An analysis of the COVID-19 crisis' consequences on fundraising, term-sheets and day-to-day startup operations.
After unprecedented highs in venture capital investment over the last two years, an entrepreneurship community that has been spoiled by a strong economy is now grappling with a starkly different landscape. For student entrepreneurs, COVID-19 has not only made many past roadmaps and projected growth rates suddenly unattainable, but also forced them to evacuate their campuses and lose access to resource infrastructure. As the VC market cannot be projected to return to pre-crisis level anytime soon, let us take a look into the concrete consequences of the crisis on fundraising and term sheets, as well as necessary operational adjustments.
On a macro level, the crisis has led to a less capitalized VC market. Investors are more risk-averse and capital-conscious due to three major levers:
Just like many startups, VC funds currently raising new funds are seeing investors hold back their commitments. Some institutional investors with portfolios heavily exposed to VC are looking for safety, not returns. Thus, little new money is entering the VC market.
Exits — the central way a VC firm makes money — will rapidly decline in frequency this year. As companies avoid going public in the bear market, less funds for M&A activity are available, and in turn, fewer acquisitions will occur.
VCs are concentrating their efforts to support and secure portfolio companies — both by negotiating seed extensions and bridge rounds to keep companies afloat, as well by advising companies to make management decisions calibrated to the new environment. The attention and funds spent on the portfolio is money lacking in the open funding landscape, especially for early-stage companies.
Many startups, across all stages of maturity, are settling for raising bridge rounds or seed extensions at flat valuations to extend their runway and expand liquidity for the crisis. That is, even though many startups seeking signing these deals have grown revenue and developed their products substantially since raising their last money. From the investor side, bridge rounds target to equip founders with at least six-months of runway to provide cash to weather COVIDalso presents VCs with the opportunity to increase their stake in companies set to grow further and faster after the crisis at a comparatively low price.
From the founders' perspective, bridge rounds are a blessing and a curse. They can provide a vital capital lifeline, but also can result in unsuspected and costly dilution. Thus, founders want to raise enough for comfort — but nothing in excess. Raising bridge rounds is not an easy feat. It requires founders to have maintained excellent investor relations and adequate performance since closing the last round. Startups should look at closing bridge rounds in the COVID era as an impressive accomplishment and vote of confidence by investors.
For more mature companies, taking on capital through a bridge round makes financial sense, as it enables them to escape exits at unfavorable market conditions. One notable example was Stripe, which delayed its IPO to raise a $600 million bridge round on the same terms as their Series G round back in September.
Even though venture is a long-run game and VCs are necessarily risk takers by nature, the new normal is marked by fewer rounds getting closed and more cautious valuations across all financing stages. Thereby, early-stage startups looking to raise their first rounds are hit the hardest by the current crisis. Understandably, investors reason that startups with proven quality are more suited to face the challenging economic environment. Series A and onwards funding has thus increased in relative frequency. In contrast, as a measure of risk mitigation, many VCs have shifted their attention temporarily away from pre-seed and seed funding, with CB Insights research estimating a 20% decline since January.
As Andreessen Horowitz’s recent backing of Clubhouse at a staggering $100m valuation proved to the market, raising money has not been impossible — but the less-capitalized market is much more unforgivable. It is a market for superstars who do not only achieve product-market fit, but even more so "VC-market fit". Specifically, those startups which make the impression to enable investors to "ride the storm" instead of hiding from it by bearing the potential to directly profit from or become significant players in solving this crisis are able to raise as or more competitively priced rounds as before.
What this means for student entrepreneurs is that little short of the cream of the crop can expect to raise their first rounds over the next few months. And for those companies, minimizing cash burn will prove to be an essential but often challenging task; convertible notes can be an efficient avenue for taking short-term debt that converts to equity at the next financing for such companions.
When closing deals against the backdrop of the pandemic, VCs want to be rewarded for the added risk of committing capital in the crisis. Thus, even when founders are able to get their hands on a term sheet in the coming months, they will be confronted with an opportunity to raise at a much lower valuation than they would have prior COVID. Specifically, many VCs report seeing valuations down by upwards of 25% when compared to Q4 2019. In addition, VCs are looking to provide their startups with extended runway (> 18 months) to carry the investment past COVID into a growth environment. Thus, round sizes have only decreased marginally, but VCs are attaining more control in return, as founders are forced to part with even more equity.
Apart from lower valuations, the recession has led to a power exchange to the investor side. In the overcapitalized market of the last years, founders were able to set the terms. Now, they have to be much more strategic when and if at all to engage in negotiation battles. As a consequence, terms (especially regarding liquidation, vesting, etc.) have become much less founder friendly.
Founders will have to be both wary and understanding of such terms. Founders must set reasonable expectations for their investors and their teams, and must not give warrants that are impossible to ensure.
Some deals include warranties concerning the business plan and are thus prospective. For instance, these warrants may ensure that the business plan's financial forecast are fair, and estimates are based on the current circumstances and broader macroeconomic environment, considering as much information as available. In this time of crisis, it is almost impossible to craft any realistic or robust forecast; thus, founders should try to avoid warrants of this kind.
TL;DR: Lower valuations are becoming the standard during this time of crisis, especially for early-stage student companies. Because of the uncertainty of the macroeconomic environment, it is preferable to raise at a lower valuation over agreeing to "tranched investments" contingent on certain KPIs.
Written by Carlo Köbe; edited by Shaurya Mehta and Shan Reddy
This is the first article of a multi-part series analyzing the impact of the COVID-19 crisis on the venture landscape and student entrepreneurs. Keep an eye out for our next article, which will discuss how entrepreneurs should approach reaching cutting cost and improving capital efficiency.
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