Debating the potential impact of a downturn on startup valuations

Is Winter coming? If you’re an early stage startup, make sure you’re prepared

The life of an early stage entrepreneur isn’t easy: if it isn’t about growing the team, prioritising limited resources to hit that 20% month-on-month growth target, understanding and incorporating customer feedback, and worrying about the competition, then it’s definitely about the next round of fundraising.

At The Venture City, we know that fundraising for early stage startups (Seed, Series A, and Series B) can be challenging at the best of times; however, the spectre of an economic downturn in both the EU and the US promises to put further pressure on entrepreneurs and valuations.

We were debating the potential impact of a downturn on startup valuations and it quickly became clear that there are a range of possible outcomes, with multiple feedback mechanisms and knock-on effects. This article discusses a few of the factors which could affect startups valuations, complimented with insights from VC industry data for the 2007–2009 US downturn. Shout out to Andy Areitio for kicking off this discussion, and adding his perspective and insights.

But wait… the US isn’t in a recession (and neither is Europe, for that matter)

Yes, that’s true (for now, at least). We are in the tenth consecutive year of a bull market in the US (post the 2007–2009 recession), and the S&P500 is up almost 300% off its lows in March 2009, despite the recent softening. Although European markets haven’t fared quite as well, the S&P Europe 350 has returned more than 110% over a similar period.

However, the US economy experiences a bear market (i.e. a 20%+ drop in the share market) every eight years on average, which means we’re overdue, statistically speaking. In addition, a flattening US yield curve (historically a strong, early predictor of recessions) suggests that a downturn is on the horizon.

The forecast for the EU is similarly gloomy, with a recession forecast for the EU by the end of 2020, driven by Brexit, and weaker than expected growth in Germany and Italy, combined with concerns over slowing Chinese growth and associated trade wars.

In summary, a downturn in the next few years is possible (if not likely) and with early stage entrepreneurs raising very 12–18 months (on average), they would do well to consider the potential impact on their fundraising strategy.

Impact on VC capital commitments

In general, LPs (Limited Partners — the investors who supply the funds to venture capital funds), tend to invest more when markets are growing rapidly; however, it seems likely that high-risk, high-reward venture capital funds become less attractive to these LPs during a downturn. Consequently, John Loeber and Patrick Mathieson suggest that if VCs have a harder time accessing funds themselves (from LPs), there’s less available for them to invest in startups.

This pattern is apparent in industry data: In 2007–2009, during which the S&P500 declined by more than 55%, US VC fundraising activity initially declined slowly from $36B in 2006, to $35B (2007), to $31.6B (2008), before falling off a cliff to $11.9B in 2009, according to Pitchbook. It took a further five years for US VC fundraising to recover to pre-2007 levels.

Companies about to IPO

Paul Cohn highlights the implications of a downturn for companies considering a share listing. Primarily, investor standards go up: companies are expected to have a stronger track record for growth and profitability. Consequently, some (unprofitable/ slower growing) companies may not be able to IPO as expected, and may need to return to the private markets for funding. Investors won’t appreciate losing out on an IPO opportunity and will likely respond by lowering their valuation (certainly lower than the expected IPO), and offering money on worse terms. If this translates into a down-round, anti-dilution protections could make employee share options worthless.

Similarly, if a public company is about to use its own shares to acquire an early/late-stage startup, lower stock market values effectively make these acquisitions more expensive, which could scupper a potential acquisition, unless that private company is prepared to lower its valuation.

Early stage companies: Exit effect and funding overhang

There is a view that early stage valuations will not be impacted to the same extent as later stage companies. The argument hinges on two components: First, that early-stage investments will only need to consider exit valuations five to seven years from now, as opposed to later-stage investments that are expected to exit in one to three years. The implication is that the price of public valuations (i.e. the IPO effect) is less relevant to early stage valuations, or at the very least, that there will be a lagged effect on the latter.

The second component is related to VC fundraising. According to atomico and statista, capital raised by European VCs is at an all-time high in 2018. Pitchbook estimates that European VCs raised €8.4B in both 2017 and 2018. VC funding in the USA is also similarly robust, with the industry securing more than $30B in commitments for the fifth consecutive year in 2018 (although 2017 and 2018 are down on 2016’s peak of $41.1B). The logical conclusion is that VCs have sizeable “dry powder” that they need to deploy in the next five years if they are to maintain returns for their investors. This would mitigate any VC fund supply shortage in a downturn, and keep Seed/Series A valuations relatively buoyant over the next two years.

Industry metrics seem to support the latter hypothesis, at least partially. Pitchbook estimates that US VCs invested over $10B into startups (“first financing”), significantly up from $7.3B and $7.4B in 2016 and 2017 respectively. The number of first financing deals did, however, continue to fall from its peak of almost 3,700 in 2014 to just over 2,100 in 2018. Pitchbook also notes that US VCs invested a record $41B into early stage companies across almost 3,000 deals in 2018, although Q3 and Q4 2018 did show a decline from Q2’s peak in both capital invested and deals closed. Nearly half of early stage deals were sized at $5M+, and more than 61% of deals by value in 2018 consisted of $25M+ deals.

Early stage companies: Risk and a flight to quality

There is a third component to take into account, when one considers a downturn/recession in the context of risk.

For those VCs with a mandate to invest in early stage only, not every early stage investment is equal, and VCs will spend more time identifying those teams that have a sound track record of success, those business models that are more focused on profitability (quite the opposite of the most recent trends!), and do not require huge amounts of cash over extended periods to achieve breakeven. This is effectively the equivalent of investors standards going up (as discussed earlier).

Many early stage businesses may not be able to obtain funding at all, or if they do, if will be at significantly depressed valuations, which could ruin their cap table for future rounds.

These startups which do receive funding could actually receive higher relative valuations than would be expected due to increased demand for this kind of investment opportunity (although the absolute figure would likely still be down on what they would have received recently). The Pitchbook metrics for 2018 which show strong capital flows into startups and early stage investments but a decline in the number of investments could be a reflection of this mindset.

Of course, risk is a double-edged sword. A downturn doesn’t mean that all early stage startups are all suddenly poor investments. There will be opportunities for VCs to achieve significant returns if they are able identify the solid fundamentals of a new idea and invest at depressed valuations (and assuming the company survives the downturn). These returns are suitably risk-adjusted, but it does mean that this may represent an opportunity for funds who focus on the fundamentals and aren’t overly concerned with financial projections.

Note that although VCs have stockpiled cash over the past few years, this doesn’t necessarily mean that they have to invest it in the same way or as quickly. Besides the flight to quality for new investments, VCs might be more likely to double-down on companies they have previously invested or be more likely to co-invest, both sensible risk-reduction strategies.

It is probably also worthwhile noting that the performance benchmarks that VCs use will also be depressed, which means there is less pressure to invest new funds, and in general makes it less likely that VCs will pursue higher-risk investments when they don’t need to.

Some practical advice for early stage startups

It is clear that “Winter is coming” and it makes sense for startups to prepare for the storm (even if it turns out to be just a flurry).

In a downturn, valuations across the market will likely be revised downwards as a whole. Consumers tend to spend more conservatively, either because they are objectively poorer (due to a decline in their stock market assets), or subjectively feel poorer (due to perceptions of a weaker economy). This inevitably means less expenditure on non-essential goods and services depressing growth forecasts, leading to lower valuations.

Hopefully there are some insightful entrepreneurs who seen this coming for some time, have raised funding early, and have stocked their bank accounts with spare cash to increase their runway. There are also those entrepreneurs who have built profitable business models which do not rely on frequent infusions of VC cash to survive.

On the other hand, the ease of accessing VC funding over the past few years has encouraged the proliferation of business models that require regular cash investment to continue operations. Paul Graham calls these companies “default dead”. This status is not unique to early stage startups: companies like Uber, Tesla, Spotify and WeWork make billions in losses; the problem is that most startups don’t have similar access to seemingly infinite piles of cash.

Consequently, those “default dead” entrepreneurs who are rapidly running out of runway would do well to prioritise fundraising before the downturn kicks in, and cut costs to make their limited cash last longer. A “pivot” to a more sustainable business model should also be considered.

Among other things, I would also suggest following Paul’s advice: don’t hire too fast. “Hiring too fast is by far the biggest killer of startups that raise money.” Hiring people or scaling prematurely will only make things worse if the fundamental problem is that the company’s product is “only moderately appealing”.

Lessons from history: All is not lost

Let’s take a look at US VC data from NVCA’s Yearbook for the 2007–2009 downturn. The metrics suggest some industry-level trends; however, it is not easy to disaggregate the various drivers of VC investment and valuation, particularly at a macro level.

As already mentioned, the US stock market lost 57% during the 17 month bear market, and although there was a lagged impact on US VC fundraising, by 2009, fundraising was down 60%+ on 2007 levels.

Total US VC investments declined by 36% in dollar terms over the period overall, although only by 25% for number of deals. The sharpest declines were for later stage investments, which fell by 43% and 29% respectively. It seems that the exit effect is very powerful in short, sharp downturns, affecting later stage valuations more than early stage.

Based on average deal size, seed and early stage investments significantly outperformed later stage investments, with seed actually showing an increase of 29%, and early stage a decline of only 8%. This seems to support the “flight to quality” hypothesis that VCs would double-down on startups with less cash-hungry business models.

In summary, the good news for seed and early stage entrepreneurs is that history suggests that VCs will actually favour earlier stage investments in a downturn, although there will be fewer deals available and “quality deals” will win.

It is worthwhile noting that while the 2007–2009 bear market was among the worst in the last 100 years, it lasted 8 months shorter than average. Consequently, a longer, sustained market decline could have very different end result, given the lagged effect on VC fundraising and on early stage valuations.

A more granular view of the data shows how a financial crisis can actually be a window of opportunity. The 2007–2009 downturn spawned an impressive list of successful startups. Here’s a selected few who have since become “unicorns” (by founding year, showing current Pitchbook/market valuation):

2007:

• Dropbox (public; $9B)
• Twilio (public; $17.1B)
• MongoDB (public; $7.6B)
• Flipkart (acquired by Walmart for $16B in August 2018)
• Github (acquired by Microsoft for $7.5B in Oct 2018)
• Glassdoor (acquired by Recruit Holdings for $1.2B in June 2018)
• Tumblr (acquired by Yahoo! for $1.1B in June 2013)

2008:

• AirBnB (private; $30B Sept 2017)
• Pinterest (public; $13.2B)
• Cloudera (public; $2.5B)
• Beats (acquired by Apple for $3B in May 2014)
• Yammer (acquired by Microsoft for $1.2B in July 2012)

2009:

• Uber (public; $71.9B)
• Square (public; $26.8B)
• Nutanix (public; $5.1B)
• Slack (private; filed for IPO in Feb 2019; $7B Aug 2018)

The likely impact of the downturn will be to weed out those startups with unsustainable business models and short cash runways, and the strong will survive the short-term decline in valuations. There’s still time to prepare, so make sure you don’t end up in the “startup graveyard”.