This Downturn Is Different: What We Expect In A Recession Marred By Coronavirus
By: Donald Butler
Tags: VC, Startup, Coronavirus, Economics, Trends

This article was originally published online in Forbes.

We all knew that we were at the end of a long economic expansion and overdue for a contraction. We’ve been through downturns before, having worked with companies in both 2001 and 2009. What’s daunting about this looming downturn is that it forces us to consider not only what will likely happen to our companies, but also what impact social isolation will add.

What Does Data From The Past Two Recessions Teach Us?

To better understand what could happen, we reviewed data from past contractions in the venture industry during these two recessions. We used that as a baseline to estimate the additional impact social isolation could have on businesses.

Our conclusion is that on top of the challenges we’ve seen startups face during prior downturns, there will be a differential impact on two types of startups in particular: those serving affected industries and those whose business models depend on direct sales.

When we look at the data for the last two recessions, we find a contraction in the funding environment, a reduction in the number of new companies funded and a drop in valuations for startups more generally.

We can follow the process that plays out from the top: investment in venture funds themselves. Commitments by limited partners to venture funds fell by 41% from 2000 to 2001; and by 58% from 2008 to 2009. So, if the past is prologue, it would not be surprising to see commitments to VCs cut in half this year.

Figure 1. Funds raised by US VC firms. Sources: PitchBook Data, Inc, NVCA Venture Monitor

Venture capitalists, in turn, cut their investments in companies in both 2001 and 2009, investing 49% less in 2001 than they did in 2000; and 30% less in 2009 than they did in 2008. So, playing this forward, we expect up a 30% drop of VC investing in startups.

Figure 2. Funds invested in US startups by VC funds. Sources: PitcBook Data, Inc.; NVCA Venture Monitor

Venture firms will be working with existing portfolio companies to help them through this downturn. If recessions cause a shift towards emphasizing their portfolio companies, it also causes firms to set a higher bar for new investments. As a result, we’ve also seen a decrease in the number of new series A financings. Specifically, there was a 37% drop from 2000 to 2001; and a 27% drop from 2008 to 2009. So again, if we see this pattern in this cycle, we could easily see a 30% drop in new series A financings. This could also be an effect rather than a cause. Times like these cause risk-averse entrepreneurs to hold off on starting new ventures. That drop in financings could stem from fewer would-be CEOs starting companies.

Figure 3. The number of series A financings each year in the US. Source: PitchBook Data, Inc.

We also expect to see a sizable impact on company valuations. If we look at the last two downturns, we saw series A drops in pre-money valuations. There was a 32% drop from 2000 to 2001; and a 13% drop from 2008 to 2009. Our expectations is that there will be a meaningful impact on valuations for those companies pursuing additional rounds of financing this year.

Figure 4. Pre-money Valuations for Series A, B, and C Financings in the US. Source: PitchBook Data, Inc.

If we look at the last two recessions, we can see an indication of what might unfold in 2020 for startups. Startups can prepare for a recession by reducing expenses and tightening their business models to focus on where they are best able to stretch their cash. The last recession focused on the financial and housing sectors; however, this one appears to be quite different.

What’s Different This Time Around

What is especially daunting to consider is the unique impact that COVID-19 could have on a recession. In addition to the medical and social costs, enforced social isolation is likely to have its greatest impact on companies that serve the affected industries — and companies that depend on direct sales.

We’ve already seen the immediate impacts on certain industries, including travel, entertainment and leisure. When it comes to the economy, we are concerned with the impact that this particular recession will have on small businesses. We can begin by considering what happened to unemployment in the last recession.

Figure 5. US Unemployment Rate. Source: US Bureau of Labor Statistics

Unemployment hit 10% in the last recession. What level of unemployment will we reach this time? The Small Business Administration’s 2018 Small Business Profile shows that 48% of US employees worked for small businesses, and small businesses accounted for 45% of GDP. Small businesses also have accounted for the majority of employment growth. If this sector is severely impacted, how long could we see high levels of unemployment? The last recession decimated Wall Street, but this one seems to be making a beeline for Main Street.

We are also expecting an impact on companies with specific sales motions, such as enterprise software companies. We’ve already seen the widespread cancellation of conferences and in-person meetings. Will enterprise sales reps be able to effectively close new sales using telesales or videoconferences alone? Will sales cycles be delayed as a result? Will online demonstrations, and by extension, UI/UX become more of a focus for enterprise sales?

This is going to present a unique challenge for startups with direct sales models. In fact, other investors have told us they believe that this year’s bookings targets could be off by as much as 40% because of the combined effect of a recession and direct-sale limitations.

Now What Do We Do?

Looking back at the last two downturns, we fully expect to see the same elements, including reduced funding levels, fewer new company financings and reduced pricing in financing rounds this year.

What is unchartered territory for startups is how the differential impacts of the novel coronavirus will affect them. Clearly, we’ll see challenges by industry and business model. We also expect to see startups react to these new situations by not only reducing expenses, but also by adjusting how they operate — and how they market and sell to these new realities.

If you are part of the management team at a startup, what should you do?

Besides the traditional wisdom of trying to conserve as much cash as possible, the objective for many companies has transitioned from growth to extending the runway while proving out unit economics.

In times such as these, we’ll see a flight to quality in the private markets that reflects what we see in the public markets. Demonstrating that your company is a quality one is the new imperative. Companies that are able to do so will not only navigate this cycle, but will also emerge stronger when life returns to normal.