What A Post-COVID-19 Funding Round Will Look Like

As we all begin to readjust our lives for the long-term consequences of the COVID-19 pandemic, Founders of start-ups and scale-ups redraft their growth plans and face a big unknown: what does the future of start-up funding look like?

Of course, we can’t predict the future, but we can make educated guesses based on how investors and markets reacted to precarious economic scenarios in the past.

That’s exactly what David Kelnar from Numis Growth Capital did, in an extensive and comprehensive piece of research that uses data from prior recessions and insights from dozens of investors to draw a sketch of what post-COVID-19 private markets are going to look like.

We evaluated Numis’ research, together with other first-hand data from VC firm NfX and CBInsights to try and answer three key questions for early stage Founders:

1. When will VCs actually go back go BAU?
2. How will they make decisions in a post-COVID world?
3. What will a post-COVID funding round look like?

When will VCs actually  go back to BAU?

As soon as the impending economic impact of the pandemic became clear, the first feedback we got from investors and Venture Capitalists within our network was that their priorities were shifting towards their portfolio companies.

That initial finding was confirmed almost immediately by a number of surveys, including a very comprehensive one from VC firm NfX.

Source: NfX

With VCs spending less time evaluating new deals, the first visible effect of the pandemic on Venture Capital is a decrease in number of funding rounds.

Source: CBInsights

That’s an issue for companies that were planning on raising capital in the first half of 2020, which are now left with short runways and a much more challenging fundraising environment. But even those with larger cash reserves are going to need investment in the near future to fuel their growth.

We already know that eight in ten investors are planning to reduce capital investment in the short-term, but what about going forward, as countries ease their lockdown measures and the effect of the pandemic on the economy becomes less direct? How long will it take investors to shake it off?

The two most recent recessions showed radically different patterns of recovery in terms of deal volume, especially for early-stage companies.

While the dotcom bubble had lasting effects on investor behaviour and risk-assessment, resulting in an L-shaped curve, the effects of the 2008 financial crisis was only felt in the shorter term, quickly bouncing back in a V-shaped graph.

The European VC landscape in 2020 has very different elements from both the last two recession:

1. A recession that’s “deeper, broader and likely longer than precedents”, according to Numis’ research;
2. Unprecedented amounts of ‘dry powder‘ sitting in recently raised VC funds.
3. A considerable momentum in terms of both value and volume of funding compared to other geographies.

These three factors point towards a V-shaped recovery, with deal volume going back to pre-COVID level in the medium-term, with investors looking to deploy their reserves of capital in hopes to realise good returns on it.

That’s good news, provided that start-ups have enough cash to weather the crisis. But there’s a caveat.

Even though volumes and value will be those we were used to, the way growth capital is distributed is definitely going to change.

How will VCs make decisions in a post-COVID world?

To define what investors will look for in a company once the recovery starts, we need to keep in mind what is currently driving their decisions:

1. The need to protect their vested interest in their current portfolio;
2. The amount of capital sitting as ‘dry-powder’ in their funds;
3. The fact that the pandemic is radically shifting consumption and customer behaviour at every level.

These elements result in an environment with loads of potential for VCs.

With the GDPs of most countries shrinking, advertising spend will take a deep plunge after a decade of growth, this will make it cheaper for companies to acquire customers.

At the same time, the wave of unemployment and the inevitable decrease in demand of office space will make salaries and rent cheaper, ultimately increasing start-ups’ capital efficiency.

High capital efficiency means that companies grow quicker with the same amount of capital. Combine this with lowered valuations as a result of the correction from a bullish pre-COVID market and it’s easy to see how investors can actually increase their returns, as long as they bet on the right horse.

This is typical of recessions, as David Coats, partner at Correlation Ventures, points out in a blog.

Source: Correlation Ventures

Both after the 9/11 terrorist attacks following the dotcom bubble, and after the 2008 financial crisis, VCs saw their realised multiples go up even with the public markets falling, GDP shrinking and median valuations decreasing.

This will determine three key changes in how VCs pick the winners:

1. Further investment into portfolio companies will be fast-tracked;
2. As it becomes clear which sectors benefit from the crisis, these will see a spike in funding;
3. The shift of focus from growth to profit margin will be accelerated.

Re-investing in portfolio companies

With operations disrupted in almost every sector – or at least radically transformed – many companies saw their runways shorten and now have to resort to raising finance earlier than planned.

But finding new investors at higher valuations, following the usual Seed, Series A, B, C paradigm won’t be an option for at least a few months. This will likely result in an abundance of follow-on rounds (top-up rounds, insider+ rounds… they have many names!)

As investors rush to provide lifelines to their struggling portfolio, they will likely get good deals out of it, with convertible structures and discounted pricing that will help them offset losses with higher stakes in those companies that make it through the crisis.

Betting on winning sectors

One key element of the current recession is that it’s been triggered by a factor that’s completely external to the economy. That is why not every sector is being hit in the same way, and some sectors (video conferencing is the most obvious) are actually thriving in the pandemic.

There will be winners in a post-COVID recessionary-type environment.” 

With investors extra cautious about spending their capital, it’s no surprise that we already saw through the public markets who some of the winners are.

What we’re seeing is the immediate reflection of shifting consumer trends, like remote working companies skyrocketing just as countries get ready to implement lockdown measures. Although some clear winners are already emerging, a wider market shift has just begun.

According to many, including Bill Gates, who have been warning the public about the danger of infectious diseases, the COVID-19 pandemic was a disaster waiting to happen. We’re now forced to face reality as we learn to coexist and cope with the risk of another outbreak.

This post-pandemic world will shift behaviour in ways that we still don’t know yet. As companies leaders in their sector collapse, unable to adapt to such a sudden change, more agile challengers will take their place by solving the problems that the incumbents couldn’t face.

As every shifting scenario, this pandemic opens up many opportunities for challenger businesses. Investors who are smart in betting early on these challengers will be generously rewarded.

Margin is king

This last change in investors’ behaviour is not a direct consequence of the pandemic. At the start of this year, most investors agreed that profit margin was going to have a central role in their investment decision, the way growth had in previous years.

For almost all growth-stage companies, the pandemic forced a reassessment of those growth plans. Showing a 50% month on month growth fuelled by marketing spend on a pitch deck won’t be as effective now, with little certainty as to whether that rate can be maintained.

To put it in Tomasz Tunguz’s words: “Richer margins lengthen runway.”

Profit margin also offers a deeper insight on the solidness of a business plan, and it implies that a company can sustain higher levels of disruption.

In addition, as it gets harder to get new investors on board at higher valuations, VCs will pressure portfolio companies to prioritise profitability, in order to ensure their returns.

What will a post-COVID funding round look like?

Now that we covered when and where Venture Capital will be invested, let’s talk about how.

From a wider point of view, it’s important to realise that prior to the COVID pandemic we were at the zenith of a very bullish market. Median valuations had been growing to unprecedented levels, and with episode such as the WeWork fiasco, some would say that a correction in the market was long overdue.

For this reason, VCs are now recalibrating and almost all are forecasting valuations to dramatically shrink, as NfX found in their survey.

As valuations shrink and the focus shifts from growth to capital efficiency, funding rounds won’t be aimed at aggressively expanding but – especially in the short term – at sustaining and restructuring core operations and reorient them towards profitability.

What we say in previous recessions is that funding round sizes tend to shrink more at later stages, but see minimal changes for Seed-stage companies.

As existing investors become the best chance for companies hoping to raise capital, many of these rounds will feature convertible structures, starting off as a loan and converting into equity at a later date, with a discounted share price. The recently announced Future Fund is a perfect example of this trend.

This structure is profitable for investors, who are not short of cash and will end up holding more equity at a lower price, while also protecting their existing investments by providing portfolio companies with much-needed capital to get through the crisis.

As shown by David Kelnar in the chart above, recovery followed a U-shaped path for early-stage private companies following the dot-com bubble and the 2008 financial crisis.

Median valuations, as well as total investment value, are correlated with investors confidence in the growing market, that’s why they take longer to adjust than deal volume.

For these metrics, recovery typically looks like a U-shape, as they take a few years to return to prior levels.