Apr 1, 2020
Responsible investing during the COVID-19 crisis
Now is the time for investors to prove themselves as great long-term partners to entrepreneurs and that it’s not just a marketing gimmick
Market conditions during COVID-19
At the time of writing, we’re about a month into the severe COVID-19 outbreak in the West. In the first two weeks, there were lots of “business as usual” signs up, proving only partially accurate. It is now clear that the market has changed. As in past crises, the main effects on the startup funding market are fewer and slower investments and readjusted valuations. There are two main drivers: 1) Lower economic activity causing loss of business and slower growth. 2) Great uncertainty related to health and economic impact short- and long-term, which will be dependant on the duration of interventions.
A few market segments are experiencing growth as a result of the pandemic, such as remote work services/tools, streaming, delivery, etc. There is no liquidity freeze and with reduced uncertainty, the investment activity is expected to pick up to a level supported by the macroeconomic conditions.
Investor adjustments
As the crisis hit home, VCs spend more time with the existing portfolio triaging to get a clear and revised view on impact, liquidity, runway, reservations, and priorities. Doors are not completely closed to new investments. Initial conversations will continue digitally and a few good investments will be made, but slower, with a higher bar and more scrutiny on terms, mainly valuation. Seasoned angels think and operate much like VCs in this respect. Less committed angels will likely disappear for now or forever.
Other investor categories, such as family offices, industrial investors, hedge funds, etc. tend to be even more cyclical, which has been most pronounced for corporate VCs in the past. The same is expected now, due to short term budget priorities and reallocation between asset classes to maximize returns. The stock market is down 30% +/- which is an important parameter for financial investors investing in multiple asset classes.
Some investors may stick around or be attracted to startup investing looking for “great deals”. This is clearly helpful from a liquidity perspective but is also tricky/dangerous with the particular dynamics of startup investing.
Liquidity is priority #1
The crisis hits startups differently based on the timing of the last funding round and money in the bank, which may be somewhat arbitrary. For startups needing liquidy for operations now, funding is priority #1 and a must for surviving short-term and thriving long-term. Fundraising in this market still requires a cool head and working with investors to make sure the “medicine” does not have side effects that damage or kill the “patient”, even if some funding terms make founders hold their noses.
Effects and collateral damage of irresponsible investment practices
In mature startup ecosystems, good cap table management and protecting cap table integrity is critical to building successful startups. The cap table is critical for shareholder alignment and founder/team incentives to build long-term value based on sustained compounding growth. The cap table is in itself an indicator of company quality and an evaluation dimension for new investment opportunities by seasoned investors. Protecting the cap table is a delicate balance in good times and even more challenging now. This difficulty is most apparent when opportunistic and inexperienced investors seek to grab a larger slice of ownership in smaller rounds in this type of slow market with depressed valuations and perceived risk. Such cap table capture will undermine the company’s future prospects, and the cap table is the most likely unintended casualty of messy funding rounds by “vulture capital” during downturns. Opportunistic valuation dumps driven by investors will likely also be a factor impacting valuation in the next funding round, at least within 12 months, further compounding the problem.
A second-order effect of “clever deals” is that it undermines the trust in the company’s investors and stakeholders. This includes other off-market investment terms (e.g. double-dipping preferences, overhanging warrants, super pro-rata, etc.). Nobody wants to be in the trenches with partners considered likely to shoot you in the back when the battle ensues.
The described irresponsible investment practices, which may look like good deal-making now, are likely to cause damage as undetonated bombs exploding later when fundability, valuation drag, and lack of incentives/alignment impedes the optimal trajectories of startups. At worst, companies become unfundable due to the damage done.
Being a responsible investor in though times
There has been no shortage of investors claiming to be founder-friendly and long-term partners to founders. Surprise! Now is the time to prove it.
Let me first be clear: Being responsible and a good partner, is not being naive. The change in market conditions is real and so are adjustments in valuations. Cash is king. Lost cases must be cut. Active investors should help founders and management make needed adjustments for a lower growth scenario and reduce burn-rate as warranted.
Fundamentally, investing in tech startups is a long-term journey to pursue growth and great value together with founders and teams. This is very different than short-term deal-making and trading of listed stock to take advantage of market movements. This distinction becomes less clear to the untrained eye in times of crisis but is equally important. The key is to avoid undermining the foundation for future success by damaging relationships, incentive structures, and companies.
So what to do, if a good investment needs to extend runway in this market? The most likely solution is an inside round. How the funding is done will impact the future opportunity space. Best practice, assuming it is a good company making good progress, is:
- A convertible debt structure is the natural bridge alternative for inside rounds. It lets the external market be the judge in due course without providing undesired signaling while avoiding friction, misalignment, damage to relationships between stakeholder and retaining full founder and team incentives to bring the company to “dry land”. A convertible is a normal structure even in good markets, albeit generally less needed. The incentive for investors to participate is a rebate on the conversion price to equity in the next round. Rebates, often in the 10–20% range in normal markets (depending on time horizon and possibly interest), are up to 10%-points higher in tough times. As a second-order effect, the bridge tends to convert at a lower price relatively unless the market rebounds quickly.
- Top-up/extend/reopen the last equity round is a good second alternative if new investors join and need to see a priced round. Reopening an existing round on the same terms and format is relatively simple and leaves little to argue about. The defacto rebate is that progress since the last funding round is not reflected in a higher valuation. The drawback relative to a convertible is that the price is a stronger signal for the next round and the structure provides less incentive for founders and team in the short- to medium-term.
Other funding alternatives may also work, but keep in mind that aggressive internal repricing of companies or exotic deal formats/terms tend to cause significant problems.
Stay true to your principles
We fear for good startups in smaller ecosystems, such as our home market of Norway, where there are fewer tier-one VCs showing the way and less experienced startup investors. The issue is likely compounded in markets where investment bankers play a larger role in connecting investors and startups, adding a layer between the primary stakeholders, and are incentivized by transactions more than the long term value. (Worth a separate post?) We call on fellow investors, angels and VCs, committed to building a thriving and successful ecosystem for the long run to think ahead and consider the full picture when investing now. Can we achieve herd immunity to “vulture capital”? We can if we stay true to the principles of being founder-friendly and long term partners that we sold to our founders while also making the hard choices needed in challenging times.
To all founders, startup team members and fellow investors out there: Stay safe! Stay healthy! Stay responsible!
