COVID-19: startups on the edge

August 2020  |  FEATURE  |  FINANCE & INVESTMENT

Financier Worldwide Magazine

August 2020 Issue

The investment industry has been adversely impacted by the outbreak of COVID-19, which has posed formidable financial and operational challenges through the first half of 2020. One of the hardest hit areas has been the startup space, with thousands of venture capital (VC)-backed companies contemplating a future that hangs in the balance.

To be sure, some startups have flourished during the crisis, particularly those supplying ‘essential services’, educational technology, and gaming and streaming products. Many of these have been able to rely on investment funds to ensure they meet a growing demand. Some cloud-based and technology focused startups have reacted directly to the COVID-19 pandemic, working on ways to track the spread of the virus or repurposing their innovations into tools that help save lives.

For most startups, however, the outbreak has caused a steep decline in demand. According to Startup Genome’s ‘The Impact of COVID-19 on Global Startup Ecosystems: Global Startup Survey’, 74 percent of startups have seen their revenues decline since the beginning of the crisis. The most common type of change in revenue experienced has been a relatively modest decline. However, a number were heavily impacted by the crisis, with 16 percent seeing their revenue drop by more than 80 percent. One of the major factors behind declining revenue was the fact that three out of four startups work in industries severely affected by the COVID-19 crisis.

They face a bleak future with the very real threat of running out of capital if the global economy does not begin to recover soon. Across the VC-backed space, revenue has been challenged and cash reserves are dwindling. Each month the pandemic drags increases the risk that more startups will cease to exist.

Constrained finances

Accessing additional funds remains one of the biggest challenges. While some angel investors are still making investments, fewer deals are being completed and for less capital than prior to the outbreak. Already, the COVID-19 outbreak has made it harder for early-stage ventures to rise above the noise and receive funding, product recognition or mindshare. According to Dealbook, funding rounds in Europe dropped by 22 percent in March and valuations are down by 10-40 percent.

“The VC landscape has certainly been impacted by the pandemic,” says Bruce Taragin, a managing director at Blumberg Capital. “COVID-19 and the ripple effect of economic, social and professional impacts have rocked every industry, including technology, and the way investors look at new startups is inherently through a COVID-19 lens.”

Of those startups with a term sheet before the onset of the crisis, nearly 20 percent have had it pulled by their investor, according to Startup Genome’s survey. Fifty-three percent have seen the process slow down significantly or faced an unresponsive lead investor. Only 28 percent of firms have either had the process continue normally or have secured the funds.

Regardless of geography or industry, a black swan event like the COVID-19 crisis means that startups must do everything in their power to control cash flow and maintain business operations, employees, product development and plans for future growth, despite the hardship.

“The most challenging obstacle for startups during this time perhaps has been identifying how to navigate this period of limited cash flow,” says Mr Taragin. “Startups may need to adjust strategies in the short term to position themselves for long-term success, by adjusting key performance indicators and evaluations with flexibility, while still maintaining rigorous measurement and efficiency.

“Startups may also need to consider reallocating resources to priority initiatives and assessing the credit situation with lenders and drawing available credit before it is needed,” he adds. “These can be challenging adjustments, but it is important to take proactive and strategic measures to maintain the health of the company when resources are limited.”

According to Startup Genome’s survey, two-thirds of startups around the world said in March 2020 they would run out of money within six months. Four out of 10 believed this would happen within three months. The increase in companies classifying themselves within what the report calls the ‘red zone’ – meaning they have three months or less of cash runway left – rose by 40 percent since December.

“The need for investment has presented challenges for many startups as there has generally been a reduction in available funds, or appetite for investment, from investors,” notes Jacqui Barrett, a partner and head of the US practice at Hall & Wilcox. “In addition, where investors have been willing to invest, they have sought to negotiate a larger percentage interest in the startup business than might be considered reasonable in better market conditions.”

She continues: “For those startups that have investment funds or grant money, the focus during this period has been on how to conserve cash and how to most productively apply those funds to sustain the business for the longest possible period. Where a startup has a VC or private equity (PE) fund as an investor, many of those funds have provided valuable assistance in helping that startup to implement strategies to minimise expenditure and ensure longer term sustainability.”

Regional responses

A number of governments have launched efforts to support startups in their hour of need. In Europe, France and Germany have made €4bn and €2bn rescue packages available to startups, respectively. Ireland, Italy, Austria and Finland have set their own plans in motion.

In April, the UK government introduced a scheme to help tech startups not covered by its Coronavirus Business Interruption Loan Scheme (CBILS). Since the CBILS does not apply to lossmaking businesses, it disqualifies many early-stage companies. Now, a £500m Future Fund will match any backing given to startups by the private sector, with state-backed loans of between £125,000 and £5m provided from June onward. To qualify for the scheme, startups must have previously raised at least £250,000 from private investors within the past five years. The loans will automatically convert into an equity stake at a 20 percent discount to the valuation set in the next funding round, unless the debt is repaid within three years.

In Australia, the federal and state governments have introduced a number of initiatives to help startups through the COVID-19 crisis. As Ms Barrett explains, the Accelerating Commercialisation programme provides small and medium businesses, entrepreneurs and researchers with access to expert advice and funding to help get a novel product, process or service to market. “Successful applicants will receive expert advice and up to AU$1m in matched project funding,” she says. “The Boosting Female Founders Initiative also provides funding for female-founded startups to launch and scale their businesses into domestic and global markets. Grants of between AU$25,000 and AU$480,000 are available to successful applicants.

“Temporary cash flow support of up to $100,000 may be made available to startups. Eligible small and medium-sized businesses that employ staff will be provided with cash flow boosts by way of credits in the activity statement system,” she adds.

But it is not all good news for Australian startups. Temporary changes to the country’s foreign investment laws have reduced the threshold for requiring Foreign Investment Review Board (FIRB) notification or approval for investments by foreign investors to zero, which presents a challenge. “The effect of changes to foreign investment has been to discourage or significantly delay investment from other countries in startups,” points out Ms Barrett. “In the current crisis, such delays can prove fatal to struggling businesses.”

In the US, many startups missed out on the $2.2 trillion government emergency relief funding package announced by the Small Business Association due to several technical rules around VC backing. Firms with the same VC backer, or group of backers, that have control through ownership stakes, management decision making or other means, are considered affiliated entities and their staff are counted together. If the combined portfolio companies have more than 500 employees, they are ineligible for a loan, even though the startup in question may only have a fraction of that number of employees.

According to Startup Genome’s survey, 38 percent of startups had not received assistance and did not expect to be helped by policy relief measures related to the crisis. Sixteen percent were not currently supported, but did expect to be helped by a policy measure soon. The remaining 46 percent were currently receiving assistance. According to founders and startup executives, the four most helpful policy responses for their businesses would be: (i) grants to preserve company liquidity; (ii) instruments to boost investment; (iii) support to protect employees, like payroll supplementation grants; and (iv) loans to preserve company liquidity.

A strong hand at the helm

The COVID-19 pandemic has caused chaos, disruption and human and economic hardship and its effects will be felt for some time to come. In responding to the crisis, there are a number of important steps companies and their leaders can take to steady the ship. “It is critical to remain calm and take a long-term view during times of volatility,” suggests Mr Taragin. “It is also important to act quickly and decisively to modify short-term strategies and preserve and extend resources to keep business running.

“Portfolio companies should quickly formulate – or revisit – their contingency plans, creating ‘what if’ stress tests for the variable length and depth scenarios of this downturn,” he continues. “With this planning, the C-suite can work collaboratively to implement short-term stabilisation efforts. These efforts may include expense reductions to operations and deferrals while defending revenue, playing offence to gain market share, advancing product development and even making acquisitions as opportunities arise.”

COVID-19 has changed the landscape for startups everywhere. The VC industry has already begun to adapt to the ‘new normal’. Though many VC firms are still investing (a report from Fenwick & West found investments in startups increased from 54 in March to 64 in April) and most notably they have been investing into what they consider to be safe bets, it has certainly become more difficult to raise capital over the first half of 2020.

In the coming weeks and months, startups and their backers will have difficult choices to make as cash runs out. Executives will need to consider laying off or furloughing staff, reducing salaries, downsizing office space and eliminating non-essential expenses.

But startups may also use this time of volatility and disruption to change their working procedures and retool themselves for the future. “This period can be a valuable time for entrepreneurs with enough resources to survive three to 12 months of minimal new sales to focus on automation of internal processes and keeping existing customers well-served and satisfied for improved business outcomes, post-COVID-19,” says Mr Taragin.

“This is also an opportunity to focus time and resources on research and development (R&D), product enhancements and even consider pivoting your offering to solve today’s unique challenges,” he continues. “Furthermore, this may even open up new opportunities for startups which can prove to investors and stakeholders that they are successful under pressure, are innovative and are agile enough to pivot offerings and strategies to adapt to changes in the market or industry.”

For startups, it will likely be a case of survival of the fittest in the short term, with companies focused on cutting expenses and maximising revenue to the extent possible. But the post-COVID-19 landscape should see innovative, bullish startups re-emerge and investors recommit. Those that survive COVID-19 may go on to thrive.

© Financier Worldwide

BY

Richard Summerfield