Should Startups Be Worried About Their Next Fundraising Round?
Early March 2020, a singular meeting happened in every startup of the Western world. Even within the rank of entrepreneurs, the most optimistic among the optimists, there was no more possibility to ignore the fact that a tsunami was coming hard and fast towards their beloved organization and their teams.
Acceptance had to be immediately followed by careful, yet quick planning. So almost all founders in the world worked on a strategy to save their companies at all costs. Sequoia, after publishing a highly publicised memo (sent first to all of their portfolio companies, the same way they did in 2008) titled “Coronavirus: The Black Swan of 2020“, shared a matrix built by one of their portfolio company CFO showing an effective template to realize such planning (because let’s be honest, planning is rarely the superpower of tech entrepreneurs, for evident reasons).
And in the boardroom, all CEO pitchs were very close in spirit. These board meetings could all have been introduced by The Enchiridion chapter one by Epictetus stating that “some things are in our control and others not.“
On one hand, the disease and its consequences, be they economic and social, were not in our control. So the best that could be done was to identify several scenarii and be prepared for a tough reduction of activity and associated decrease of the topline, with different duration (depending on how we would control the virus and if several waves were to happen). On the other hand, entrepreneurs had something in their control: the ability to decrease their cost structure and postpone their capital expenditures. The measures could be done radically upfront or several decisions could be launched sequentially with pre-identified trigger points.
A good strategy is never generic. And depending on many factors, including the mental projections of board members, decisions would be custom-tailored.
Some entrepreneurs are in a more comfortable position than others: they have secured a significant runway or their activity hasn’t slowed that much (or even accelerated). Some rare chosen ones can even reach profitability, even during this turbulent period. But the runway isn’t large enough for others and they cannot avoid thinking of a coming fundraising round in the next 18 months.
And as newspapers started to report, even the most promising companies, backed by blue-chip venture firms, had to reset their expectations and raise with conditions much more degraded than they thought. Airbnb for instance, which was preparing its IPO, had to raise a mixed round of debt and equity at a far lower valuation than expected.
Airbnb for instance, which was preparing its IPO, had to raise a mixed round of debt and equity at a far lower valuation than expected.
Hans Swildens, chief executive of Industry Ventures, assesses that “about 80 percent of venture capitalists will be investing at “flat” or “down” prices compared with previous funding rounds“.
And to know whether entrepreneurs should be worried about their coming fundraising round, we should take a closer look at the forces at play.
One key parameter to consider is the dry powder, which refers to cash reserves kept on hand by private equity firms or individuals to cover future obligations, purchase assets or make acquisitions.
At first glance, dry powder seems to be rather significant and could be enough to cover entrepreneurs’ needs.
In the US, using both a fund-by-fund analysis (looking at 975 funds over $50m starting in 2014) and averages across the industry, Jon Sakoda, founding partner of Decibel, estimates that the industry has ~$150bn of dry powder in US venture funds.
In Europe, similar work has been done (tab ‘Stats‘) by Yann Roux and Stefano Bernadi. They estimate that the industry has around 18.39bn€ of dry powder (since the estimation starts in 2016 you can imagine it’s slightly above that). This estimation is backed by data collected from Dealroom and shared in a report co-published with Sifted. Given the fact that some of these 20bn€ has been invested but that you should add dry powder from vintages between 2015 and 2018, we could guess that the actual amount of dry powder in European venture capital funds is somewhere between 20 and 35bn€.
(As a side note, the amount of money raised by VC & Growth funds in Q1 2020 has grown by roughly 50% YoY, showing that LPs honoured their commitments.)
In France, the amount of dry powder has been estimated by Paul-François Fournier SEVP at the sovereign fund Bpifrance to be around 10bn€. (Once again, as a side note, it’s interesting to observe that the capital invested from VC and Growth funds have increased in Q1 2020 compared to Q1 2019 (+20%), as showed in a report realized by Franck Sebag, Partner at EY Partner in charge of Fast-Growing Companies & IPO.)
All of this seems like good news for entrepreneurs. But we should not jump too quickly to overly optimistic conclusions. Let’s examine at least 6 key issues regarding the situation and these amounts of dry powder:
#1: As noted by Franck Sebag, there is an increase of money invested in Q1 2020 compared to Q1 2019 but if you look at a higher granularity, there is a decrease of money invested in startups in March (-23% YoY) and April (-31% YoY) and this could be just the beginning of the visible slowdown since Franck reminds that “the typical fundraising last around 3 and 6 months so today’s rounds have been initiated several months ago“. (To look at the bright side of things, we should not forget that there is still more than twice the money invested in the same period compared to 2018, even in March.)
#2: Even if the total amount of dry power seems high in absolute terms, TheInformation showed that, if no additional money is raised by VC funds, in the US it would last only four quarters at the recent pace of investment ($35bn/quarter) and two years at the pace of 2016 (€20bn/quarter). In Europe the situation is almost identical. Assuming the higher range of 35bn€ and no additional money in funds, and taking the data from dealroom, the dry powder would not even last four quarters (€~10bn/quarter) with 2019 pace and it would also need to follow the pace of 2016 (€4.35bn/quarter) to last two years. (As a side note: hopefully public institutions are doing their best to avoid a sharp drop of money raised by funds.)
#3: These amounts of dry powders could turn out to be overstated if limited partners (LPs, the people and organizations that invest in VC funds) renege on their capital commitments. This would be especially a risk for family offices, high net worth, corporates and hedge funds.
#4: Also, the dry powder should be mentally separated into two different brackets: money kept as reserves for the investors’ portfolio companies and money for new investments. And all things being equal the first bracket will increase relative to the second — when exits are frozen and that it’s unclear what the behaviours of investors will be, VC should make sure to defend their portfolio companies when they can to avoid too heavy losses. So at least 50% of the dry powder should be virtually committed to portfolio companies at the time being (and more for early-stage investors since they keep around 50% of the reserve as a default situation). Assuming that there are still as many entrepreneurs launching companies, they will have slower capital available for their needs.
#5: A lot of money in the growth stage were fueled by alternative investors (hedge funds, mutual funds and wealthy individuals) that join recently the game due to the increase of attractivity of private companies (they were lasting private longer and were raising larger round, in 2018, $61bn were invested in deals over $100m), and they may leave the game as things get messy in the private market. They may also leave the private market because the relative attractivity of the public market may be increased given offering both liquidity and very high volatility. This would have an impact on the width of potential investors, leaving scale-ups financing to more specialized institutional investors, but also on the overall dynamics of the late stage, which would end up less competitive (which is good news for Growth investors sticking to the game).
#6: There is also a risk of reduction of capital invested from larger institutional investors such as endowments or pension funds. They are indeed facing what is called the denominator effect — the allocation in venture capital may have been mechanically significantly increased for asset owners as the price in the public market crashed. To illustrate it quickly, if you have 10% of 20bn invested in venture capital (2bn) and 90% in the public market (18bn), and public market lose 30% of their value then you end up having only 14.6bn with 2bn in venture capital and 12.6bn in the public market, which leads you to have a total allocation in VC shifting from 10% to c. 14% (since the denominator decreased).
This could be coupled with a “nominator effect“ if your venture portfolio is performing well — taking the last example if your VC investments that were 10% have doubled in value, you end up having 4bn in venture capital for a portfolio of 14.6bn, which is now 27% of your asset. (As a side note, French pension funds seem to be keeping the same pace of investment in venture capital funds. Kudos to them!)
#6Bis: This risk is also strengthened because large institutional investors are using the cash flows from their private equity portfolio to be able to pay new drawdowns from young funds. When exits are frozen, these cash flows may disappear since the fund managers will try to prolong their fund duration and ensure finding proper exit conditions. They can also use more liquid investment, such as their allocation in mutual funds. As ironically described by Chris Douvos of Ahoy Capital, “the public markets end up being the ATM for the illiquid stuff”. The issue is that it would not only actualize the loss in the public market (prices may go down, as long as you don’t sell it is just paper loss) and destabilize even more their asset allocation model. This is the reason why 20 years ago, during the dot-com crisis, many funds had to downsize even after their closing. Even blue-chip ones such as Accel had to reduce the size of their fund twice, in 2002 (-32%) and 2003 (-29%), after trying to just defer their drawdowns. (As a side note, situations are very different, there were 250m of internet users worldwide in 1999 and 4,574m today).
#7: General Partners, the managers of the funds, can try the secondary market and sell shares of their funds (or of portfolio companies) to get liquidity. It would allow them to meet LP expectation in term of cash flows for old funds, or recycle some of their proceeds into their portfolio companies (either by selling at a discount price shares of the most promising company that would anyway generate a good multiple or by selling shares of their less promising companies to save their more promising ones). Yet there is just too much uncertainty to ensure these transactions will occur now. So secondary transactions will probably happen only in several months for Hans Swildens, the founder of 20-year-old Industry Ventures an investment firm that invests in hundreds of venture funds and is also among the industry’s biggest buyers of secondary shares. He explains: “sellers have to reset pricing expectations, then buyers have to come up with a price they are willing to pay, and those things have to meet. And that takes one to two quarters.”
As you can read once again (it’s quite a recurring theme for us), the equity chain is highly interconnected. And what entrepreneurs will face cannot be found solely at the VC level. These 6 forces described are happening at every level and includes startups, VC, growth funds, all types of LPs, secondary funds and even public companies (and we didn’t even mention the impact of central banks, or the massive initiatives by governments and sovereign funds (Nicolas Dufourcq, head of Bpifrance, gave an estimation of 57bn€ of cash injected in 350,000 French SMEs and anticipated to lend over 100bn€ to support small companies during the crisis in France alone).
Now having this in mind, the question is concretely how investors and entrepreneurs can design the best deals in a situation where the dry powder is available but far from infinite, and where uncertainty is still high for everyone.
Investors will without a doubt favour companies that showed both resilience and integrity to their stakeholders, while being open and transparent towards their shareholders. Having made the right decisions early and demonstrating discipline will also be key elements that will be evaluated for the next round of fundraising.
Symmetrically, entrepreneurs will remember who were the supportive and helpful shareholders during the crisis and who were not. And they will spread the words. (And as described by Fred Destin, they will also do it for investors that don’t just adapt to the new market conditions but abuse from their bargaining position.)
The trending growth of price valuation and amount raised observed (often x2 every 12–18 months for these two parameters) will be probably disturbed.
And there should be discussions to design the best deals, for both players. Deals done in their purest form — super simple, and maximizing all possible elements — will probably morph into deals where trade-offs have to be made, between amount, valuation, protection.
These deals should be created as fairly as possible (keeping a certain symmetry and balance), while ensuring the right level of incentives. Tech entrepreneurship is a long time journey and should be made between aligned and cooperative parties.
Happily, as mentioned by Nicolas Brien, General Manager of France Digitale we, as entrepreneurs and investors, “should keep in mind that we are living a historic transformation of usages. The future shines bright for tech entrepreneurship and venture capital.“
A special thanks for people who helped me find data or shared their perspective, including Arnaud Bonzom, Nicolas Brien, Yoann Caujolle, Nicolas Colin, Mathieu Daix, Alexis Dupont, Kevin Kuipers, Nicolas Perard, Pauline Roux, Sebag Franck, Serge Vatine, the wonderful Gaia team, and people that prefer to remain anonymous but that will recognize themselves.
