Why the VC market has stayed resilient despite COVID-19 shutdown

Despite the latest drop in funding, the industry holds a tremendous stockpile of dry capital. What can we expect for the rest of 2020?

VC market stays resilient despite COVID-19 shutdown

As expected, the impact of the COVID-19 pandemic slackened the market for VC funding in the second quarter of 2020, however, not as much as I would have expected. Overall funding dropped just 12% from Q1 2020 with $28.4b invested into US-based startups in Q2, compared to $32.1b in Q1 2020.

Addressing numerous challenges at once

It didn’t take long for the implications of the shelter-in-place orders to take effect, as limitations on travel and face-to-face meetings made it challenging to get new deals done. With scant opportunities to meet new entrepreneurs and understand their business models, investors focused their attention on entrepreneurs they knew and companies in their existing portfolio, particularly those that needed assistance and additional capital.

Investors and entrepreneurs had to contend with numerous other challenges this past quarter, including:

• Deciding whether to apply for stimulus packages, particularly those tied to the Coronavirus Aid, Relief, and Economic Security (CARES) Act
• Grasping the short- and long-term impact of the pandemic on their business models and companies
• Embracing the digital future, such as virtual working environments, including video conferences with investors, customers and suppliers
• Juggling demands for both work and life. With personal lives disrupted by the shelter-in-place orders, many investors found themselves fighting for “meeting space” and bandwidth in their own homes

Deal volume dropped 40% from Q1 2020, setting a new 10-year low mark, and continuing a trend that we’ve seen for the past several years as deal sizes have grown. Private equity investors put 51% more cash into growth-stage rounds over the prior quarter for a total of $1.8b. We saw this pattern from corporate investors as well, with increased investment to just over $1b. This was largely due to investing in unicorns that needed additional cash.

Using this time wisely

With so much uncertainty in the world today, and the fact that venture capital is a long-term asset class, the current environment provides an opportunity for VCs to tap the brakes a bit. They can spend more time with their existing investments, as well as evaluating new deals. This will slow the pace of investment and allow the market to absorb the massive amounts of capital that have been deployed over the past five years. It will also force companies to be more capital efficient, which often helps drive innovation. There is an old saying in the venture world: a downturn is a great time to invest.

The pandemic has thrown many businesses off their anticipated growth trajectory, which means they may need to stay private longer to bring their companies back on track to their prior valuation. Some may want to consider an IPO, a market that has shown signs of life much sooner than expected. This could lead to more direct listings as entrepreneurs try to raise capital on top of selling direct shares. Longer-term, entrepreneurial companies may rethink their capital strategies and look to go public sooner rather than rely on numerous rounds of later stage capital.

Sector activities and insights

Of the $28.4b invested in US-based start-ups in Q2, $6.5b was raised in the last two weeks of the quarter. In the flurry of activity in late June, 20 mega-round deals accounted for $4b, with 50% invested in health care. Other industries included biotech, consumer information services, food delivery, travel and leisure, cybersecurity, FinTech and entertainment. QoQ mega-round financing deals were up from 62 deals in Q1 to 74 deals in Q2.

Certain sectors, beyond hospitality and travel, are still trying to find a way forward as a result of the pandemic.

Cutting-edge technologies may face increased challenges as a result of COVID-19. The sentiment and demand for technology, like self-driving cars, may change in light of the economic challenges we find ourselves facing. Companies in these sectors may also find it more difficult to continue raising capital, and it will likely take much longer for these technologies to come to fruition.

COVID-19 has also dropped a significant challenge squarely in the path of companies in the sharing economy, with people unwilling to venture into unknown spaces until society finds a vaccine or cure. As a consequence, many of these companies face significant questions about their long-term sustainability. A second wave could put many in major peril.

Looking ahead

As we look ahead, it will be interesting to see how things unfold. Will private equity firms continue to participate as actively as they have in the past, tapping into vast amounts of dry powder to take advantage of key opportunities? Or, will they slow their pace and be more selective as we expect the overall market to slow?

To that end, we believe we will see several trends unfold within the VC community:

• The first is the ongoing need to support existing portfolio companies, which are continuing to grapple with the challenges posed by the pandemic economy. This is particularly true for companies that have exposure to such consumer-oriented sectors as travel or entertainment and are backed by venture funding. They will need additional support as they plot a course forward as the economy begins to reopen.
• The second trend is around identifying areas where VCs can capitalize on the opportunities emerging in a transformed landscape. These include remote connectivity and establishing a more secure work-from-home environment. We have yet to truly master remote schooling/training and still have a lot to learn about holding successful virtual investor meetings and conferences. We could also see dramatic changes in health care not only in the expansion of telehealth, but also in increased attention to mental health to help people cope with stress and take better care of themselves emotionally.

Clearly, the environment we face heading into the second half of 2020 has changed significantly due to COVID-19. In January, we could never have predicted such a significant slowdown in funding.

While I hesitate to make any broad projections, I suggest it’s better to plan for the worst and adjust if the recovery comes faster, rather than to make optimistic plans that need to be curtailed later. We are fortunate the industry holds a tremendous stockpile of dry capital, and as opportunities arise, venture capitalists will be ready.

Find helpful information at the sources below:

• National Venture Capital Association (NVCA)