State of startups: Fundraising during a financial crisis
Times have changed. COVID-19 has disrupted the funding landscape for tech startups, and founders need to be more creative when financing their companies. Brex recently sat down with partners TriNet, Halogen Ventures, BootstrapLabs, and Smith Shapourian Mignano PC (SSM) to discuss the pros and cons of raising capital in an economic downturn, from the venture capital (VC), legal, and fintech startup perspectives.
Driving the conversation on behalf of their respective industries are Alexa Binns of Halogen VC, which invests in early stage consumer technology companies with a female founder; Jacquelynne Suguitan of TriNet, the leading strategic HR partner in streamlining operations; Matt Estes of fintech unicorn Brex; Luigi Congedo of BootstrapLabs, a leading Silicon Valley VC firm focused on Applied AI; Lindsey Mignano of SSM, a female and minority-owned law firm specializing in emerging and small businesses; and moderated by TechCrunch contributor Sophie Alcorn, founder of Alcorn Immigration Law.
The group agreed that while the outlook may appear bleak at first glance, the current funding climate has actually offered opportunities for tech companies to adjust, adapt, and come out even stronger on the other side. And while there are ample avenues for securing funds, this session focused on three key forms: Venture capital, debt financing, and bootstrapping. As COVID disrupts the status quo, each of these is morphing. But that doesn’t mean that the opportunities aren’t still there.
The basics of venture capitalist funding
Prior to the coronavirus outbreak, fundraising for tech startups was driven largely by venture capital. Over the past decade, the structure of and process for interacting with VCs has been reliable and well-defined, but that might be changing. From seed to series A and beyond, it’s a good idea to look at all of the options. In general, most VCs are financially driven or strategically aligned to a specific industry or interest. Basing much of their allocation on a company’s potential to return the fund and/or become profitable, many define their check size by the amount of ownership they want to commit to the new company. Most aim for double-digits whenever possible.
Venture capital firms come in all shapes, sizes, niches, and funding structures. Most focus on 3, 5, and 10 year projections of their portfolio companies. Generally speaking, the amount of ownership you give a VC will determine the amount of time they invest in your business. Check sizes are based on how much a VC firm can raise itself. Some firms invest small amounts over a prolonged length of time, rather than writing one large check upfront. Early-stage investors tend to look for companies with under $12M valuation, focusing on those that will allow them to ride the full wave together. Some will balance investments in very early-stage companies with a few later stage investments that will have quicker exits to public markets. At the end of the day, many VCs see themselves as money managers, so they may have very specific agreements and expectations regarding their representation.
That said, while many of the prevailing VC trends still hold true, much has changed in recent months. In the wake of the global pandemic, a lot of investing has been put on hold. As startup funding becomes more limited and investors postpone their funding rounds, startups in need of capital should be looking to secure alternative sources of financing — and founders might need to get creative about where they go to access money. The current market benefits investors, but clients can still find funding if they’re willing to look for it. Angel investors might be able to offer you more if they’re in a position to do so. But debt financing and bootstrapping are two alternatives many are turning to in the absence of traditional VC funding. Understanding how startup funding is changing — and where else to look — will be critical in the coming months and years.
VCs are adapting to the post-COVID ‘new normal’
Although statistics are dynamic and change over country and time, the US generally saw more big seed rounds (lovingly referred to as ‘avocado seeds’ or ‘mango seeds’) prior to the coronavirus outbreak. But that doesn’t necessarily mean the rate of deal flow is slowing.
One benefit of the pandemic and its subsequent lockdown has been the democratization of fundraising. Since a lot of VC investment is based on meeting the team, many VCs initially found it difficult that they couldn’t meet prospective clients in person. Now that the world is settling into its new normal, VCs are adapting well. Many are becoming comfortable hearing pitches via phone or teleconferencing, and these tools are making the process more intimate and accessible. The abandonment of in-person meetings has also opened the door for small businesses and early stage startups in foreign markets and those outside of New York and San Francisco.
Another rising trend is the underlined benefit of established relationships. According to trusted partners in the legal field, in March and April, the clients who had been in talks with investors before the outbreak were more successful in securing venture funds than those pitching for the first time. If you expect to raise money in the next six months, you need to start building those relationships now. Start the process as a list-building activity similar to sales outreach. The easiest way to start building that list is to look at similar (but not identical) companies on platforms like Crunchbase, and see who has invested in them. Look at their business models and current funding stage so you have an idea of what their investors focus on when investing. Identify specific partners who care about industries like yours, and treat the process the same way you would choosing a graduate program. When looking for the best educational fit, you’d identify the appropriate program, along with the professors who care about your interests, and who are positioned to help you grow. The same holds true for investor fit. And note that while the best way to access a VC was historically through an intro, the way to do it now is to have fellow founders and co-founders reach out on your behalf.
Pitching to VCs during and after COVID
When pitching investors in the post-COVID world, ask for help rather than trying to sell. And ditch the deck you used six months ago. Little is relevant now that was back then. Prepare a prediction of the future of your industry, and communicate how your business fits into that landscape. Explain why your business is positioned to be the next big business in the post-COVID reality. Express both the importance and urgency of your funding request, and be able to articulate why you need the capital today. For example, while it might be hard to pitch a travel app in the current climate, the idea of a SaaS or Zoom platform for kids is incredibly relevant — and in high demand — during the homeschool and WFH reality. Remember that VCs invest in solutions that can reach public markets. If you have a breakthrough technology but no go-to-market strategy, it can cost you the funding you need to execute your vision. With no tangible economic value, it will be hard to convince a VC that your product is worth the investment.
Keep in mind that onboarding an investor is a lot like getting married. Just like a dating app for VCs, your assessment is just as important as theirs. Ask a potential investor where they are in terms of their fund. If you’re planning to invite them to join the board, ask them how many seats they already sit on. By asking these questions, you’ll find out how much capital — and time — they have left to invest. And remember: While VC funding is great for some businesses, it isn’t right for everyone. Depending on your stage and industry, keep an open mind when deciding whether to look into this form of financing. Look for alternatives to VC funding, like debt financing and bootstrapping. And in the meantime, get a good handle over your finances.
Debt financing as an alternative to VC funding
In the context of a slowing VC funding market, debt financing can help a startup find much-needed finances. Note that there are pros and cons of working capital versus gross debt financing. For example, debt financing increases the total current liabilities of the business, creating the impression that the company may have a more difficult time meeting its obligations. And as with any borrowed income, working capital debt will need to be repaid in a timely manner, regardless of what becomes of your business. To make sure you find the best option for your business, look at monthly recurring revenue (MRR)-based financing, accounts receivable and inventory back loans, and non-revenue, non-diluted options, as well as bridge loans to tide you over. Many loan documents now include a Corona clause, which allows you to add in lost or anticipated profits that were not forthcoming because of COVID, so talk to your legal team when entering into negotiations.
When it comes to debt, discipline is key. If leveraged incorrectly, debt can lead you in a destructive direction. So debt management is a critical component of any financial plan. Remember that debt doesn’t care if you meet your business goals or hurdles; you’ll still have to pay it back at some point. That said, when it comes to venture debt, you can be more flexible since your investor is bridging the debt. So consider all options and their alternatives when deciding which type is best for you.
Bootstrapping is the new black
In a bull market, funding can prove difficult enough. But it’s especially hard during an economic downturn. If you’re having trouble building VC relationships because of limitations in technology or access, bootstrapping is a tried-and-true alternative to raising — and can, in fact, place you in a much better position for raising further down the road.
With a focus on managing cash flow and maintaining reserves, the ideal bootstrapping solution is a combination of optimized resources and intelligent use of debt. Financial solutions like Brex’s expense platform can provide visibility and control over existing funds while you search for additional funding — and can streamline the pitching process once you find it. In recent months, founders and CEOs have realized that overhead expenses like physical workspaces and real estate are no longer necessary, as once commonly assumed. Identifying and cutting these costs can help stabilize a company’s burn rate and increase margins.
The key is to align your financing type with the duration and ROI of existing projects within your business. Avoid financing ongoing capital with equity, which should be reserved for big projects with a large ROI. For example, if you know you can hit payroll every week and pay vendors on time, you’ll ideally want a low-cost, flexible line of credit you can draw down on any time you need it. On the other hand, if you’re looking to pull off a full website rebrand with a product haul, that’s a growth problem that should be solved with growth debt or equity. And if you’re growing your business 2x or 3x per year, are able to raise equity, and can secure debt at 12% APR, that’s very much worth considering.
Bootstrapping now will help you down the road. Investors will appreciate the fact that you’ve focused on your gross profit and contribution margins, and that you’ve identified alternative sources of funding in the interim. And putting skin in the game signals dedication and resourcefulness. At the end of the day, be strategic and do what’s in your company’s best interest. Be creative and inventive. And don’t just do something because you see everyone around you doing it. Only you know what’s best for your business.
Trends and predictions on the horizon for startup fundraising
No one can say for sure what will happen in the next year or two, or when the pandemic will start to subside. Sequoia provided a grim analysis at the onset of the pandemic, noting that the companies most likely to survive and succeed would not be the smartest, but the most adaptable to change. If you look at the market today, the bar is already higher, and raising money is a little bit harder. But there are also great alternatives to venture capital, and decision-making might end up being a little faster, too.
In the short-term, many experts anticipate 12-18 months of pain, followed by several breakthrough innovations emerging from the wreckage. Amidst layoffs, lockdowns, and supply chain disruption, the economic impact of 2020 is uncertain, but we can hope for the best. Fifty-seven percent of today’s Fortune 500 companies were founded in the wake of a depression or recession, making the strong argument that necessity is the mother of invention. Our panelists point to 2009 as an example of this trend, with the birth of tech giants like Uber, Github, and Airbnb after the 2008 global financial collapse.
One of the first trends Brex noticed following the initial coronavirus outbreak was the emergence of hypergrowth, profit-focused tech businesses. Although industries like sports, travel, and blockchain have cooled since COVID, the shifting landscape has also opened doors that were previously closed or stagnant. Similar to 2008 and 2009, this year is already showing a massive opportunity to build and transform several industries. Many companies are beginning to focus on turning a profit. And companies that have been profitable for awhile are now in a position to capitalize upon the changing status quo. Sectors like healthcare, wellness, AI, and e-commerce have already seen massive growth and acceleration, as have digital technologies that allow people to work and engage remotely.
The present climate also offers a lot of acquisition opportunities. Companies that are not trendy or adaptable in the new post-COVID reality are now available for these deals. While industry law firms previously focused on securing financing for their clients, they are now prepping many of those same clients to sell their companies — or acquire others. That said, it is not a seller’s market. Smaller deal sizes, lower valuations, heavy due diligences, and holdouts as opposed to escrows skew the terms to favor the purchaser.
The future of venture capitalist funding
Like all events in history, many hope this episode will be time bound. But absent a crystal ball, experts can only offer their predictions for the current crisis. Anticipating a trend toward profitability, the outlook is hopeful. But new companies bootstrapping today can no longer rely on pre-COVID trends to guide them. Founders must be smart and innovative when looking for funding. A founder that looks for alternatives to VC funding not only situates themselves to be financially prepared, but demonstrates to potential investors that they are a savvy businessperson who has a goal — and a path toward it.
While the current landscape may look bleak, success will depend on individual resilience and business savvy. As the world clamors for a vaccine, innovation won’t just stop. Crises force societies to adapt and modify their behaviors, but a new norm doesn’t mean an end to innovation. In fact, it demands it. This upheaval of the status quo could be just the opportunity many startups needed to thrive.
Successful startups in a post-COVID reality will be those that seized the opportunity to outperform and overdeliver through a financial crisis. The ones whose founders set themselves apart by capitalizing on every available source and making the right connections. Who managed their debt and resources wisely, and articulated their vision and market fit.
At the end of the day, there are a little over 1,000 VCs in the US, so it’s about being relentless. Be ready for 99 “No”s for every one “Yes”. And, just like the college search analogy: Be selective, but don’t put too many eggs in one basket. If one funding avenue falls through, look for the next one. And the next one.
And as you look, keep dreaming big.
Check out the full conversation here.