VCs are congratulating themselves on being “open for business” during this coronavirus crisis.
Good for them! Startups are founded everyday, and generally speaking, the more get funded, the better off we’ll be! More innovation, disruption, choices, etc. However, this is likely a party that won’t last for much longer.
This is especially true if you’re running a large VC firm (>$1 billion AUM). Here’s why…
In portfolio theory, there’s a concept known as drift — it’s the simple idea that due to unexpected market movements, your portfolio may all of a sudden be allocated in a way you hadn’t planned for.
Most LPs (assuming they’re large pension funds, sovereign wealth funds, endowments, family offices, etc. and excluding your regular individual investor) allocate 5-10% of their portfolio towards venture capital. In their minds, it’s capital that has the best chance of generating the highest alpha, but also the best chance of going to zero. Given the sums involved, not play money necessarily — although that’s how some think of it.
So, remember: only 5-10% of their portfolio can be in this super risky class of assets. If venture capital’s at the tip of the pyramid, then the other bases on the bottom are made out of safer asset classes: stocks, bonds, Treasury, etc.
But what happens when the S&P collapses by 30% in the span of two weeks? What happens when other usually safe asset classes tank, or become less liquid (as the fixed income market has been in the last few weeks)?
At the same time, venture capital firms are still holding steady onto their December 2019 marks which means valuations have not been adjusted for the reality we’re currently living in.
Following the pyramid analogy, that means the bases on the bottom are contracting, therefore giving the tip of the pyramid disproportionate weight. This is how LPs can wake up one morning and find out that they’re “overweight” on venture capital — the riskiest asset class of all.
What happens now?
Most LPs, except in the most extraordinary of circumstances, are not going to default on their capital commitments to the VC firms. But they can do is, certainly, call the GPs up in each VC firm they’ve committed to and say, “slow it down,” or “I don’t want to see anymore drawdown notices until…”
To be 100% clear, it’s very important for founders to understand these VC/LP interpersonal dynamics when a downturn arrives — it may not seem like you have any control over it, but it will affect you.
1. VC Triage — VC firms will begin to triage capital allocation between funding new startups and supporting their existing portfolio. This week, at least a dozen of VCs have started sending “how are you doing?” messages to their portfolio CEOs.
The correct answer they’re looking for is not “great, hope you’re staying safe!”.
When VCs ask that, they’re trying to figure out a few things: how impacted will you (and more importantly, your metrics) be by this crisis? How close are you towards profitability? Will I have to bridge you? Are your metrics strong enough to justify a bridge?
2. Term Sheets Recut/Retrade — A VC firm extended you a formal term sheet offer and had to recut/retrade it with a lower amount and/or a lower valuation. Why?
Because market conditions have changed, and it’s unlikely that you’ll hit your projected numbers. If you’re a B2B SaaS company, buyers have vanished into thin air. How are you going to hit the sales numbers you said you would even a week ago? Pretty self-explanatory…
3. Fully Funded Plans — VC firms will be more inclined to fund companies that can and will become profitable with this last round of funding. Usually, when a startup raises funding, they have three options on the table: 1) M&A exit, 2) Chapter 7/11, or 3) IPO.
With options 1 and 3 fast disappearing, VCs need to quickly figure out if they should bridge you until those exit opportunities open back up again, or if it’s better to just push you off the edge of option 2. Believe it or not, it’s often times a gut feel decision.
It’s important to note that much of the impact described above will be felt most acutely by growth stage companies, rather than seed/Series A (although there will be a broad slowdown there too). Why?
Because when you’re a startup that’s raising from a larger fund (>$1 billion AUM), those funds themselves will be more exposed towards LP pressure — after all, LPs have dedicated a larger allocation towards those particular funds.
No one knows how this will shake out at the end of the day, but this much is true: the best war strategies are not formed haphazardly or reactively, but rather, thoughtfully in the beginning and having the nerve to go through with it when the time comes.
The time has arrived.