Amid Downturn, Silicon Valley’s Balance of Power Shifts From Startups to VCs

By Kate Clark

For years, entrepreneurs have called the shots in Silicon Valley’s startup ecosystem as an abundance of capital chased a limited supply of good ideas.

But in a matter of weeks, as businesses everywhere lurch to a halt due to the coronavirus pandemic, the pendulum has swung decidedly back toward venture capitalists. These investors say cash-hungry startups are now coming to them for investments on more favorable terms, offering more equity for less money than in the past.

“If you need to raise money, you’re kind of screwed,” said Mitchell Green, a founding partner of Lead Edge Capital, a growth equity firm with investments in Uber and Spotify. “Over the last decade, companies have had the upper hand because there’s so much money. Now, if you are forced to raise capital, [investors] will have the upper hand and be able to get good prices.”

THE TAKEAWAY

• Startup valuations are dropping as the coronavirus hits the economy
• VC firms stand to gain more equity at lower prices in startups
• Some investors are delaying, reneging on financings

In one recent example, Lime, the once-hot operator of electric scooters, is trying to raise an emergency round of capital at a valuation of $400 million, an 80% discount from its last round, The Information reported last week. The drop in valuation means investors can buy more for less, a prospect that has many funds preparing to accelerate the pace of their investing. Lime is one of the first “unicorns”—startups worth more than $1 billion—to see its valuation slashed due to the fallout from Covid-19. It certainly won’t be the last.

Venture capital itself won’t be immune from the economic turmoil. Some startup investors are reneging on deals, or taking much longer to make decisions about potential financings to preserve capital.

The best-positioned firms are likely to be the more established ones with long track records of backing entrepreneurs. Firms that have recently raised substantial funds from university endowments, pension funds and other institutional limited partners are in a much better place than those that have to refill their investing coffers now.

Some well-known VCs have begun talking about the current moment as something like an integrity test for startup investors and a reckoning for the dilettante investors that veterans of Sand Hill Road—the Silicon Valley street that is home to many VC firms—often grumble about.

“Reputations are built in hard times, not the easy times,” Bill Gurley, a general partner at Benchmark Capital, tweeted recently. “If you shake a hand, sign your name—stand strong, or your word is no good. Otherwise you are a transient that only wanted the easy take. And you should move on.”

Valuation Haircuts

While it’s too soon to tally the damage to startups, many are likely to see steep drops in their valuations—assuming they don’t shut down altogether—as private asset values tend to reflect a big drop in public market values.

“There is $1.35 trillion of value locked up in unicorns globally,” said Wouter Witvoet, founder and CEO of Secfi, a financial advisory business catering to startup employees. “You will see a drop in valuations of about $350 billion if the private markets follow the public markets.”

Total VC investment falls during economic downturns too, because funds behave more cautiously and conserve cash for their portfolio companies. From 2007 to 2009, for example, total U.S. VC investments dropped 28%.

If there is a similar economic decline this year, VC investment could drop by as much as $39 billion in 2020 from last year, when total capital invested in startups hit $136 billion, according to financial data firm PitchBook. As venture investments shrink, so will startup valuations.

The result for VCs sitting on piles of cash is cheaper stakes in startups. In its most extreme form, the hunt for value involves investors—derisively referred to as “vulture capitalists”—who focus on finding steeply discounted deals for distressed companies. Rarely does anyone admit to being a vulture capitalist.

“The vultures do come out,” said Neil Sequeira, co-founder and managing partner of Defy Partners, a Series A venture firm, “but they aren’t usually folks like us who rely on our reputation.”

“What makes you a vulture is preying on the weak or the near-dead—that’s what a vulture does,” said Scott Lenet, founder of Touchdown Ventures, which helps corporations set up VC arms. “The question is, are you taking advantage of someone who can’t help themselves? That’s what makes it wrong.”

Vultures or not, venture capitalists will take advantage of the current environment to increase stakes in their best companies and to make new investments in hot companies that would, in normal circumstances, ask for capital at a much higher price.

And they won’t always get off scot free. Some investors are already feeling the burn of a downturn. In addition to advising their companies to conduct mass layoffs, they may have to reinvest in companies at pre-money valuations so staggeringly low their existing shares lose significant value. These “cram down” financings, a type of recapitalization, become more common in a recession.

Collapsing Deals

For startups, a grim sign of how the investing landscape is shifting is the growing number of deals that are blowing up.

One artificial intelligence and machine learning startup had recently lined up a $10 million investment from a New York–based growth equity fund backed by Chinese limited partners. But once the virus hit, they backed out, according to financial documents shared with The Information on the condition that the startup wouldn’t be named. The company furloughed 40% of its staff and is hoping to secure a financial lifeline from earlier investors, according to the documents.

Maanav Patel—founder of Glyde, a recently launched tool for ordering and paying for food at restaurants—said two high-net-worth individuals in New York City recently committed $75,000 each to his pre-seed financing but dropped out of the round in early March, citing recent market changes. “That created a domino effect, and the two other investors that were going to participate in the round also backed out after that,” Patel said.

Michael Jones, CEO of the venture fund and startup studio Science Inc., said three startups recently approached his fund for capital after angel investors backed out of their round. Similarly, Sequeira said an investor he wouldn’t name reneged on a financing deal for one of his companies after the investor had already issued a term sheet. And a managing director of a $400 million early-stage fund, who asked not to be identified, said two companies he passed on investing in earlier have returned with a new pitch at a major discount.

“From my vantage point today, the people that I have seen back off and flake have been angel investors who aren’t as liquid as they thought they were,” said Katie Jacobs Stanton, founding partner of seed venture firm Moxxie Ventures.

Some startups still have VCs banging on their doors. Earlier this week, Notion, which develops software tools for workplace collaboration, raised a $50 million round at a $2 billion valuation, a huge increase from an $800 million valuation earlier in the year.

Meanwhile, Oh My Green, which delivers meals to offices around the U.S., is in negotiations with its investors to close an emergency funding at a flat valuation as it adjusts its business model to deliver meals to employees at their homes instead of their offices. CEO Michael Heinrich said he had let go 70% of the company’s 600 employees through layoffs and furloughs as a result of the economic disruption caused by Covid-19.

“Our investors are incredibly supportive of what we’re doing,” said Heinrich, whose investors include Alumni Ventures Group, Fuel Capital and Astanor Ventures. “Nobody could have prepared for a pandemic.”

While flat rounds dilute founders and earlier investors, they do so to a lesser extent than down rounds and are a cause for celebration in the current environment. “If you’re getting a flat round and you can keep the dilution minimal, you should take that as a victory,” Sequeira of Defy Partners said.

Slow Money

VC investing could see a shakeout of its own, depending how long a recession lasts. Many investors in the sector would welcome a culling of the herd after years of new money sloshing around Silicon Valley.

To help its portfolio companies avoid disreputable investors during the turbulence ahead, the venture firm Tribe Capital recently sent an email to its founders with an analysis of historical investment data intended to highlight the funds that behaved poorly during the 2008 financial crisis.

The analysis, prepared by Arjun Sethi, Ted Maidenberg, Jonathan Hsu and other members of Tribe’s investment team, identified Sequoia Capital, Accel and New Enterprise Associates as “slow money” firms that developed a reputation for standing by their companies.

Among the investors that can’t be trusted in a bear market are corporate investors, private equity firms and hedge funds—nontraditional VC investors that have become increasingly active in private tech investing, wrote the investors at Tribe, which has stakes in equity management tool Carta and email service Front. Tribe included GV, Tencent Holdings, Salesforce Ventures, Deerfield, Tiger Global, IDG Capital and Silver Lake among the investors that companies couldn’t rely on in rough times.

“Fast money can come in quickly, sometimes opportunistically or for transactional reasons, and also trade out quickly,” they wrote. “These ‘fast’ money firms are not in the business of venture capital. They aren’t interested in helping with company building in the long run. They are what is commonly referred to as ‘fair-weather friends.’”

GV, however, is ramping up the pace of its investments, said one person familiar with the matter. A spokesperson for Salesforce Ventures said the firm is actively investing in new and existing portfolio companies. Tiger Global declined to comment. Tencent, Deerfield, IDG Capital and Silver Lake didn’t respond to a request for comment.

None of these firms saw a pandemic coming, but many have for years been expecting and preparing for another downturn.

“There had to be a reset,” said Sequeira. “A bull market for 10 years and that much capital in the market actually isn’t healthy. A higher bar leads to better companies.”