A precipitous drop in funding-round closings by local startups the past few weeks has coincided with economic turmoil due to the ongoing pandemic and, more recently, nationwide unrest after the death of George Floyd on May 25, at the hands of the Minneapolis Police Department.
In seven of the last 13 weeks, total capital in deals reported or announced by Central Texas companies has fallen below $25 million. Two weeks ago, that total barely surpassed $2 million. This past week, total VC funding reached $6.5 million.
Many, though not all, Austin-area venture capitalists say they, too, have observed an investing slowdown.
“The amount of fundraising in the past 60 days in Austin does appear to be down materially with the few larger rounds getting funded for more established companies,” said Peter Freeland, Unbundled Capital managing partner.
Charlie Plauche, S3 Ventures partner, cited PitchBook data predicting the second quarter will be one of the slowest for new investments in the past decade.
The rise in uncertainty has caused several VCs to increase their focus on existing portfolio companies. Others say an inability to meet founders face to face has reduced term-sheet signings. And some have hit pause on capital allocation simply to better absorb and process the instability that has pervaded national and global economic and political institutions.
Startups that rely on venture capital to fuel growth are in a precarious position. DocSend Inc., a company that entrepreneurs rely on to send pitch decks to potential investors, found in a survey of users that only 9% of founders who are fundraising had 12 months or more of runway – the period of time before a business runs out of money.
But interviews with more than a dozen Central Texas VCs revealed a fundamental optimism about the future of Austin’s entrepreneurial ecosystem. Lots of these investors are themselves company founders – a group that is inherently positive.
On an individual level, many have weathered the economic downturns of decades past, from the oil shocks of the 1970s through the dot-com bust and, more recently, the Great Recession of 2007-09.
One may recognize parallels between the convulsions gripping society today and those that seized the country 50 years ago. At the same time the United States was landing astronauts on the moon in the late 1960s and early 1970s, the nation grappled with burning cities, racial riots, police killing civilians and an overtly indifferent president. Richard Nixon watched a November 1969 Ohio State-Purdue football game inside the White House while nearby more than 250,000 protested the Vietnam War.
Against the backdrop of America’s return to space on May 30 after a nine-year absence – SpaceX successfully launched two U.S. astronauts into orbit – citizens throughout the country burned down buildings to protest systemic racism and police brutality. President Trump, two days later, urged governors to “dominate” the activists.
ATX Venture Partners Managing Director Chris Shonk, a former U.S. Army special operations sergeant, described a confluence of events that has produced today’s dynamic.
“We are now more tied to our phones/TV and media to consume, distribute and amplify content than ever before,” Shonk said. Plus, the things that typically would cause people to put down their phones or turn off the computer – air travel, driving, social gatherings, conferences – have largely vanished. “You have the largest unemployment of my lifetime, a [digitally] hyperconnected society who has been pent up and quarantined and frustrated with that just looking for a pressure-release valve. … The protests are a very real concern that will likely persist as long as a positive emotional and financial outcome is [not] realized by the participants.”
Getting back to normal
For those awaiting “a return to normal,” it might be a while.
“I’m not sure our old normal was, in fact, normal,” Shonk said, ticking off the spinning out of funds and record levels of venture-capital fundraising by first-time managers; the online angel investor networks that increased member size, deal count and dollars invested; and, the chasing of founder-led financing rounds with intense competition over terms and pricing.
Instead, what’s occurring now, Shonk said, “is a regression to the historic mean.”
Yet, even that could be an overly rosy view of what is happening and what’s about to happen.
“We aren’t returning to the old ‘normal,’” said Mike Erwin, general partner and chief investment officer of Ecliptic Capital. “It will continue to be volatile across the summer, and will be dependent on how bad a second wave of Covid-19 is – coupled with geopolitical unrest and racial discord. This is further exacerbated by how pronounced the disconnect is of the public markets from the underlying economy. I think we can expect great turbulence over the next 12 months for everyone in the VC community, which can be both good and bad. There are so many new risks to the environment that aren’t going away soon, that we think folks should plan for operating in uncertain times as a ‘new normal’ for at least a year.”
Without a vaccine for the coronavirus, VCs and founders can expect continued virtual meetings and phone calls, rather than the in-person introductions and conversations that always have been critical to the process of obtaining funding for entrepreneurs and choosing companies to join their portfolios for VCs.
That already has hampered deal-making to a certain extent, said Krishna Srinivasan, founding partner of Austin investment firm LiveOak Venture Partners.
“Normally, we spend a lot of time chatting about companies and deals” within LiveOak’s offices, Srinivasan said. With so many companies still working remotely, that activity also has become “compromised,” he said.
Moonshots Capital General Partner Craig Cummings predicted it will take 24 to 36 months for startup investments to return to “normal” levels.
Virtual meetings
Because LiveOak invests a significant amount of capital locally, the loss of in-person conversations perhaps is magnified to a greater extent than for those VC firms whose investors are used to meeting founders after a plane flight.
“We spend a lot of time with local entrepreneurs in the flesh; it’s virtual calls only now,” said Srinivasan, who pointed out that LiveOak still has not completed an investment based on virtual meetings exclusively.
The firm has officially closed two deals since the pandemic hit, he said, and two others are possible.
“But we knew all four founders from before” Covid-19 appeared, Srinivasan said.
Going forward, Srinivasan sees investors “undoubtedly” becoming “more cautious,” if only due to a lack of confidence in companies’ potential “for building revenue,” he said. A “mismatch on valuations” among investors and entrepreneurs also could contribute to “a temporary pause on deals about to happen.”
Last year was a banner one for venture investment nationwide, with $136.5 billion in deals, according to PitchBook and National Venture Capital Association data. Austin also saw funding swell, with local companies raising $2.2 billion. That was the highest annual total since the $2.52 billion raised in 2000, before the dot-com bubble burst.
Now, there’s a great deal of money sitting on the sidelines.
“I am seeing a lot of investors sitting on their hands, taking more of a watch and wait strategy,” said Clayton Christopher, who co-founded Sweet Leaf Tea, Deep Eddy Vodka, Rhythm Superfoods and CAVU Venture Partners. He has also seen “more downside protection for the deals that are getting done.”
Valuation mathematics
On the founder side, Christopher said he was “seeing companies push out funding rounds or trying to switch to smaller rounds that are convertible debt or SAFE notes. It’s not a good time to be raising a priced round for a lot of entrepreneurs, as most businesses haven’t benefited from Covid. But the best-in-class businesses and startups will continue to get funded and at strong valuations.”
Other impacts on capital in general include depressed valuations “for at least the remainder of the year and probably beyond,” Capital Factory President Gordon Daugherty said. “The overall balance of negotiating power [for terms] will remain strongly in favor of the investors for at least the next 12 months for most deals.”
Depressed valuations aren’t necessarily a bad thing. Christopher said he believes those of many startups “needed to come down. There has been too much easy access to capital at valuations that didn’t really make sense, and that creates bad habits within businesses. Long term, these austerity measures that are being forced upon businesses will be incredible learning lessons for Entrepreneurs Programme. But, there is still a lot of capital waiting to be invested in businesses and that ultimately drives valuations.”
Other VCs, such as True Wealth Ventures General Partners Sara Brand and Kerry Rupp, have completed deals without in-person meetings.
“Most of the investors we talk to are still investing, like us – and most have stated that they’ve done at least one deal post-Covid, many at least one where they haven’t met the team in person yet,” Rupp said. “That includes us.”
Keeping the portfolio healthy
Any slowdown in investing is at least partly due to VCs “spending a bit more time than normal supporting the existing portfolio companies to make sure they weather the Covid storm,” Rupp said.
Moonshots Capital’s Cummings likened the practice “to putting your own mask on first before assisting others. We worked especially hard to help stabilize our own existing companies directly impacted both negatively and positively,” he said.
Brand added that type of work consumed much of “late March and all of April” for VCs, “but I think most VCs have largely moved through that work and really started to lift their heads again in May and are sincerely ready to invest now.”
Regardless of whether VCs are ready to invest, Capital Factory’s Daugherty underscored a constraint unique to VCs “versus angel investors.”
“Since [VCs] are investing others’ money, they can’t just sit on the sidelines for a year because it will negatively impact the performance metrics needed to raise future funds,” Daugherty said. “Because of this, VC investing activity should gradually increase throughout the rest of this year, and probably even through the first half of 2021, before we consider the activity level back to something in the range of ‘normal.’ But since the activity level in 2019 was elevated versus normal, it’s hard to predict how long it will take to reach that level again.”
Mark Jennings, co-founder and managing partners of Austin-based investment firm Generation Partners Management LLC, expects near-normal levels of investing to return this summer, “with pent-up transactions and funds using previously raised dry powder.”
He predicts “the real test will come in the fall, as the stimulus wears off, flu season starts and the reality starts to set in that earnings will take a serious hit for an extended period.”
That’s because Jennings foresees a “majority of companies” throughout the world hiring and spending more conservatively, he said.
“This will seriously extend the period of devastatingly high unemployment,” with businesses turtling “until a real therapy and/or vaccine is actually available,” he said.
And, as Elsewhere Partners founder and Partner Chris Pacitti put it, “Most all past recessions, we just dip hard and bounce back to normal over a certain period of time. In this circumstance, will there be more permanent changes going forward?”
Impact of remote workforces
While many Austinites see the remote workforce shift as a positive, Pacitti asked, “What are the implications of that? What sectors will be impacted positively and negatively? These are the challenges in assessing the risk-reward of investments [when there are] too many unknown variables.”
One likely consequence of the current unpredictability will be an acceleration of what’s already been occurring the past few years: the relocation of businesses to Austin from both coasts. Companies such as Sonim Technologies Inc. (Nasdaq: SONM), a maker of heavy-duty cell phones, have moved their headquarters to the Texas capital because it’s cheaper here.
“Our distributed and flexible workforce will become part of the norm,” ATX Venture Partners’ Shonk said of Austin.
Ecliptic Capital’s Erwin added that “the mature ecosystems of Silicon Valley and New York/Boston are experiencing stress from the over-competition for deals and by chasing unsustainable growth, creating an ‘opportunity flight’ to places like Texas, Salt Lake City and Atlanta, among others, where there’s less competition, growing emergent capital, and, where living expenses are significantly cheaper.”
Whatever the future holds, Cummings said he’s been reminding his team and investors, “Many of the largest companies in the world were born during periods of crisis.” Examples he cited include Whatsapp, Venmo, Groupon, Instagram, Slack, Pinterest and Dropbox.
What are the 4 types of entrepreneurship?
It turns out that there are four distinct types of entrepreneurial organizations; small businesses, scalable startups, large companies and social entrepreneurs.
Along those lines, Next Coast Ventures Managing Director Mike Smerklo emphasized that he and his colleagues “are highly aware of the human condition right now, and don’t want to seem insensitive to what is happening around us.” Yet they focus “on the power of amazing entrepreneurs” and “remain actively looking to fund the next disruptive, big ideas as they come forward.”
Erwin added, “We have to work together to build our way out of this mess. It’s what we as a species are good at, and, what we as Americans cherish as our way of life.”
BuildGroup LLC co-founder and CEO Lanham Napier said that “complex systems are more resilient than people realize.” He didn’t believe “all the doomsday prophets” who forecasted a 10-year recovery after the Great Recession, and he doesn’t believe anyone predicting similarly gloomy outlooks now.
“When times are tough, that’s when you make changes,” said Napier, former CEO of San Antonio-based Rackspace Hosting Inc. “Sometimes it takes a breakdown to have a breakthrough.”
11 Austin VCs’ advice for entrepreneurs
Sara Brand
Go for it. This is a good time to get out there, as you literally have a captive audience who is not likely to be taking any summer vacations.
Clayton Christopher
Figure out how to run a profitable business. Focus on the business gems this crisis can teach you. Never waste a good crisis.
Craig Cummings
Continue to build relationships with potential investors by keeping them informed of your progress. Fundraising will take longer, so you want to position yourself for a quick “yes” when the conditions improve.
Gordon Daugherty
First, ignore what was normal before and prepare for a whole new set of expectations. Second, realize that investors won’t get excited about a funding round that doesn’t provide the company at least one year of runway, with some investors expecting 18 to 24 months of runway. Third, realize that many VCs won’t fully commit to an investment without meeting the founders in person. That shouldn’t inhibit the typical relationship-building process that precedes a term sheet, but it could make it much, much harder to actually get a deal done until everyone is more comfortable having in-person meetings.
Mike Erwin
Be thoughtful, be creative, be nimble. The time of the entrepreneur is now. Focus on creating sustainable value.
Peter Freeland
Consider raising a smaller round through a convertible note to get through the next 12 to 18 months if raising a larger, priced round isn’t an option. Evaluate all your potential funding sources. Cast a wider net beyond traditional institutional investors. Manage expenses to minimize burn – when the market returns, you’ll have a stronger, more durable business on the other side.
Mark Jennings
Raise money this summer if you can. Have reasonable valuation expectations, as uncertainty is currently at a high point in our lifetimes.
Chris Pacitti
It is very situation specific, but if [you] need money in the very near term, do a small inside or friends-and-family round. Get runway at least until Q4 to Q1 [2021] to have easier access to outside investors. Founders that exhibit the creativity and resilience to effectively navigate these challenging times will have a high degree of investor interest in the coming quarters.
Charlie Plauche
Be as personal as possible on video calls. Don’t worry about the kid or dog wandering into the background – it might happen to us, too!
Kerry Rupp
Continue to reach out to targeted funds where you’re a potential match. Participate in online pitch events or company/investor-matching events, etcetera, where possible. They can be way more efficient than traveling around to lots of conferences.
Chris Shonk
Explore your customers and strategic partners as a primary source for capital at the early stages. If you do raise VC money, take it from investors who have built and operated companies through a recession who can help build your business – not just provide capital and grill you at board meetings.