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By: Daniela Sanchez

Generally, Venture Capitalists (VCs) tighten their investment criteria and become more conservative deploying capital during economic downturns. Although it will become increasingly challenging to secure funding, startups that demonstrate product market fit and growth will have an advantage. Additionally, COVID-19 and enforced isolation present unique challenges we are just starting to understand. We expect that small business and companies that depend on direct sales will feel the greatest impact, but only time will tell. In this uncertain world, startups should reassess their strategy and transition to conserving cash and only spending where they are best able to stretch their cash.

 

Venture Capital in Economic Downturns

While most asset classes underperform during recessions, private assets, like venture capital holdings, tend to do well over time. Despite their long-term resilience, the venture industry saw (1) a contraction in the funding environment, (2) a decrease in the number of new companies funded, and (3) a drop in valuations during the last two recessions.

 

During a recession, new commitments by limited partners (LPs) decrease because they become over- allocated to venture as an asset class. Generally, LPs set target allocations for venture in their portfolios and stop investing in new funds once that target is reached. During economic downturns, venture tends to surpass those targets. As the value of LP portfolios drop, the amount of capital committed to venture remains constant due to the venture funds’ illiquidity. Commitments by LPs to new venture funds fell by 41% from 2000 to 2001 and by 58% from 2008 to 2009.

 

As a result, VCs become more conservative deploying capital which makes it harder for startups to secure funding. VCs invested 49% less from 2000 to 2001 and 33% less from 2008 to 2009. VCs also tend to shift towards supporting their existing portfolio companies which leads to a higher bar for new investments.

 

In the public markets, we also see multiples compress which means potential exits are smaller and VCs need lower valuations to get the same returns. For example, from 2000 to 2001 and from 2008 to 2009 we saw a drop in series A pre-money valuations of 32% and 13% respectively.

 

What is Different Now?

Although the venture industry can expect to see similar trends during a pandemic induced economic downturn, we must consider the unique impact of COVID-19 and enforced social isolation. Companies that serve affected industries, particularly small businesses and companies that depend on direct sales, are likely to feel the greatest impact.

 

The impact on small businesses is concerning because they employ 48% of US workers, account for 45% of the GPD, and drive the majority of employment growth. During the last recession Wall Street was decimated and the country faced a 10% unemployment rate. This recession “seems to be making a beeline for Main Street” which will likely lead to a higher unemployment rate.

 

Companies that depend on direct sales are already seeing widespread cancellations of conferences and meetings. Investors predict that booking targets could be off by as much as 40% because of the recession and limitations posed by enforced social isolation.

 

What Does this Mean for Startups?

According to PitchBook, as of June 2019 global investors were sitting on $189 billion of dry powder. Dry powder is the amount of cash a venture fund has on hand waiting to be invested. VCs cannot sit on capital because that impacts their timeline and returns, so they will likely continue deploying capital regardless of the economic climate. However, the manner in which that capital is deployed will change with VCs possibly prioritizing portfolio companies over new investments and quality over quantity.

 

Some say that VCs have been prioritizing quality already as the number of rounds has decreased while the amount invested per round has increased. However, the poor performance of unicorns in the last year calls that into question. For example, Smile Direct Club shares were down nearly 60% after it went public, at its lowest trading price Lyft shed about $25 billion in market value, and the anticipated WeWork IPO never happened.

 

If they were not doing it before, VCs will now have to focus on quality as smaller exits become the norm and the ability of LPs to make new commitments is likely to decrease. VCs will continue investing their dry powder, but we can expect a higher bar to receive funding as they tighten their investment criteria. Startups that demonstrate product market fit and growth will receive capital, while startups that cannot demonstrate positive financial or customer metrics will have a tough time raising capital.

 

Startups cannot control for the availability of venture capital, but founders can prepare by conserving as much cash as possible and focusing on where they are best able to stretch their cash. For example, as highlighted by Aydin Senkut of Felicis Ventures, spending unlimited dollars to get revenue growth does not make your startup a sound investment if your margins are not great. Other venture capitalists are urging their portfolio companies to focus on satisfying their existing customers and achieving a break-even point or profitability faster than before.

 

Although private assets like venture capital tend to do well over time, raising money will become more challenging for startups as VCs become more conservative. VCs will continue deploying their dry powder for now, but what happens when the levels of dry powder drop because LPs cannot longer make commitments?