others, a recession would hit (almost) every company out there.
I’m not going to provide a full account of the potential impact of Covid19 on the economy here since there is lots of great reading material out there, e.g. read this for a great (German) summary or subscribe to The Economist. The main take-away here is that startups, similar to more mature companies, should prepare for a period of lower revenues, i.e. increased burn if costs are not cut to the same degree, which will shorten the time before your startup runs out of money. If less cash-inflow means that startups need more money from investors sooner than expected and with the 6-month timeline of an average fundraise, founders might have to start fundraising right now.
However, investors are hit just as much as any other company during this time. Let’s remember: VC money comes from insurance companies, large banks, pension funds, wealthy individuals and corporates that want to diversify. As part of their portfolio strategy, these individuals and institutions invest a certain, small percentage of their assets into the risky asset class “Venture Capital”. If they have fewer assets under management (due to losses on the stock exchange or because their companies are also experiencing lower revenues), this naturally decreases the Euro amount they can invest in Venture Capital (given the percentage is fixed).
Does this mean funds that recently closed their fundraising do not have this problem, because they already have the capital? Unfortunately, no. The way that funds work is that they receive money from their investors in tranches, also known as capital calls, in order for the money to not lie around idly (not investing it would come at high opportunity costs). A concept that makes a lot of economic sense now puts even closed funds at risk: if investors have gone insolvent in the meantime, funds will not be able to call this capital. You can now see why we can expect a lot less VC money on the market in the near future, which brings me to the next risk for investors (and startups).
Not only will each fund itself have less money to invest in startups, this in turn obviously also means that follow-on and especially exit routes will become much more difficult. VC funds make their money by investing in startups at a relatively low valuation, which is then constantly increased in each follow-on round until an exit event happens at a (hopefully) incredibly high valuation. This exit event can be a secondary sale, an acquisition or an IPO (the holy grail of VC). But if each of financial investors (secondary sale), strategic investors (acquisition) and the public (IPO) have less money available, they won’t be able to spend as much on startups, meaning you can expect less activity in terms of exits.
But this does not only affect the activity of investments: as Entrée Capital put it delicately, “valuations have reset — we are not interested in pre COVID19 valuations” (at least they’re honest). Valuations for deals right now will be significantly lower than they would have been only a few weeks earlier. Although seemingly forgotten in the past few months / years, startup valuations are actually based on real world financials and methods such as DCF, meaning that less future cash inflow (due to lower revenues) and a high discount rate (due to the uncertainty) simply leads to a lower valuation.
So, what can you do if you really need cash?
One thing that I did not mention before is that investors are extremely focused on their existing portfolio companies right now. These of course have the same problems as all other companies, and the number one priority for investors right now is to extinguish the fires around them. This behavior has been found to be true for the financial crisis as well, where the number of first round investments was much more affected than that of later funding rounds (again: Block, Vries & Sander, 2010). While this means investors will be less open for new investments, it also means that you can speak to your existing investors about options for bridging the current time. If you have a good relationship with your investment managers and your business was previously on a good growth rate, the investor will be interested in keeping your company afloat. A word of caution though: make sure that your investors don’t exploit this situation. Of course, valuations are at a different level now, and yes you don’t have many options, but in the interest of working together in the future, they should be able to offer you a fair deal. And, as a side note, this is the point where you’ll finally know whether you chose the right investor: how does she/he handle this difficult situation?
Another option that you have is finding a wealthy individual that is interested in a bridge financing: for one, they have much more liberty in their decision processes (and will hence not be affected by corporate cost cutting programs) and secondly, they are known to be less focused on financials and more on the overall vision. In fact, investments by Business Angels do not seem to be impacted as much by financial crises as that of institutional investors (cf. Mason & Harrison, 2015). Some other investors out there might fall into this category as well due to leaner decision processes and a longer-term outlook, e.g. family offices such as Russmedia and really cool exceptional investors such as Speedinvest (biased but #unpaidad). Find a list of the currently most active investors here.
Generally, you might want to avoid priced rounds (and resulting down-rounds) right now, so a good option is using convertible notes. And make use of government-sponsored subsidies which provide money on the basis of very fair conditions, e.g. in Austria. Of course there are other, more creative measures such as starting with a clean slate by filing for insolvency. Either way, make sure you plan your strategy and start strict cashflow management right now, in order to make sure you don’t miss any (last) opportunities.
I really hope your company will be one of those that make it through this crisis. If you need help preparing your fundraising process (because you really have to right now) or have any specific questions around fundraising, feel free to reach out to me at email@example.com.