VC market: what to expect?

The great wave of Kanagawa

This story is the second of a series of stories about what we are experiencing as a fundraising advisor being close to both startups and investors during the coronavirus outbreak. For the first article, head out this way to hear more about the current situation from a macro perspective. In this second story we dig into what is going to happen to the VC market while and after the lockdown is over.

Usually, when an economic crisis hits, one of the first effect — mostly due to uncertainty — is a massive drop of investments. Cash becomes very scarce and the companies who manage to survive are either those that had enough cash to hold on to, or those that were able to react quickly.

To get some further insights, we shall check what happened in China right after the beginning of the lockdown. Indeed, as you can forecast the propagation of covid-19 in France by following the trend of Italy or Spain (they are about 10 days ahead of us), we as Europeans, can forecast the next few months by watching what happened to China’s VC market.

As a matter of fact, Chinese VC deals have contracted between 50 and 57 percentage points since the onset of the crisis. If a drop like that happens globally, even for just 2 months, approximately $28 billion in startup investment will go missing in 2020, with a dramatic impact on startups.

Figures from 2008

To further measure the impact of such a crisis, we can also check what happened to the VC market right after the 2008 crisis. Crunchbase recently gave us some numbers to back that up.

Hereunder are the few takeaways from this Crunchbase study :

• The earlier the stage, the lower the impact is
• For seed-stage, dollars volume took a fall of 50% in Q3 2008 and then grew back in 2008 (in Q4), 2009 and 2010. Probably because at that time, teams started to work with new technologies (Amazon Web Services or Iphone) and it quickly created new opportunities. Also, recessions are known as fertile ground to build startups…
• The funding environment shifted dramatically for Series A, B and C rounds in 2009 down year over year by 40 percent, 41 percent and 46 percent, respectively
• A, B and C round counts in 2009 were down between 27 and 28 percent year over year. That means one-third fewer startups raised early-stage funding in 2009
• In 2010 the funding market started growing again, but it took until 2011 for Series A and C round amounts to reach and surpass the volume of invested dollars in 2007

Obviously the startup ecosystem changed a lot since 2008 (especially in Europe) and also the very nature of this crisis is completely different as a great part of humanity is being locked down. As I speak, almost 3 billion people are confined to their homes for an indefinite period of time. The longer the lockdown, the bigger the impact.

VC’s focus on their portfolio

Lately, we spoke with a lot of VC partners and their feedback is always the same ! They are currently focusing on their own portfolio rather than investing in new opportunities. Basically they try to get the best picture of their portfolio companies in order to know how they can help each and every one of them. Whether they need Funding, HR, Tech or Exit, they have to know.

In order to do that, they try to split their portfolio into quartiles :

1 — Those who have enough cash and at least a 2 year runway. What those companies have to do is keep their focus to enjoy the ride when the market rise again.

2 — Those who have good fundamentals, great growth rate but unfortunately at the end of their funding cycle. Here most of the existing investors will have to bridge them up with some money.

3 — Those who have good fundamentals but bad growth rates and KPI’s. The best advice you can get in this situation is limit your cashburn by reducing your team and cut every superficial spendings so that you maximise your runway.

4 — Those who unfortunately are in a tricky situation considering their advancement. There is unfortunately not much to do in this situation and they will eventually die during the next few months.

By doing that, each investor can prioritize their tasks and allocation of funding for 2020 but it has become very clear that a large part of their fund allocation and energy will be for their startups.

Learnings from 2008

Such behaviours will have a real impact on the market. Here are some things we might see in the next few months :

• Startups who’ll be able to raise will have to last longer with that money. It’s something that we actually saw right after the subprime crisis. Indeed startups funded in 2008 on average took nearly 2.1 years to raise a second round, several months longer than the near 1.7 year average seen in startups that raised VC in 2010. The collateral damage of such a situation is that a lot of startups won’t be able to refinance themselves
• Rounds are going to get smaller and smaller. The constant rise of round sizes we’ve experienced these last years for each stage is over. For example, after the 2008 crisis Series A average round size fell from $4M to $2.6M, from $10M to $6M for Series B and from $10M to $6M for Series C. It took almost 8 quarters to reach back the same level as in 2007
• We will observe an inversion of the balance of power between startups and investors resulting in a downward pressure on startup valuations and smaller round sizes. Startup funded in 2008 saw a considerably lower step-up of just 1.35x from the post-money valuation of its first round to the pre-money valuation of its follow-on round, compared to post-recession cohorts whose median valuation step-up hovered in the 1.6x-1.8x range.
• More selective dealmaking: VCs are expected to be more selective in dealmaking during a recession and to place greater emphasis on a startup’s burn rate and path to profitability.
• Fewer available funding sources: as the recession hits, the VC’s Limited Partners will will reallocate their assets. It could affect the ability of LP’s to make new fund commitments, with knock-on effects being that fewer funds will reach a close. We’d also expect pullback in venture investment from nontraditional investors such as mutual funds and family offices or CVC’s.

Are startups screwed ?

It’s clear that many startups will be unable to raise a new round of funding. The firsts to run out of cash will be those who won’t succeed in maximizing their runway. As Sequoia puts it in its now famous post “Coronavirus: The Black Swan of 2020”, those who survive “are not the strongest or the most intelligent, but the most adaptable to change.”

It’s difficult to assess how high the percentage of startups who will fail will be l, but with startups needing to raise money every 12 to 18 months with 3 to 6 months worth of cash at closing, a six-month drought in VC deals could wipe out a large portion of startups — and worse if we consider the potentially fatal direct and indirect blow to one’s business model and operations.

In order to survive it will be necessary that the government as well as the financing actors take their responsibilities in order to limit the breakage so that 3 years of efforts building the Frenchtech ecosystem are not lost.

However, there is no diamond without pressure and those who will go through this very delicate period will find a new universe in 2 to 3 years. A world most of the time depopulated by the current competition. A world where those who survived are the one that scaled best.

Sharpn is a fundraising advisor supporting ambitious entrepreneurs. We aim to support startups from late-Seed to Series A round.

So if you’re interested in our killer program please contact us at contact@sharpn.eu or visit our website https://www.sharpn.eu/