And These Times Are So Hard, And It’s Getting Even Harder

In the short- and medium-term, entrepreneurs and our fellow venture capitalists are going to face challenges in accessing capital that have been unprecedented since the Global Financial Crisis of 2009, and with many of us not having professional experience in anything other than a bull-market — this is going to be a shock.

There has been much written by brighter and more experienced investors than me (including the likes of Chris Douvos(Ahoy Capital) — Twitter, and Brian Caulfield (Draper Esprit) — Medium, about why movements in the seemingly alien world of public markets should affect early-stage venture capital financing, but to summarise:

Denominator Problem

Limited Partners (i.e. LPs — the technical term for investors in VC funds) traditionally allocate capital using a structured portfolio allocation model, a strategy that aims to balance risk and reward through a thoughtful composition of asset classes (equities, fixed income, and cash and equivalents). These investors are now meaningfully over-exposed to venture due to declines in their public market allocations, as in people buying stocks from ventures (i.e. a ~20% drop in the S&P500 from the beginning of March to the time of writing will have hurt), which will result in a reduced allocation to venture and by extension fewer VC managers entering the market.

Fringe Money Dries Up

Angels, Corporate VCs and Hedge Funds will reduce or zero exposure to venture, as the denominator and liquidity challenges bite. Therefore, these investors will likely revert to their core competencies and/or preserve capital for existing portfolio companies.

Exit Environment Worsens

Corporates will hoard cash to shore-up balance sheets, which will diminish the primary source of liquidity for VCs in Europe — Mergers & Acquisitions. This has a particularly extreme effect on growth-stage investors who have less room for manoeuvre in terms of time to exit and return profile.

LP Capital Recycling Slows

Fewer and smaller exits will pressurise existing LP VC fund investments, as LPs often fund new VC allocations from more mature funds in their exit phase. This may result in the enforcement of increased temporal diversity on VCs (i.e. slower deployment) by their LPs, further throttling the supply of venture money.

This is the harsh reality, and a dynamic adjustment to and clear understanding of this new environment will be critical for founders who will need capital in the next 18+ months.

There has again been much written about strategies for extending runway ranging from redundancies, pay-cuts, cutting office space etc. by experienced operators.

This Opportunity Comes Once In A Lifetime

However, I wanted to focus on what may be the beams of sunlight cutting through this economic doom and gloom, and the opportunities that may present themselves to founders who are able to survive:

Deals Will Still Be Done

A decreased supply of VC funding will result in tempered valuation appetites, but there is a significant amount of dry-powder (uninvested capital) that still needs to find a home. This can be exemplified by the €2.2b was raised across just 4 funds since November (Accel, Atomico, Balderton and Northzone). The bar will just be much higher.

Clearing of the ‘Competitive Canopy’

Early-stage start-ups with more flexible cost bases and smaller capital requirements will benefit from a thinning of the ‘competitive canopy’ as more capital-intensive competitors will likely be met with funding challenges, resulting in a loss of momentum, downsizing or complete liquidation (i.e. shutting down). This may potentially create unexpected commercial opportunities in previously highly competitive markets.

Customer Acquisition Costs May Reduce

The Global Financial Crisis of 2008/9 saw a cut in marketing spend in the US of ~13%, with a similar if not greater pullback expected in this crisis as saturated digital channels are abandoned by start-ups and corporates alike. This may present opportunities to acquire customers more efficiently, however, balancing this with a potentially declining ATV (i.e. Average Transaction Value — the average dollar amount that a consumer spends with a business in a single transaction) will be crucial.

Improved Talent Environment

The misfortune of larger competitors may offer early-stage start-ups the opportunity to access talent that would have been prohibitive from a cost or access perspective. This will clearly need to be balanced with runway considerations, but this may be a unique time to add A-Player talent.

2008/9 Was an Industry Defining Vintage

The last venture funding crunch in 2008/9 yielded many of the unicorns of today including Airbnb, Uber, Dropbox and Spotify. This has been a lesson learned by many venture capitalists investing today.

Therefore, whilst it is MSM’s expectations that in the short-term (<6 months) we are likely to see some significant start-up casualties of the crisis, in the medium-term (>12–18 months) there will be winners created on a truly unprecedented scale. This will be primarily driven by fewer funds allocating more money into fewer start-ups (– 2019 saw a ~25% increase in total funding into ~30% fewer companies vs 2018 –) this trend will accelerate in 2020 and potentially beyond.

It is also important to note that it is MSM’s hypothesis that in this environment of uncertainty, that these winners will be concentrated amongst those businesses that are working to address the social and environmental issues that this crisis has highlighted.

Special thanks to Gareth Jefferies (Northzone) and Sia Houchangnia (Seedcamp) for their input.

Photo by Macau Photo Agency on Unsplash