VC Is Built for a Crisis
Like most law, accounting and consulting firms, in March McGuireWoods was occupied advising clients on their response to COVID-19, in addition to closing investment deals and acquisitions. News headlines have been disturbing and repetitive. The COVID-19 outbreak and response, sudden yet slowly evolving, real but unpredictable, foreshadows the following:
- Reduced consumer and business spending which catalyzed an economic contraction = a VC financing slowdown, particularly for Series B, C and later-stage deals, as mentioned below
- More conservative, investor-favorable VC investment terms around liquidation preferences and investor protections
- Lower earnings protections + higher cost of capital = lower exit multiples and pre-money valuations
- Large amount of investor dry powder + deeper investor due diligence + longer periods to funding close = renewed focus on capital efficiency (which is often hardwired into a business model), burn rate (cash management) or runway (financing sufficiency and options)
See fortune.com/2020/03/17/private-equity-and-venture-capital-will-feel-the-effects-of-the-coronavirus (citing the latest Pitchbook Analyst Note, March 16, 2020) and www.wsj.com/articles/startup-funding-dwindles-due-to-coronavirus-slowdown-11585175702 (April 2, 2020).
COVID-19 will likely stall VC fundraising and investment deals in the near term. The question is whether that stall will become a freeze into the next two or more quarters of 2020. VC-backed companies and investors have endured previous crises, including in 2001 and 2008. Of course, this one is different, although no one can yet predict the mid- to long-term impact. Startups, like other small businesses, usually take the brunt of recessions. But their entrepreneurial management teams and long-term-oriented investors know how to pivot. Risk and struggle are not new to founders and angels.
Seed and early-stage VC historically have held up better than other VC financing stages in bad times, and many of the world’s greatest companies were founded during recessions. VC deals have closed since the full magnitude of the pandemic became obvious and deals are still scheduled to close this month. VC funds indicate that they plan to close committed deals, continue vetting term sheets and have management video conferences, but to some extent, they will focus on supporting their existing portfolio companies through the crisis. Many believe this may bode ill for Series B and C deals as legacy investors are forced to decide which companies warrant follow-on investments and which do not. See www.venturecapitaljournal.com/series-b-c-companies-could-get-left-behind-in-this-downturn and www.venturecapitaljournal.com/seed-funding-may-slow-but-wont-halt-in-the-midst-of-covid-19.
VC is a complicated and uniquely multifaceted sector of private equity. Pre-revenue, development-stage companies can actually attract more funding during a recession because they have little revenue and no customers to lose, and they have already paved a sufficient runway through budgeting and milestone-based capital calls. Industry and business models matter as much as life-cycle phase, and may matter more during the COVID-19 crisis. Having led one of the hottest VC runs in history through 2018 and into 2019, technology and biotech bets will likely be the most resilient survivors — healthcare and life sciences, SAAS, data analytics and artificial intelligence, renewable energy and all things “clean tech.” Businesses dependent upon travel and leisure, supply chains, OEMs and discretionary consumer dollars may struggle well beyond the end of this crisis, and business model re-engineering may be their only way to survive and ultimately thrive. This pandemic-driven economic shock will differ from previous VC downturns tied more directly to fundamental financial market issues. No one can yet predict how, so it’s best to focus on lessons from the past, trust in individual creativity and judgment, and double down on cash, revenue and relationship management.
“VCs Are Still Open for Business …”
McGuireWoods is still seeing and working with clients on VC deals of all sizes, from seed to later-stage rounds. Some of these deals closed toward the end of March and some are scheduled to close in April. In addition to seed, Series A and later-stage deals, the recent deals include Series B and C, and growth equity, investments in SAAS, software, biotech, healthcare, clean tech and business services.
Seed and early-stage deals are underreported. We are seeing seed, super seed and Series A through C deals getting funded in round sizes from $2 million to $100 million. Most of these were probably in process before the potential human and ecnonomic magnitude of COVID-19 were fully accepted. The following published list further reflects that mid- to later-stage deals have also closed in March, but, as noted above, Series B through C deals could fall off sharply in Q1 and Q2 2020:
- SteadyMD, a St. Louis, Missouri-based telehealth company, raised $6 million in Series A funding led by Pelion Venture Partners and Next Ventures, with funding from other funds and family offices.
- Hashicorp, a San Francisco-based developer of applications for software managed datacenters, raised $175 million in Series E funding from Franklin Templeton Investments.
- Proxy, a San Francisco-based provider of digital identities for the physical world, raised $42 million in Series B funding. Scale Venture Partners led the round, and was joined by investors Kleiner Perkins, Y Combinator and others.
- Axis Security, a San Mateo, California-based application access company, raised $17 million in funding. Investors include
- Airmeet, a Bengaluru, India-based virtual meetup management startup, raised $3 million in funding. Accel led the round, and was joined by investors including VentureHighway and Global Founders Capital.
- Nurix Therapeutics, a San Francisco-based developer of targeted protein modulation drugs, raised $120 million in funding. Foresite Capital led the round, and was joined by investors including Bain Capital Life Sciences, Boxer Capital (Tavistock Group), EcoR1 Capital, Redmile Group, Wellington Management Company, The Column Group and Third Rock Ventures.
Source: Fortune and Pitchbook.
In addition to managing growth and cash burn through this cycle (there are too many articles to count on investor and portfolio company crisis management), clients should stay the course on already-in-process capital raising and investment efforts and processes, even if they are stalling, at least until there is more visibility into the likely Q3 and Q4 impact of the pandemic. Deal flow may certainly slow and deals may certainly take longer to get done, but companies and investors should not neglect relationship-building and longer-term planning just because meetings will be held via teleconferencing. The market is seeing fewer VC investor term sheets, but VC investors are seeing a sustained number of company term sheets. By nature, entrepreneurs are optimistic and resilient, and VC investors are opportunistic and patient, but as in any economic crisis, these qualities will be tested in the coming quarters. VC ecosystem players show up; they don’t run and hide. See files.pitchbook.com/website/files/pdf/PitchBook_Q2_2020_Analyst_Note_COVID-19s_Influence_on_the_US_VC_Market.pdf.
Smaller VC hubs — including emerging hubs like Austin, Atlanta, Miami and Denver — may be more challenged than larger metropolitan areas with deeper VC fund pockets and more established ecosystems. Investors may return to focusing on investments in companies close to where they live. But it is equally possible that VC will continue to cross state borders and that the “rise of the rest” will continue, with companies in all regions getting funded. See files.pitchbook.com/website/files/pdf/PitchBook_Q2_2020_Analyst_Note_COVID-19s_Influence_on_the_US_VC_Market.pdf.
Venture Debt May Rise in Short Term
There is a growing consensus that, particularly in light of depressed valuations, venture debt will trend up rapidly through any 2020 VC investing decline. The market is already showing this tendency in connection with pending startup and growth company capital raises. The reasons include declining valuations, investor hesitancy to do follow-on rounds as discussed above and the overall maturity of the venture debt market and increase in the number of providers. To obtain a venture loan, a company must usually have completed one or more equity financings and be operational, although it typically will not have achieved sufficient cash flow to attract traditional bank financing. Venture debt is a short-term supplement to equity, not a complete alternative to equity.
“Venture debt” is really not one particular type of debt but, rather, refers to the different types of commercial loans that are made to early-stage companies. Technology banks and dedicated debt funds are the most common providers, although sophisticated angels and some VC funds might include a debt “strip” in a VC equity financing. Venture debt often acts as a bridge between equity rounds to provide working capital and equipment financing. Many venture debt loans are for a term of one to three years and provide for interest-only payments at prime (or much higher depending on subordination, security and other factors, and may involve a combination of cash pay and “PIK” interest) for some initial period, such as six or 12 months. Some are secured by company assets (but may be subordinated in rights to existing bank or equipment financing loans), and some provide for multiple tranches or advances subject to the achievement of performance milestones. The lender may also ask for a warrant to acquire company stock representing some “coverage” or percentage in value of the principal amount of the loan (e.g., 15 percent to 20 percent of the loan principal — importantly, not that percentage of the company’s stock), especially if the loan is not secured with company assets or other collateral. There has recently been an uptick in specialty venture lenders to SAAS companies due to such companies’ more dependable subscription-based revenue model.
Venture debt usually requires some level of revenue or valuable assets such as intellectual property. Venture lenders also typically want some level of prior or commensurate equity investment in the borrowing company. However, if it can be obtained, venture debt avoids company valuation issues, owner and legacy investor dilution and the more in-depth due diligence typically associated with a VC fund making an equity investment. Venture debt loan agreements also usually require less-stringent affirmative and negative loan covenants or restrictions from the borrowing company as compared with traditional bank loans. It is not uncommon for a venture loan to be limited to some percentage of the borrower’s last equity round (e.g., 30 percent). Terms vary widely and often include costs or fees for closing and prepaying the loan, in addition to interest costs.
As a general proposition, other than for SAAS companies with customer traction, venture debt will be a more viable option for companies that have completed a significant seed or Series A round and have access to relative committed investors. Companies and their VC should understand that the cost of minimal equity dilution is a higher cost of debt, with statistics suggesting venture lenders look for 20 percent return on a loan from closing fees, interest and prepayment fees over a two-year period. With a warrant providing 20 percent coverage, venture lenders can achieve as much as two times their loan over that two-year period.
Helpful information on venture debt financing and terms is available from Silicon Valley Bank and SAAS Capital, among other sources and providers.
Possible Corporate VC Pullback?
The economic impact of COVID-19 could cause corporate venture capital arms to pull back stock prices and declining revenue to take on more importance. See www.venturecapitaljournal.com/corporate-vc-expected-to-take-a-smaller-piece-of-the-venture-pie. On the other hand, large companies that depend on startups for “outsourced” research and development, rather than viewing their CVC divisions as a non-core luxury, will likely continue to participate in VC rounds with financial investors. Certainly continued corporate VC footholds might be expected in the pharmaceuticals and medical device sectors. See www.venturecapitaljournal.com/corporate-vc-expected-to-take-a-smaller-piece-of-the-venture-pie.
Will Emerging Hubs Struggle if A to C Rounds Halt?
While the dominant VC hubs — San Francisco, New York City and Boston — are bearing the brunt of COVID-19, at least for now, some commentators predict (while many disagree) that emerging “hot” VC hubs like Austin, Denver and Atlanta may decline and have to be restarted later. The main reason cited is the more limited amount of dry powder resident in these hubs. If seed and Series A companies are unable to get through the crisis without B and C rounds, these companies and their investors will pay the price. It follows that the local ecosystems of professionals and support will dwindle and have to be rebuilt from the ground up. We are more optimist that these VC hubs will be able to attract capital from the coasts and be ahead of others in a rebound.
Food and Agriculture
Like clean tech, the food industry is large, diverse and integrated into much of the overall economy. COVID-19’s impact on sit-down restaurants will obviously be different than its impact on fast food, food delivery, grocers, food tech providers and agriculture. Like healthcare and energy, the crisis will likely bring a renewed focus on costs, efficiency, supply chain and safety. With that, food and ag products and solutions will continue to attract specialist VC investors as well as corporate VCs.
Telemedicine and Edtech Will Stick Around After COVID-19
It is ironic how many evolving IT and AI solutions seem to have anticipated a changed world, where patients meet online with doctors and students with their classes. And, of course, the VC appetite for all things cybersecurity promises to trend up after the crisis, as the world becomes even more reliant on the cloud and robots.
Demand What You Deserve From Your Advisers: Real-Time, Tailored Advice
Once everyone is through the crisis, having first cared for those suffering and in need, good things usually come out of a bad event or time. We are all more connected (albeit virtually) with our families, employees, partners, competitors, clients and government officials. All business owners are reminded that they should have been doing certain things before the crisis — things that have become more critical now. Law and accounting firms, and financial and insurance institutions and advisers, have been circulating information about everything from government stimulus programs to risk mitigation in the areas of employment, supply chain management, cybersecurity, and financial and tax planning. Entrepreneurs, startups, growth companies and VC investors and funds should take advantage of their professional, financial and business advisers’ loyalty, commitment and real-time experience with other, similarly situated clients. The legal and financial implications of COVID-19 for every business and investor are yet uncertain but wide-ranging, and are short-, mid- and long-term. Ensure that advisers provide what you need now — real-time advice, judgment, recommendations and practical solutions for getting through 2020 and coming out stronger on the other side. Now, more than ever, lawyers, in particular, need to serve clients and their general counsel like “in-house” counsel, albeit working remotely.
Good Advice for Startups From VCs
There has been an outpouring of great advice for startup CEOs from the VC investment community. Here is a good one based on the perspectives of several leading VCs. Most importantly, never let a crisis go to waste — seek out advice, particularly from those trusted advisers who are giving it out gratis. This doesn’t happen often and is a huge opportunity.