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Two months into sheltering in place, it is becoming clearer how Covid-19 is going to affect the early-stage venture community. Raising venture funds will become harder, but some companies will get a boost from lockdowns and remote work.
Here are several of the most important ways in which early-stage company formation and seed financing is changing in the Covid-19 era.
Early-stage valuations are dropping quickly.
Early-stage venture-backed startups that are just getting off the ground are in some ways the most disconnected from the broader state of the economy right now. They are many years (and perhaps even an entire economic cycle) away from broad engagement with the public markets. That said, valuations are still dropping rapidly at the very early stages for two reasons.
First, early-stage investors don’t know what the market for later-stage financings is going to be in 12 to 18 months, so they don’t know how to price deals. Over the last several years, early investors got comfortable with having a clear financing pipeline where they knew that if they hit certain metrics, later-stage financiers would line up to fund rounds at increasing prices.
Now, early investors worry that even if companies hit their milestones, there might not be capital available at attractive prices for ventures in Series A, B and so on. So most early investors are looking for much lower valuations to make sure there is room for markups at the next round and beyond, even if things get much tougher.
Second, and just as important, most venture funds recognize that with the public markets under pressure, it is going to be much harder to raise new venture funds from institutional sources of capital. Institutional capital sources were already generally topping out their venture allocations going into 2020. But now, with public equities having fallen, their overall portfolios are far too heavily invested in venture. Since dollars are going to be scarcer in the coming years, investors are looking to conserve capital.
Early deals are including a lot of protective provisions.
For the last several years, term sheets at the early stage have been extremely “clean.” Investors were signing documents like Y Combinator’s simple agreements for future equity (SAFEs), which provided almost zero investor protection. This is changing. I am seeing more term sheets with all sorts of added controls and defensive provisions for venture capital. Things that were rare—like forcing teams to revest equity, mandating certain levels of burn, and all sorts of rights to participate in future financings or put more money in on certain terms—are becoming common.
Generally speaking, while some of these terms seem out of bounds to me, most of them make good sense given investor worries about getting wiped out in the next 12 to 18 months if later-stage financing markets turn.
Early investors are reserving more capital to be prepared to stick with companies for multiple financing rounds. Angel investors who can’t follow suit face a squeeze.
For the last several years it has been a great time to be an angel investor who writes one small check to a company early but doesn’t participate in later rounds. So long as everything is “up and to the right” this strategy can work out very well.
Now bigger funds are starting to reserve more capital per deal on the theory that even if a company is doing well, there isn’t clearly a next financing to be had at good prices in the future. This allows them to easily invest more in the companies that are working.
Angels that generally can’t (or don’t) do this now face the prospect of being seriously diluted by low valuation and “pay to play” rounds even on companies that are doing well.
There will continue to be angel investors and breakout successes. But in some ways the cost of entry to the venture game just got a lot higher. People who aren’t reserving capital early on are at much greater risk of being washed out of companies.
Rapid swings in the fortunes of big technology companies (and startups) are starting to force questions about risk tolerance and risk sharing for employees.
There has been a shocking reversal of fortunes for so many Silicon Valley startups, and the ecosystem is starting to discuss what that means in terms of risk sharing.
Compare, for instance, how fortunes have changed for a company like Airbnb versus many of the delivery startups. Airbnb was perhaps the most high-flying company in Silicon Valley pre-Covid, while many delivery companies were struggling. Now, Airbnb has hit a rough patch, and many of the delivery companies are doing fabulously well.
I believe this will affect the mentality of many Silicon Valley workers on how they value illiquid equity compared with cash. It may encourage employees to be more open to the idea of buying into a pool of companies so they can diversify their risk.
Access to talent feels less pressured than it has been.
One of the challenges most early-stage startups have faced in recent years is that it has been very hard to get employees to join a team. The financing market was so open that every engineer, designer and product manager who would be ideal to join early-stage companies could instead start their own company. There is a theory starting to be discussed that perhaps as financing tightens and people get a bit more risk averse, it might become easier in the coming years to put together high-quality teams. This is only feeling more true as top-tier later-stage companies shed talent.
The declining cost of advertising and reaching new customers is creating new opportunities.
In the last several years, many startups have been priced out of “paid acquisition” because Facebook and Google ads got too expensive for them to afford, at least in the U.S.
With the contraction of advertising spending by big companies, the cost of ads has come down. All of a sudden, many companies that recently couldn’t afford to buy distribution and new customers now can do so economically and rationally. This is a big win for any company with products to sell and enough of an understanding of their economics to pay efficiently for growth.
There is renewed focus on quick profitability and separating truly venture-dependent companies from businesses that can grow without venture.
Founders and investors are more focused on quick paths to revenue and profit because everyone is worried that capital won’t be there when companies need it in the future.
There are some ways in which this discipline is clearly helpful. I like to remind entrepreneurs that venture capital is the most expensive capital in the entire world, and that they should seriously consider growing without it if they can execute their business plan without venture funds.
More founders seem to be moving in this direction—considering bootstrapping for longer periods of time, possibly all the way to profitability—and treating venture capital as more of an optional accelerator if the stars align.
Geography is becoming less of a factor in team building and fundraising.
It is pretty clear that now that most companies have been forced to try remote work, many will stick with it in a meaningful way even after the Covid-19 era.
This is going to open up the talent pool and allow Silicon Valley technology companies to draw from the whole globe. That was already starting to happen. But this episode is going to greatly accelerate this trend, likely leading to lower-cost access to talent for companies and new opportunities for people who to date have been geographically excluded.
On the financing side, I have heard at least some non-Valley–based entrepreneurs say that this episode is leveling the playing field because all meetings are on Zoom regardless of physical location. This diminishes the advantage enjoyed by founders and teams living in the Bay Area.
Startups thematically focused on remote work have a huge momentary tailwind.
The story of companies targeting remote work has clearly accelerated by years in the past month. People and companies that might have experimented with working remotely and the tool ecosystem around remote work—Zoom, Slack, Asana—were suddenly forced into that model.
This is drawing forward a ton of growth for remote work–oriented software, as is evidenced in the public market by companies like Zoom and Slack. This growth has spilled over into big rounds and rich valuations for productivity and remote work software and services.
There is nothing wrong in theory with this acceleration. The question is only whether in the long term, people will stick with the software they are using to work from home today.
Consumers are open to new social experiences for the first time in a long time, opening space for new social products and creating a financing tailwind.
Slow Ventures, the early-stage fund where I am a partner, hosted a conference on the future of social right before Covid-19’s outbreak. At that event, there was a sense that, for the first time in a long time, many builders were starting to experiment with next-generation social networks and products. Attendees had a vigorous debate about whether the future of social would be a “return to the real world” or a move deeper into virtual worlds.
What we have seen in the few weeks that have passed since that conference is that because people are at home, there is a huge amount of openness to try new virtual social experiences—and of course people are blocked out of the real world.
I have felt this change, whether playing multiplayer virtual reality games with friends or playing the game Codenames over Zoom. There are many social experiences and products I wouldn’t have had the time or space to try before that I am now engaged with.
Much like the long-term impact on the productivity ecosystem, there is no question that new digital social platforms have an enormous opportunity. People are willing to try new things, and the capital is following the potential.
Within social, there is a renewed focus on ‘real’ versus ‘professional’ friends and content.
In the last several years “professional” friends on Instagram have been huge wells of engaging content. In many ways the story has been about “professional” social media crowding out the amateurs and real friends on networks.
Covid-19 has, at least temporarily, reversed that. Facebook is alive with real friends looking to connect. People care about interacting with and supporting those with whom they have real relationships.
On the flip side, professional celebrities and social media charters are stuck in reruns because they can’t go out in the real world and produce new content. Much of the overproduced, manicured and appealing realities they build seem tone-deaf given the world situation we face.
Even my beloved TikTok is starting to feel stale after some great initial creativity in the earliest days of lockdown.
This reversal is creating opportunities for countless startups focused on real relationships and friends.
Transportation and real estate startups are challenged both by questions about how Covid-19 will affect long-term societal trends and by high capital requirements.
On the transportation side, there is the argument that people will avoid mass transit for a very long time after this incident—so that while the lockdown is damaging, there is an enormous global opportunity for private transit. Perhaps.
On the real estate side, the very large question is whether commercial real estate will ever recover—or whether the whole model (and not just WeWork) will have to change. If many people come out of this crisis believing that remote work is effective and commuting is wasteful, will companies slim down their commercial real estate? Will all startups that touch office workers suffer as a result? These are such large unknowns that, for the time being, it seems hard for early-stage companies in this space to do financing deals. It isn’t impossible, but the macro uncertainty, coupled with the usually high capital requirements for operating in the real world, make this space difficult.
There is an interest in new ways to earn from home, but not many new companies are coming online yet.
We all know the dire unemployment statistics, and the challenge to service workers and entertainers who work in the real world and are sidelined at home.
One of the areas where I think technology can have an enormous impact is helping people make money with their skills and talents from home. People are talking about this a lot, but I haven’t seen much momentum building in the space yet.
One of the only things I have seen is something I helped get off the ground—LiveStack video. This startup makes it dead simple for creators, from yoga instructors to comedians, to charge a fee for “pay per view” access to livestreams they host. I am expecting to see more things like this.
There is a lot of energy in telemedicine, which affects seed companies.
Many states are relaxing regulations around telemedicine, and even things like HIPAA compliance requirements, during the emergency. Different people have different predictions on what will happen long term and which regulations will be reinstated or dropped forever.
This, coupled with the fact that people still need medical support but do not want to go to doctors in person, is dramatically accelerating what was already good growth in the telemedicine space.
There is early demand for companies and projects focusing on advocacy services for small business owners and individuals.
The small businesses and individuals that are most under pressure from Covid-19 are clearly going to need support and guidance as they navigate their future. Getting trusted viewpoints and help in both renegotiating loans and leases, and dealing with displacement, is a new and very large business space.
Take, for instance, what is going to happen with restaurant rent in the coming months. Many restaurants are going to be stuck in a position of technically owing rent they can’t afford to pay if and when they are able to reopen. This would generally put a lot of power in the hands of whoever owns the real estate and holds the lease. But the problem for those owners is that if they kick out their current tenants, they will be unlikely to find a new one anytime soon at good prices to fill the space. That gives the restaurateur who wants to reopen a ton of leverage.
That creates an opportunity for helping small businesses and people renegotiate their obligations and commitments.
This is obviously just the start of a longer list of implications for early-stage venture capital in the coming years. The best companies will always get financed. But everything else about the early-stage pipeline presents many challenges and unknowns.
The Takeaway
Covid-19 and the accompanying economic downturn will affect startups in numerous ways. Early-stage valuations are falling, investors are demanding stronger protections, and angel investors might find it harder to compete. But there are more opportunities for startups in areas like social media and working from home.