Survival of the fittest: The effects of COVID-19 on early-stage start-ups
April 5th, 2020
As the world watches the events of COVID-19 unfold from the comfort of their homes, it is certainly not a comfortable time for many start-ups. With the demand for such companies dropping significantly, it is not surprising that the venture-backed start-ups will be particularly susceptible to economic problems in the wake of COVID-19.
Start-ups will face substantial challenges as they struggle to ramp up production, operations, and sales, at a time when demand is weak, and customers are few and far between.
Venture-funded start-ups, that rely solely on external capital to fund their projects, are unlikely to have significant revenue and may not be profitable, leading to the withdrawal of investors. With the start-up world already seeing the pool for funding drying up, following WeWork’s failed IPO, we predict that the availably of capital will only continue to disappear as more venture capitalists will begin to scrutinize deals far more closely.
While predictions for the current crisis state a more substantial economic impact than the 2008 Recession, the severity of the Recession that follows will significantly impact the resilience of the start-up sector. In the event of a drawn-out recession, there could be a more widespread impact on VC strategies and portfolio allocations. The nature of the current crisis, a global health pandemic that has shut down entire industries for an indeterminate period, adds to the incalculable complexity of the situation.
During the 2008 Recession, venture investment dropped by 28%, and the deal volume reduced by 5% compared to the previous year. However, it is important to acknowledge that the VC industry nowadays is more significant, better understood, and more liquid. Today’s VC ecosystem includes several non-traditional investors such as pension funds, equity hedge funds, and corporate VC (CVC), and the development of the secondaries market provides more liquidity opportunities for investors and shareholders.
Furthermore, the digital revolution over the past ten years will make it easier for new start-ups to continue operations remotely as well as introduce new products via digital channels. Finally, federal stimulus from working capital loans, as well as an outpouring of support from vendors to relax payment terms and provide free services, will undoubtedly mitigate the economic impact. It is also worthy to note that angel & seed deal count increased during the Recession and that the best performing VC companies were those that invested at the depths of a recession and into recovery.
The combination of government stimulus efforts to boost the economy and the maturity of the current venture capitalist (VC) environment, means we could see a decline in economic growth less radical than during the Recession. Nonetheless, early-stage tech start-ups may not have the same access to these services due to their lack of ability to provide guarantees.
In these uncertain times, we predict that VCs are more likely to favor enterprise start-ups that offer longer-term SaaS contracts and easy remote onboarding. As for retail transactional businesses, they may have a more difficult time finding investors, given the drop in consumer activity and the nature of this pandemic keeping people at home.
Later-stage start-ups that have successfully completed several rounds are likely to see the most significant valuation reductions since they are more often valued relative to public markets. These companies will also have to battle with complicated down-round accounting related to liquidation preferences that could make larger deals harder to close. However, these companies will likely have an easier time accessing stimulus-related debt capital or other loans.
The discussion around “staying private longer” is likely to have more attention as investors concentrate on whether later-stage start-ups should have completed an IPO sooner.
Overall, according to our analysis, it is the healthtech, foodtech, IoT and mobility tech verticals that will be the most affected as a result of the COVID-19 pandemic. The insurtech and fintech sectors will experience a moderate-to-significant impact, AI & ML and supply chain tech verticals could experience moderate impact, and finally, we predict cloudtech & DevOps and information security tech to experience a relatively low impact, by comparison. Other key indicators suggest early-stage investment activity will remain moderately active.
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