VCs, Startups and Covid-19
By: Marc Penkala
Tags: Entrepreneurship, Venture Capitalist, Startup Lessons, Startup, Funding

2020s BLACK SWAN, THE PRE- AND POST-COVID-19 ERA

VCs, Startups and Covid-19

Opportunity or Genuine Economic Deterioration?

Powerpoint skills — Level Pro

The past years have been like a never ending romantic walk in the park for startups and VCs, love was in the air — no doubt.

VC funds have raised massive amounts of capital within the past decade, as values have gradually shifted from public to private markets. Within the same period startups experienced an aggressive funding bull run, peaking at USD 140B in 2019, compared to USD 28B in 2006.

Within the same period pre-money seed valuations doubled from USD 4.2M to USD 8M, series A pre-money valuations went up from USD 10M to USD 29M. Currently, we have more VC financed USD 1B+ (>60) unicorns than ever — what a time to be alive.

As if this wasn’t enough, VC funds sit on a Dagobert Duck sized pile of dry powder, waiting to be deployed. Though, Covid-19 may kill the romance for good. The VC ecosystem really hates uncertainty, as well as deflation.

Why should I buy something today, if I may buy it cheaper tomorrow? A USD 20M pre-money deal today may fund a USD 10M pre-money deal in 6 to 12 month, even if the financial performance did not change at all.

The pre-Covid-19 Era

If there is money in the market for “tinder for adoption”, “social networks for unemployed”, “yelp for people” or a website to “blackmail your friends” (YES, all of them received funding), you actually know something is fundamentally wrong.

Usually the invisible hand (Adam Smith — smart guy) would correct the market, like it did during the dot-com bubble. But nothing happened so far, that’s why the VC market used to look like this:

Valuations across all stages were at an all time high, they have been growing steadily in multiple industries, for the past 15 years.

Round sizes were sky rocketing from high to higher, especially in series B/C/D rounds, mostly due to massive USD 1B+ VC funds and of course Softbank.

Dilution was gradually decreasing and fairly low, as VCs were competing for the best startups and entrepreneurs, while LPs continued to seek yield in a zero interest environment.

Liquidity could not have been higher, due to the vivid and growing ecosystem of VCs, CVCs and government initiatives.

Burn rates hit the ceiling and were higher than ever. Growing cash-burn monsters were fuled with VC money, like a bodybuilder on steroids.

Profitability on a unit economic basis was low, hyper growth and market share were the main success indicators.

C ovid-19 brought a massive change of wind, the world is upside down now. We are in the middle of an economic free fall, capital markets are down, credit markets are frozen, central banks are interfering and uncertainty is our new companion.

The post-Covid-19 Era

Ups and downs always occur the oil squeeze, the dot-com bubble, the global financial crisis, the euro crisis and now Covid-19—though, this situation somehow feels very different, I assume that recovery will be long, painful and paved with uncertainty.

In order to grasp the actual implication of Covid-19, I would like to compare it to the global financial crisis in 2008 and the dot-com bubble in 2000. Right after Lehman fell, the invested VC Dollars dropped by 40% and whopping 49% after the dot-com bubble bursted, it took over two years to recover from the crisis in both cases. Though, it is important to remark that seed rounds recovered the fastest and series C rounds took the longest.

Looking at historic data, I found an interesting aspect. The deal count for early stage funding rounds did not change at all, aside of Q3/2008 which saw a dip. Valuations and round sizes were the main contributing factor to the decline in VC Dollars invested.

On the VC side, limited partner commitments to VC funds fell by over 40% after 2000 and by whopping 58% after 2008. Therefore, we will likely see a similar dip here after Covid-19.

Lets compare today and the next 12 to 24 month with the pre-Covid-19 world:

Valuations across all stages will dramatically go down, especially in series B/C/D rounds, VCs will be very cautious with new deals. They will focus on their existing portfolio and opportunistic deals only.

Round sizes will drop and see new lows over the next month. Cash is king and so is runway, startups will opt to stay funded for as long as possible.

Dilution will increase over time, especially in seed rounds. Blended dilution over multiple rounds will see new highs.

Liquidity of VC funds will go down over time. New first time funds will be seldom, second and third time funds will be smaller than expected.

Burn rate of startups will go down, downsizing and bootstrapping will be basic survival requirements.

Profitability will have to increase, being cash-flow positive will be the new hyper growth.

The market will change for startups and VCs, we will move from a honeymoon phase to a real marriage with problems and challenges ahead of us. There will be fewer fear of missing out rounds and the upcoming rounds will surely be tougher than last year.

Startups, as well as VCs will have to expect slower growth rates, longer sales cycles and higher (natural) churn rates. Fundraising velocity will slow down, while being more difficult in general. There will be a general drop in business activity across industries, due to uncertainty and market volatility. Supply chains will see massive disruptions, due to the unprecedented lockdown in China and other markets. Prices, M&A activities and IPOs will decrease or slow down.

Could this be an opportunity to re-think how VCs invest into startups and how startups deploy their capital? Maybe a reset from 1 back to 0 is necessary from time to time, in order to maintain a sustainable and frugal startup ecosystem?

The Covid-19 Crisis Playbook

Most of the entrepreneurs raising money these days have never been in a recession, probably because they are too young. Entrepreneurs need to prepare for a down market, as the rules have changed.

Raising capital is somehow like playing a game of chess with a grand master (in this case the VC). Every conversation or meeting is a strategic move to position your startup, as an awesome investment and the best deal around.

Great companies are build in good and bad markets, the best companies will still get funded—survival of the fittest. Therefore, entrepreneurs have to sell their startup according to the adjusted investment criteria of VCs.

Typically recessions are great markets to start a company. For example Google, PayPal and Salesforce soldiered through the aftermath of the dot-com bubble. Or more recently Airbnb, Square, Stripe, Uber and Instagram were founded in the midst of the global financial Crisis.

Entrepreneurs should carefully think about the following 10 action steps:

Burn your 2020 business plan and strategy, start with a blank canvas. React, adopt and iterate fast! Be proactive and focus on profitability. Extend your runway, cut costs and streamline cash relevant operations. Focus. Eliminate side project, experiments and underperforming units. Be conservative raising funds, accept higher dilution and lower valuations. Question your business fundamentals, revise key performing indicators. Raise productivity and re-think your headcount, downsize your team. Communicate well and often with your customers, investors and board. Demonstrate the leadership your team needs, during this stressful time. Cash is king, evaluate all alternatives and don’t rely on VC investments.