5 Ways Venture Funding Will Radically Change In This New World
Startups need to brace for fewer seed rounds, harsher terms and more earthly valuations
“My mom used to tell me, ‘I think you were born with a horseshoe up your ass,’” says Eric Rea.
He has reason to feel lucky. He’s CEO of Podium, a messaging platform for small businesses that’s based in Lehi, Utah, which at the end of March closed on a $125 million Series C round. It was one of the largest venture deals of a first quarter unlike any in memory — and not in a good way. Like most financing events consummated during the Covid-19 shutdown, Podium’s deal, which valued the fast-growing SaaS business at about $1.5 billion, had been negotiated well before any shelter-in-place orders were issued. But despite a significant change in macroeconomic conditions, Rea says, “we got the round done at the exact terms signed at the end of February.”
Thanks to getting a jump on the pandemic — and an existing relationship with returning investors, led by Y Combinator’s Continuity Fund — “we got lucky,” he says. “They would have had a legitimate rationale to say they changed their mind based on new evidence.” Other founders, he knows, are having a tougher time, facing not only Covid-discounted valuations, but the reemergence of some dicey deal terms that could haunt them for years to come.
Then again, what choice do they have? It’s brutal out there. Thanks to vanishing revenues, an April survey by research and policy advisory organization Startup Genome found that 65% of all companies, including 34% of startups that have raised at least a Series A round, have less than six months’ worth of runway. To slow their burn, nearly three-quarters of startups have had to let go of full-time employees, with 26% of them letting go of 60% or more of full-time staff. Companies desperate for cash now find themselves in a new world, where the power dynamics for negotiating venture deals are less in their favor. Here’s what they can expect.
Deals will be made, but there will be fewer of them
VCs are quarantining with $120 billion in cash reserves. But it won’t last forever.
Since 2014, VC funds have collectively raised $35 billion or more annually. While U.S. VC funds raised a strong $21 billion during Q1 2020 (compared to a total of $51 billion raised for the full year of 2019), a new National Venture Capital Association (NVCA) report forecasts a “capital crunch” in the coming months as VC firms’ traditional limited partners (“LPs”) flee to safer, more liquid assets, like public securities. VCs can also expect less support from corporate venture capital — the non-VC venture arms of companies across tech, health care, and transportation — which accounted for nearly half of total deal value last year. (See, for example, the second-biggest U.S. funding rounding of the first quarter, a $590 million Series C round for air-taxi startup Joby Aviation, led by Toyota and JetBlue Technology Ventures.) Such nontraditional investors have been quick to pull back in past recessions.
An anticipated lack of exit opportunities will add to the difficulty of VCs replenishing their coffers, encouraging them to be more frugal with their current reserves. VC-backed IPOs accounted for 43% of all U.S. IPOs in 2019, but no one’s expecting to see many of those again until the public markets stabilize. In the first quarter of 2020, there were just 10 VC-backed IPOs in the U.S., according to the PitchBook-NVCA Venture Monitor.
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Forecasts for the rest of the year look more like the last recession — 13 and 11 VC-backed IPOs closed in 2008 and 2009, respectively — rather than the 80-plus annual listings of the last two years. “Some companies will do it because the business is healthy and it’s time,” says Taylor Greene, a partner at New York City-based Collaborative Fund, an investor in Beyond Meat, Impossible Burger, Lyft, and Sweetgreen. “Some will be forced to do it because it’s their only option.” (Nearly all the U.S. IPOs that have taken place after the WHO’s Covid-19 emergency declaration have been for biotech or health care companies.) And some will do anything necessary to avoid IPOing in such an unfavorable market—just look at Airbnb’s $1 billion private equity raise, which shaved $5 billion off the company’s 2017 valuation.
Although acquisitions accounted for some of the biggest exits of the first quarter — including Intuit’s $7.1 billion purchase of Credit Karma, and Visa’s $5.3 billion for fintech Plaid — M&A activity is also likely to slow dramatically. Techstars data shows zero new M&A activity in April. “Big companies like Google and Salesforce will continue to find deals,” says David Cohen, the Denver-based cofounder and managing partner of the accelerator and seed fund. “But with companies that don’t do it all the time and aren’t as good at it, M&A will stop.” We haven’t yet seen an outbreak of canceled deals. Techstars found that through March and April only about 8% of previously negotiated financings had been delayed or canceled due to Covid-19.
But things are slowing down. Law firm Fenwick & West’s Q1 report on Silicon Valley venture deals showed a steady decline in financings, from 126 in January — the largest number in a single month in at least five years — to 60 in February, to 44 in March. (By comparison, there were 61 deals closed in March 2019.) “We’re looking at new deals, but we don’t feel pressure to spend or not spend,” says Greene. “If we see a good investment, we won’t hesitate to do it. But we’re going to be triple-checking our work and decisions.”
It will be much harder to raise early-stage funding
A good chunk of the $120 billion that VCs have amassed is reserved for reinvestment in portfolio companies. “I’d predict that VCs are going to focus more heavily on existing investments to make sure they’re taken care of,” says Cynthia Hess, a partner at Fenwick & West who co-chairs the firm’s Startups and Venture Capital Group. Tech-focused investors typically reserve $1 for follow-on investments in existing companies for every initial $1 invested in an early-stage company, while investors in life science companies usually reserve twice as much. Greene expects to see more insider “bridge rounds” — short-term financing from existing investors — at flat valuations, to keep companies afloat. (See Stripe’s recent Series G+ round, which raised an additional $600 million from investors including Andreessen Horowitz, General Catalyst, GV, and Sequoia, on the same terms and valuation as the previous round.)
“I’m hearing a 25% to 30% lower valuation as a ‘rule of thumb.’”
That means less money for early-stage companies. A recent CB Insights’ Q1 2020 MoneyTree report found a sharp decline in the number of seed rounds in the first quarter, which were down 27% from Q4 2019 and 43% from Q1 2019. If you’re simply reupping an existing relationship, “meeting on Zoom may not hinder things at all,” says Hess. “It’s so much harder for a new company without venture backing to go and raise money now.” Many investors are trying to push things off a bit. Rea has heard from at least one founder trying to raise a Series A only to be told, “Let’s catch up when the craziness dies down.”
Valuations will drop by around 25%
While there continue to be big raises, valuations overall are heading downward. “Whenever there’s disruption, prices decrease,” says Greene, in New York. “That’s driven by public markets and comps.” That is, as public company values decline, investors will recalibrate the value of similar private companies. Fenwick & West’s Q1 Silicon Valley report showed the average price increase in new financing — the change in company valuation now compared to its last funding round — declining through the quarter. In March 2020, the average increase was 46% (compared to 63% in March 2019), an indicator of more flat and “down” rounds.
Compared to funding pre-Covid, “I’m hearing a 25% to 30% lower valuation as a ‘rule of thumb,’” says Leslie Goldman, a partner at Houston- and Park City-based Artemis Fund, an early-stage investor in female-led and -founded businesses. Whether you see that as a discount or a correction is a matter of perspective, says Mark Suster, a partner at Upfront Ventures, a Santa Monica-based early-stage VC firm: “Perhaps your valuation was 50% too high when you raised 18 months ago. Valuation isn’t static and as a market we tend to only focus on corrections being ‘crushing’ rather than a reversion to the mean.”
“Entrepreneurs are seeing the world has changed and not expecting the same deals as before,” says Techstars’ Cohen. Sam Eder, cofounder of Big Wheelbarrow — an Austin-based provider of SaaS supply-management software services for the restaurant and retail food industry — has been meeting, virtually, with angels and VCs since the pandemic hit, trying to raise a seed round. “There’s money out there and people are writing checks,” he says. “But it’s moving slower, and there’s going to be discounting. If you were trying to raise $5 or $6 million pre-money before, then you’re in the $4 to $5 million range now.”
Term sheets will get a lot more complicated
As VCs seek to protect themselves, we’ll see more favorable terms built into financing deals. Although Fenwick & West’s report found no significant change in term sheets in Q1, “we’re already seeing a resurgence of terms we saw in prior downturns,” says Hess. Pay-to-play provisions, for example, are becoming more prevalent, requiring existing investors to chip in on new funding rounds or else lose their liquidation preferences. “That’s usually actually beneficial for founders,” Hess says, although it can create a perception problem if it looks like no one is subscribing to a follow-on round voluntarily.
Also poised to make a reappearance: the dreaded full-ratchet provisions, which require that investors be compensated for any dilution in their ownership caused by future rounds of fundraising. “Investors don’t know in full how the pandemic is going to affect companies,” Hess says. “They don’t want to put money in at too high a valuation.” Full-ratchet provisions, though, can be expensive from the perspective of company founders, diluting their ownership stake, and a deterrent to later-stage investors.
Some 12% of startups have seen their revenue increase by 10% or more since the beginning of the crisis, according to Startup Genome, and they’re not having trouble getting multiple term sheets.
Rea, at Podium, also expects to see more investors asking for so-called “participating” liquidation preferences, which allow venture backers to get their money back first in any liquidation event (IPO or sale), as well as receive a share of additional proceeds. While a 1x multiple is pretty standard, expect to see higher multiples — allowing investors to get back two or three times what they’ve put in before anyone else sees a penny — showing up on more term sheets, particularly in distressed sectors. “I’ve heard that Series B and C deals are coming back with 2x or 3X [liquidation] multiple on them,” says Franklin Isacson, a partner at Coefficient Capital, which launched a $170 million early-growth fund focused on consumer businesses last year.
More VCs are asking for board advisor seats, says Goldman: “We all want more transparency and ability to weigh in. That becomes even more important now than before, because we have more perspective to help guide the ship.” And even companies in “regular” industries could start to see investors asking for provisions that are much more common in emerging marketplaces, says Emily Paxhia, cofounder of Poseidon Ventures, a cannabis-focused San Francisco VC firm whose portfolio includes cannabis vaporizer unicorn Pax Labs. For example, she says, “if you can’t get aligned on valuation,” then “tranching” the investment — or doling out a funding round in increments tied to performance milestones — can provide a kind of mutual guarantee. “If founders don’t then hit those, we get a better price,” Paxhia says. “You can set this up to be way more predatory, but we tend to be pretty aligned with our founders.”
“New normal” businesses will still get funding
Some 12% of startups have seen their revenue increase by 10% or more since the beginning of the crisis, according to Startup Genome, and they’re not having trouble getting multiple term sheets. Startups focused on the “new normal” — remote work, telehealth, distance learning, and fintech — have all done well; more than half of the top 25 early-stage deals of the first quarter were in pharma and biotech startups. Notion Labs, a productivity software startup in San Francisco, raised a $50 million round in late March that valued the company at $2 billion (compared to $800 million at their last raise, in July 2019).
“We have more companies than we would have expected getting $100 million-plus term sheets because of the opportunity in the moment,” says Cohen. One of Goldman’s portfolio companies, UNest, which makes an app for managing 529 college savings plans, expects to close a Series A this week at double the valuation of their last financing, in late 2019. “They’ve had a tremendous surge in users since the stay-at-home mandates became effective,” says Goldman. “Seems people are thinking about the future for their children.”