Last week, Sequoia Capital, one of the oldest and most respected venture funds, issued its “Black Swan” memo to its portfolio companies warning them to have enough cash on hand and make decisive decisions to weather the storm that has been the financial, economic and social crisis triggered by Coronavirus. Since then, there has been a debate among venture investors whether to continue to fund, pull out of existing commitments, write “Corona Clauses” in their term sheets, or invest as an opportunity against the drop in other asset classes.
There are many smart investors who are continuing to invest right now. There is still dry powder out there that needs to be invested, just cautiously. It seems like much of the venture business is “open for business” according to Fred Wilson at Union Square Ventures. Others are posting about how they are closing deals from start to finish using Zoom and not meeting in person. The technology and investing businesses are used to operating fairly decentralized anyway. It seems as if Coronovirus has just accelerated that trend – and perhaps will make it more permanent.
Historically, startups might find it difficult to raise capital with recession warnings. No matter what the economic circumstances are, there’s always capital for companies that have the product market fit and a strong relationship with a diversified set of customers. Some investors already have been pressing founders to be more mindful of the fundamentals of running a sound business: cut unnecessary expenses to extend cash runway, expand their customer base, be sure to have a dependable board of directors and, at last, become a great storyteller about how their company is successfully solving a problem. Companies should hold off on deploying capital until they understand business drivers that enable them to become category-owning companies offering a defensible product or service.
As Sequoia notes “Google and PayPal soldiered through the aftermath of the dot-com bust. More recently, Airbnb, Square, and Stripe were founded in the midst of the Global Financial Crisis.” Some of the best returning funds also happened in those years.
So what is the case for investing in technology at the earliest stage besides the fact that returns are the best and investors are seeking a long term game now? Early stage pre-revenue tech startups become in relative terms less risky. At the early stage, risk doesn’t change much in absolute terms but changes dramatically in relative terms. If you at normal times evaluate a pre-seed startup risk to be, say, 100x higher than that of a later-stage company, at the time of crisis this could become only 20x. this of course assumes the crisis is bounded in time. If the crisis is long-term other factors come into play, like sharply increased funding risk.
Pre-revenue startups have zero exposure to market, and generally benefit from crises, because they can get cheaper workforce (this assumes employees will still want to join a company with financing risk). If you expect the crisis will take x number of months, and the startup has >x runway, you know it will survive. There are almost no other variables except in the Coronavirus instance, we don’t know x number of months yet.
There is no supplier risk. Compare this with revenue-generating companies. Market demand squeeze makes them shed costs, which is detrimental in the long term. Growing back to the same size will take more time than small companies. They also are more exposed to supplier risks, and systemic economic shocks (lending etc.).
Technology trends are not going to stop moving forward in a crisis – in fact they will accelerate in many areas. Think of the Blockchain, Artificial Intelligence, Internet of Things and other technologies that are currently being used to assist in the Coronavirus crisis for instance. In China, Blockchain startups popped up to assist this quarter. Innovation is born of necessity. It’s a matter of looking in the right places at the right time.
Article first appeared March 13, 2020 on Forbes.com.