Startup investing in the age of the coronavirus

We live in tragic and uncertain times in this global crisis. We’re in a new world today and things have changed dramatically since a few weeks ago. I’d like to take this opportunity to give advice and recommendations for how investors can react to the coronavirus.

Market Segments

Due to self quarantining, certain industries will be more in-favor, and others will be challenged.

Projected challenging industries:

• Transportation — due to travel bans and self quarantining
• Hotels — lack of travel will cause a dip in hotel bookings
• Sports — crowds can’t gather, sports teams can’t interact
• Spas — customers will fear going to retail in-general
• Apparel / luxury goods — if you’re at-home for the foreseeable future, there’s less reason to buy a dress or necklace
• Restaurants and bars — customers will fear group settings at restaurants. They may also fear restaurant delivery out of a concern that the cooks may have the virus
• Construction — it may become less feasible to create new buildings due to the group interactions required among the construction workers
• Fitness facilities — gyms, yoga studios will see a drop in usage / may close for safety reasons
• Tourism — also a losing market segment due to the lack of travel being permitted
• Online dating — since people are fearful to interact, there are likely to be fewer new romantic relationship opportunities
• Colleges, trade schools, and in-person bootcamps — some schools have already started to close. students won’t be comfortable going to classes even if schools are open
• Blockchain — since many blockchain companies don’t have a business model and are dependent on investor capital that may be less available
• Film production — movie actors can’t get-together to film for safety reasons
• … plus any business that involve physical stores or involves group interactions.

Projected strong market segments:

• Online education — in the absence of physical schools, students are turning towards online education as a solution
• Video conferencing — office workers are remaining productive by using tools such as Zoom
• Virtual event technology — physical conferences are being cancelled, and virtual events are replacing them
• Remote work technologies — Technologies such as Loop and Slack which enable virtual offices to coordinate and communicate are more essential than before
• Subscription entertainment — Netflix, HBO, and others will need to fill-in the void left by external entertainment
• At-home delivery networks to bring goods to people’s homes — Now more necessary than ever due to retail stores being closed and fear of crowds. Depending on how long the downturn lasts, this may accelerate regulatory approval for drone delivery as well.
• At-home exercise companies — To stay in-shape, consumers are likely to workout at home more often than in gyms which are perceived as risky
• Online E-Commerce — We’re seeing a large surge in demand for E-Commerce due to self-quarantining
• Video games and virtual reality — Being at-home means more boredom and fewer hours worked, with less employer scrutiny of your time. This means more free time to use at-home entertainment
• Subscription food delivery and subscription commerce — Having products delivered on a subscription is going to become more important due to a lack of local options
• Air purification / sanitization — Having clean air and clean facilities will be top-of-mind for the foreseeable future
• Internet-based services — Reliance on the Internet (especially at-home Internet) is likely to surge in demand, and traffic will likely become congested

How startups will favor

In the long-run, the market will recover and each of these market segments will likely recover. But in the near-term and mid-term, we believe that startups who build products/services in the above favorable categories are generally going to have an advantage to succeed over those who build in the out-of-favor categories. We are already starting to see this play-out within our portfolio. For example:

• Steezy (online dance education company, from our portfolio) had their best week ever — see here
• Crowdcast (virtual conferences, from our portfolio) is also exploding on traction right now — see here
• 99 Minutos (E-Commerce delivery network in Latin America, from our new fund) also had their best week ever.

What this also means is that future financing rounds will be easier to secure for startups building in favorable categories, and tougher to secure for out-of-favor categories. This is a big deal for a venture firm, because if the growth path ahead is stunted, then that affects their fund’s returns. Investors will price that into deals they deploy capital into, since follow-on rounds are important to factor-in when making a risk-adjusted bet.

This will also impact startups who sell into those industries. For example, if you’re a startup that sells products/services to E-Commerce space or to the Netflixes of the world, you have an advantage towards having a bright future. On the contrary, if you’re building a startup that sells software to the hotel industry or sports industry, you should expect long sales cycles and fewer deals. This is because the customers have less revenue to justify purchasing your technology. Note that selling into favorable verticals is likely to be a strategy implemented by your competitors too. So it’s not a complete solution, since the target verticals will get saturated.

It’s also harder to get face-to-face meetings, which means deals will take longer to close because you can’t make a face-to-face impression. Buyers are going to scrutinize the value proposition of their purchases and will need to justify the ROI (either by saving on costs, or by increasing revenue).

What is correct investor behavior in a downturn?

A common emotional reaction to an investor is to pull-out of investing during a downturn, as a safety protective measure. Yet history has taught us this is not correct behavior. The dot-com bubble burst gave rise to Amazon, EBay, and many others. During the 2008 financial crisis, Github, Pinterest, Slack, and Stripe were created. If you were not investing in the market at that time, you would have lost-out on those opportunities.

We believe that to make returns as a venture investor, you must be willing to be a bit contrarian to the market. If you’re in the right deals, early-stage startup investing is likely to be more attractive (rather than less attractive) during a downturn. This is due to less competition from other VCs, and more reasonable valuations.

Prediction: Startup valuations will become more reasonable

We’re predicting a reduction in valuations across the board, and valuation multiples are going to recede. We’ve already started to see that unfold, with valuations having a 30%-50% haircut (anecdotally).

Note that various sectors intertwine. There’s a butterfly effect that’s very real and in-play here. Markets can be correlated, and so even if a company isn’t in an out-of-favor sector, there will be an overall industry slowdown. Because of this, startups will generally experience lower valuation multiples even if a startup is in a favorable industry.

The startups that serve the less-favorable industries will likely have a tougher time in the near-term earning revenue and getting profitable. This will result in them relying more heavily on venture capital, and coming back to investors for bridge rounds. There’s also an emotion-based psychological impact that is likely to set-in, where startups will raise extra capital as a way to buffer future uncertainty.

This will cause a supply/demand shift where there’s more demand for venture capital from startups. This is one of the causes of a lower valuation multiple.

What this means for investors

The venture capital industry will change. The reduction in valuation multiples is likely to create a market that’s attractive for price-sensitive investors who can remain disciplined and not over-pay when investing in startups. We’re already starting to see early-signs of having choices of startups at reasonable valuations, and we expect this to continue as time passes. As such, we are open for business, and our strategy is to be patient and to discover fairly-valued, strong companies. We are keeping significant capital in reserve for this reason.

Conversely, this could be tough news for companies who raised at high valuations. They may have a rude awakening that their next round of funding is more challenging to raise than they expected, and startups may risk failing as a result. The venture firms who invested in those companies that may be at-risk are firms who have large positions in Series B/C/D rounds. Some of their portfolio companies are going to have a hard time raising because later-stage investors will arbitrage between public market valuations and private market valuations. As a result, those firms may be responsible for providing those bridge rounds themselves, and discovering a path to profitability. This one of the reasons why having strong reserves will be important for venture firms. Higher reserves means less capital for new investments, further depressing valuations.

The best startups are still going to be competitive and oversubscribed. But the power dynamic is likely to shift a bit from the entrepreneur to the investor. Across the board, the bar is going to increase. Due-diligence will take longer, more questions will be asked, and fewer deals will be oversubscribed. This is generally positive news for newer funds who have dry powder to deploy, and potentially risky news for legacy funds who may have overpaid a bit on historical deals.

Advice we are giving our startups

We’re preparing to communicate the following general advice to our portfolio companies —

• Prioritize selling into verticals that are corona-resistant
• Don’t over-optimize on valuation. It’s better to have a bit more dilution if it means more runway and cushion.
• Keep burn low and get profitable quickly. Prioritize profitability over growth.
• Don’t rely on a future fundraising round. Control your own destiny.

Our strategy with the Hack VC Fund

About 5 months ago, we sat down with a highly regarded Chief Investment Officer of a well-regarded pension fund. We both agreed on something that may surprise you — that a market correction could be healthy for the venture capital industry. The reason is there’s been a bubble on startup valuations over the past few years. An overall market correction may help bolster the returns for investors who have new funds in the market. It may conversely injure returns for investors who have large exposure to existing positions in overvalued companies who are far from profitable.

With our new Hack VC fund, we have started to deploy capital in small quantities, but have not yet deployed a material amount of capital. In fact, we haven’t even had our 2nd close of our fund yet. As a result, we have not been negatively impacted and have a fairly blank slate for our new fund and are open for business. Here is our strategy going-forward —

Early stage — we are doubling-down on focusing on early-stage. This is because it generally takes 5–10 years for early-stage technology companies to mature and have an exit. As a result, early stage startup performance isn’t strictly correlated with public markets. We will likely be in a very different economic cycle (potentially another bull cycle) by the time our companies exit. This is one of the reasons why we love early-stage startups since they’re somewhat isolated from public markets as an asset-class.

Be stricter on valuation — we’ve become extremely valuation sensitive. This is because follow-on rounds are likely to be more challenging to raise, and anticipating the future valuation multiple depression. So unless we are more strict on valuation, we run the risk of future rounds being tougher to raise. This month we were fortunate to be able to invest in a high-quality stealth startup at a much more sensible valuation than what the company would obtain normally during bull markets, and we feel lucky to have had the opportunity to partner with this company. We expect trends like this to continue.

Diversification — this market calamity also is a good reminder for why diversification is so critical for investors. You never want to be overly-exposed to any particular asset class or sector. At Hack VC, we have an inherently diversified portfolio because we write modest-sized checks into early-stage companies. We do this intentionally to protect ourselves from the inherent risk that comes from being too concentrated in any one company. Market calamities have a muted effect on us.

Prefer capital efficient startups — We prefer startups who have a remote development team (e.g. in Eastern Europe or Latin America) since engineers are about 1/3 of the price of US engineers, and are much easier to hire and retain. We also prefer to invest in software, rather than manufactured products. These types of startups can get profitable much more quickly.

Seek out startups that can still thrive, even in the age of the coronavirus — we’ve started to de-prioritize investing in startups that cater to industries which are impacted by the coronavirus, and emphasize startups that are in more favorable categories. Here are two examples —

1) This month we made an investment into an early-stage company that saves companies millions of dollars per year on their data logs. This type of value proposition is likely to resonate strongly in the age of the coronavirus where businesses need to reduce costs however possible. The company doesn’t need this round of capital (they have plenty of runway) and this gives them even more cushion to get profitable with this round so that they do not need another round of capital.

2) Another investment we’ve made this month is into the #1 E-Commerce delivery network in Latin America, 99 Minutos. This company is seeing a large spike in demand this week due to the coronavirus due to a higher demand for E-Commerce deliveries given self-quarantines of consumers.

We are doing a fairly deep analysis of our existing portfolio of 150 historical companies to identify additional winners who are likely to be break-outs in this new world, which may be candidates for our new fund assuming the price is reasonable.

Closing Thoughts

If you have questions or comments feel free to relay them to me as I’d enjoy having a conversation with you at ed@hack-vc.com.