Los Angeles-based venture capital firm Alpha Edison recently hosted a webinar featuring leaders from multiple investment firms speaking about the current state and immediate future of the funding market during the COVID-19 crisis. The panel included Eva Ho, General Partner at Fika Ventures in Los Angeles, focused mostly on seed and early-stage funding; Nate Redmond, Managing Partner at Alpha Edison, also focused on early-stage investing; and Dennis Phelps, General Partner at IVP, focused on later-stage funding. The discussion was moderated by Comparably CEO & Co-founder Jason Nazar, himself a serial entrepreneur and angel investor.
VENTURE FUNDING CONTINUES, BUT AT AN UNDERSTANDABLY MORE CAUTIOUS PACE
“Investors are definitely still writing checks, first and foremost,” said Redmond. “That part of our business doesn’t change necessarily. Fundamentally, great entrepreneurs continue to start great companies through downturns.” Redmond notes that more than half of Fortune 500 companies were started during economic downturns or recessions.
“We’re fortunate,” Ho said, after noting that her firm was indeed still writing funding checks. “And that’s not the case with a lot of other funds, some bigger than Fika, and some smaller. Many of them are spending more time focusing inwards, looking into their portfolio, and really playing a lot of defense, helping those companies stay alive.” This focus on existing relationships, Ho notes, means that inevitably there will be some slowdown in terms of forging new relationships and funding new companies.
“Follow-up financing is not something we like to endorse,” said Phelps about which companies it looks to focus on, especially in times of stress. “Obviously there are some companies that are already profitable. For other companies, we assess whether our round can bridge the gap to profitability. And there are other situations where we assume Follow-up Financing risk and help the company raise future rounds.”
“We anticipated a downturn. We were in a bull market for 11 years. We were preparing our companies for a downturn,” Phelps said, “But we didn’t expect anything like this.”
“Most of the cycles seen in the venture industry have been boom and bust credit expansion cycles,” Phelps explains. “There has been financial-led euphoria and then recompression. But what we’re seeing now is a health crisis and a complete evaporation for demand in some segments.”
“I think this is going to be a lot tougher than anything we experienced in ‘09 or ‘01,” moderator Nazar added. “None of us have lived through a time when we’ve been forcefully quarantined for months, and where we’ve seen millions of people go on unemployment. There will be a rebound, but I think every operator will be more cautious going forward with where they spend money. No matter how tough you think it is going to be, I would plan for it to be twice as hard. And personally I would recommend having 18 to 24 months’ runway at this point.”
“We’re all humans,” Redmond added, “As a consequence, there’s a layer of fear that’s built into our community and the system overall. That fear tends to translate to an increased sense of risk, and that tends to slow the investment processes down. While there’s no denying that this downturn in unique in many ways, the reputations and capabilities of these firms are really determined during downturns much more so than the upswings.”
“We have an opportunity to play offense and really look for gems out there at a much more reasonable entry price,” Ho added. “We want to take our time. There’s too much ambiguity right now. I want to say we’ll do the same amount of investments, but time will tell.” Ho, a survivor of previous downturns, agrees that the current COVID-19 crisis feels unique when compared to earlier downward slips.
All stressed the absolute uncertainty of the moment and cautioned against overconfidence until a viable way forward, whatever it turns out to be, appears out of the current haze.
“There’s a reassessment process, then there’s a portfolio triage process,” Phelps noted, especially for early-stage funds that may have a larger part of the companies
in their portfolios in need of follow-up financing. “What I’ve seen historically, and I’m seeing it right now, is a little bit of ‘Game of Thrones.’ A third of the companies in a venture capital portfolio may receive bad news over the next term, so you may need to take dramatic action to get to profitability faster. There’s going to be a period here of one to two quarters where things slow down quite a bit.”
THE NEXT SIX MONTHS AND BEYOND
AN ENORMOUS IMPEDING FACTOR AT THE MOMENT FOR ALL BUSINESSES IS THE UNAVOIDABLE UNCERTAINTY ABOUT WHAT COMES NEXT
“Founders are inherently optimistic,” Ho says, “But many of them have not lived through anything but a bull market. They really want to believe that it’s all going to go back to normal in 3 months. Those who have been here before know that what we think is going to be the future will probably not be the case.”
“You can probably imagine how it’s been playing out,” says Phelps. “Our consumer businesses, especially those with a retail presence, were impacted immediately. Those that were depending on advertising revenue saw impact immediately. Businesses that are selling software, some smaller companies, are seeing a material impact in their pipelines right now.”
“The speed of this shock is unprecedented,” Redmond added. “I would say the depth
of the shock is unprecedented vis-a-vis these last two recessions. With the level of pullback in GDP and the level of growth in unemployment going into Q2, every bank seems to be competing with themselves
on the level of pullback that we’ll see in Q2. Almost everyone expects growth from Q2 to Q3, but obviously the question is what kind of acceleration will we have there?”
As far as what message VC firms are sending to their companies, Phelps says the universal signal right now is that cash is king: “Reserve cash in every way possible. Try to extend your runway if you’re not profitable. If you thought you had 18 months of runway, think about what it would take to make sure you still have that if your revenue declines 20 or 30 or 40 or 50 percent.”
Some companies will flourish, but there’s potential for many more to face substantial struggles.
“The best we can do with our individual companies is really good scenario planning, and advising them to plan for the worst. If it turns out better than that, great,” Ho says, adding “This is not an easy message to deliver, and every company doesn’t get the same message.” More difficult than even those conversations, Ho says, are discussions with companies that have successfully raised A or B funding rounds and are entering the next stage flush with cash and wanting to continue spending money apace: “Those conversations are harder. We’ve been actively talking to our founders about things like really assessing whether they have product-market fit, sales repeatability, the amount of fat they have in the system, and salaries.”
The value of being right when so many other middle-stage companies are going to struggle with this same question is hugely increased in the current scenario, argues Redmond. “If you are right about those investments that you made to go to market, and if you’re accelerating in growth as the market comes back, investors like Dennis and others will be looking for those high growth companies, then you’re one of a smaller number which is a great position to be in.”
With data showing that the growth rate of the COVID-19 crisis is beginning to slow, Redmond adds “the byproduct is that people, emotionally and psychologically, are moving from fear of the unknown to the fear of the known, and in that environment, you can actually start making plans, and lots of opportunities fall out of that.”
SEEKING FUNDRAISING DURING THE CRISIS
FOUNDERS CAN INCREASE APPEAL TO INVESTORS AT A MOMENT LIKE THIS IN SEVERAL WAYS
DON’T GIVE INVESTORS A REASON TO SAY NO: “Don’t over negotiate or over-optimize. Those times are gone. Investors are stressed,” Ho says. “They are distracted and busy. Be reasonable and get clarity on the timelines.”
DON’T BE AFRAID OF DILUTION RIGHT NOW: “We’re telling companies that if they need to raise a further funding round, and someone wants to add on to the last round, take the money,” Phelps says. Don’t be worried about half a percent of dilution if it means survival.”
RETURN TO EXISTING INVESTORS: “We’re not telling anyone that it’s a good time to try to solicit from an investor you’ve never had contact with. VCs are going to work right now with companies we know and trust, and that have proven themselves,” Phelps says. Instead, Phelps suggests approaching existing investors again to find out where you are in their portfolio triage, and if there’s anything you can do on your end.”
REMEMBER THAT EVERYONE IS DEALING WITH UNCERTAINTY: “In an unchanging economic condition, once you understand the unit economics of your business, you have an ability to project forward and assume what those costs are likely to look like in the coming months and quarters. For many companies, this has just changed quite significantly.”
WHAT ARE THE BEST LEADERS DOING RIGHT NOW?
As far as what the venture capital leaders look for among the leaders in their portfolio of companies, a focus on their people is most valuable, that means both employees and – eventually – customers.
“This time is a great separator from a CEO or founder perspective. ‘Who is going to be able to rise to the occasion?’” Ho says. “I think everyone looks for folks who are decisive, who know how to proceed based on information that changes on a daily basis, who don’t panic, and who know how to communicate with investors. Be transparent, and be vulnerable, and don’t appear to have more than you have.”
“I think it’s a combination of communication and decisiveness,” says Phelps in terms of what the best leaders seem to be leaning on. “Communication in terms of the fact that it’s up to leaders to be visible at times like this, and also keep a dialogue going with employees, key managers, the board, customers, and partners.”
“And in terms of decisiveness,” he continues, “What we’ve seen not work in the past is the kind of situation where you have, say, three scenarios: Maybe Scenario One
is it all has a small impact on business, and then on up to Scenario Three, which is that you get catastrophic impact. The problem is when you start incrementally acting
under Scenario One, then as data comes in you start working under Scenario Two and then Scenario Three. It’s really bad for the employees that you plan to retain when it’s a matter of death by 1000 cuts or bad news that trickles out over time. So if you’re in a situation where you know you’re going to be impacted, taking decisive action now. No matter how painful it might be, it is really important.”
“The big challenge right now is deciding where to be more defensive and where
to be more selectively opportunist and lean in and increase spending in certain areas,” Redmond added. “These are not easy decisions. We really seek to be close partners with the great founders we are lucky enough to partner with, and it’s in these times that those relationships are really cemented. The returns for making good decisions right now are potentially greater than they have been for the last ten years.”
PARTING THOUGHTS
EVA HO: “Whatever you need to do to get the point to make your company survive is going to be critical, even if it’s painful in the short term. Take advantage of whatever you can. And also take care of yourself. This is a mental burden that is unlike anything else.”
NATE REDMOND: “Get closer to your customers. Their needs just changed, and they’re screaming and almost nobody is listening. You have this wonderful opportunity to get closer to those customers, to listen and to hear things that others aren’t, and ultimately fold that back into the decisions you’re making.”
DENNIS PHELPS: “There’s a natural tension between empathy and responsibility here. But you have the ability to be both. How you treat people through this really does matter. That being said, you’ve got a responsibility to employees and customers to survive. You need to take decisive action. These are not easy decisions if you’re talking about laying someone off into an environment when unemployment is high. That said, some of IVP’s best investments ever were made during drops like this. We co-led the series B at Twitter in February 2009. It looked like the end of the world was at hand, at least the investment world – Lehman Brothers had just blown up – and yet that turned out to be our largest investing return in terms of dollars back.”
JASON NAZAR: “There is a mountain to climb right now, and we’re all going to have some shared sacrifice. Don’t talk about it right now as the two-year goal, but rather as the three or four or five-month goal, and here’s what we’re going to focus on, and this is what we’re going to over-communicate.”
