Who Will Save Startups?

Facing the threat of recession, venture capitalists are conducting "population control" on startups. At this moment, the key is not to save all startups, but who can survive to the other side of the economic downturn.

Relying on a 12-to-18-month funding cycle, startups at the end of their runway are meeting with investors, but the outlook is bleak. Investors must judge whether they are investing in the next Facebook or a project not worth the risk. Venture capitalists have become more cautious; according to GlobalData, as of March 29, venture capital funding fell 22.5% from the previous week.

The runway (or gap) between venture capital financings may determine whether a startup can weather a recession—or an acquisition offer that an industry cannot resist.

Economic recession provides B2B startups with opportunities to finance through new customers. If a startup can prove its value—even during a recession, customers subscribe to its services—then it has hope of continuing operations or being acquired.

For startups with shortened runways and depleted capital, the acquisition appetite of big tech companies in a downturn economy is another survival opportunity. The last option? Demise.

"The real question is how many strong acquisition targets exist and whether they are in a position of being forced to sell?" ISG Chief Analyst Blair Hanley Frank told CIO Dive.

According to Gartner data, during the 2001 recession, M&A deal volume fell 23% compared to economically stable years. During the Great Recession (December 2007 to June 2009), M&A activity plummeted 34%.

In a bear market, valuations of public and private companies fluctuate. Public company stocks are economic indicators for private companies. When stock prices fall, public companies use liquid assets to acquire private companies with declining valuations.

"I'm often asked, 'Are those big companies that didn't succeed failures?' They are not failures. Venture capitalists are very smart. Entrepreneurs can foresee the future," Martin Pichinson, co-president of Sherwood Partners, told CIO Dive. However, telling startup founders it's time to shut down is "very difficult," even for Silicon Valley's "gravedigger." Pichinson earned this nickname for selling parts of emerging startups since the internet bubble.

Although there were nearly 2,300 venture capital deals in the first quarter of 2020, according to PitchBook data, this momentum may decline in the first quarter as the COVID-19 pandemic disrupts future investment.

If startups can achieve critical scale, they can "loosely" become "regular companies," Pichinson said. But becoming a regular enterprise depends on who is at the helm. "I've been telling investors for years, but no one listens: the most blasphemous practice is to have the founder serve as CEO from the start."

With recession approaching, runways possibly shortening, and few acquisition options, it is too late for startups to restructure leadership. Startups need at least a year of runway to consider restructuring to survive a recession. For other startups, Pichinson gives them six months to save themselves.

Big tech's burning wallet

Investment and acquisitions are often affected by recession. Not knowing how long the COVID-19 crisis will last, companies are reluctant to take risks. According to GlobalData, in the week ending March 29, deal volume fell nearly 20% from the previous week.

In 2019, Brexit and tariffs caused a slight decline. "Most people didn't expect 2020 to be so weak," Gartner Senior Research Director Max Azaham told CIO Dive. COVID-19 "completely evaporated" the first quarter, leading to a sharp drop in deal volume.

According to GlobalData, COVID-19 caused M&A activity in technology, media, and telecommunications to fall 26% compared to the first quarter of 2019. GlobalData thematic analyst Sapana Meheria said in research that by mid-2020, cash-strapped startups "will be highly vulnerable to potential acquirers."

Despite sluggish M&A activity, big tech companies may be bullish in turbulent markets, especially when they have cash on hand. "This will be a great time to be a buyer," Ryan Corey, CEO and co-founder of Cybrary, told CIO Dive.

Gartner found that in 2019, 71 companies had at least $5 billion in cash (excluding highly indebted companies). Of these, 57 companies in IT, communication services, and internet businesses held over $1.1 trillion in cash combined.

In 2006, Microsoft had over $34 billion in cash or cash equivalents, but in 2007 and 2008, the company had about $23 billion, according to financial records. As the economy began to rebound, by June 2009 and June 2010, the company had $31.4 billion and $36.8 billion in cash, respectively.

In 2008, Microsoft's cash investments decreased, partly due to spending $6.9 billion on acquisitions the previous year.

During the Great Recession, companies like Microsoft, Oracle, Amazon, and IBM had balance sheets strong enough to support acquisitions. Microsoft, Amazon, and Oracle acquired as many or more companies in 2008 than their average in normal fiscal years.

Even with strong funding, the last recession weakened tech companies' confidence.

During the Great Recession, Google announced only a few acquisitions. One deal involving advertising service ZAO Begun was blocked by Russian antitrust authorities in 2008.

Google's advertising business (its main revenue source) slowed during the Great Recession. The company generated nearly $22 billion in revenue in 2008, but growth stalled.

Since going public in 2004, Google's quarterly revenue declined for the first time in the first quarter of 2009, as customers still paid for ads but interactions (i.e., shopping) decreased. Meanwhile, Google was investing in broader technology areas, including mobile and software solutions.

In September 2008, then-CEO Eric Schmidt told Reuters Television, "Google's acquisitions have restarted, and we are doing routine operations, namely acquiring small companies." Schmidt predicted Google would make one acquisition per month, as the worst of the recession had passed.

Google's cash reached nearly $35 billion in 2010, and its spending spree began. The company "invested $1.8 billion in acquiring companies, products, services, or technologies," according to its SEC filings. "We expect the current pace of acquisitions to continue." As of September 2010, Google had completed 37 acquisitions.

Coming to the surface

Although acquisitions may be a salvation for some startups, they are not always the right answer.

One of Microsoft's first acquisitions during the Great Recession was Fast Search & Transfer (FAST), costing $1.2 billion. Microsoft was both a customer and competitor of FAST.

"From my perspective, I never focused on building a company for acquisition," John Markus Lervik, former CEO and co-founder of FAST and current CEO and co-founder of Cognite, told CIO Dive.

Startups may "get distracted and lose focus" during uncertain times, he said. "Companies can use this time to be creative and do more with less."

If a company has a stable product and believes it can weather the recession and wait for better prices, it may eventually attract more customers.

If startups can get customers to prepay for services, "there's no illusion," that's revenue, Twilio CEO and co-founder Jeff Lawson said on an investor call with Pinterest and Shopify founders on April 7. "That's the best money."

Corporate buyers don't want to sign contracts with companies that might go bankrupt early in a recession.

Depending on the business, customers may delay deals, which will affect future revenue targets. "You may not get cash in the coming months, and certainly won't grow new customers," Corey said. "That's a very scary place."

If startups don't want to sell but their runway is ending, some may find comfort in federal relief, or this may just prolong the startup's demise. "Everyone now has a feeling they'll get some government money. It's meaningless," Pichinson said.

Congress's $2 trillion rescue plan is full of potential pitfalls for startups. The U.S. Small Business Administration's affiliation rules count all personnel related to the business, including investors' workforce. If employee count exceeds 500, startups may not qualify for loans.

On April 3, the Treasury updated the affiliation rules, but it did not automatically eliminate ambiguity for startups: can startups with investors apply for loans?

Since the purpose of the loan is to keep employees on the payroll, startups must decide whether these personnel (and costs) are strategically important for surviving the downturn. If the answer is yes, startups still need to overcome numerous hurdles to obtain the loan.

Startups may "get distracted and lose focus" during uncertain times.

Loans are granted on a first-come, first-served basis, so startups may rush to apply, which "creates unnecessary urgency," and even unnecessary applications, venture capitalist Mark Suster wrote. Startups considering applying for loans "shouldn't do it just because all your peers tell you to."

Like startup founders, investors are watching whether the economic impact of the current health crisis is short-lived, whether interest rates remain low, and whether the Fed's stimulus measures succeed. "Similar to after the Great Recession, institutional investors will reap rich rewards," and will turn to the venture capital market, Frank said.

Even as Microsoft strengthened solutions and talent through acquisitions, the company laid off thousands of employees in 2009 to reduce operating expenses. By the end of the fiscal year in September, the company experienced its "first" annual revenue decline, according to the company.

"The question is, for other companies we think are large and well-capitalized, some may feel more pressure than others," Frank said.

Declining value

For startups, figuring out how much runway remains is crucial.

"If you're burning too much cash, you obviously need to cut staff," Corey said. It's "the bottom 10% discussion, old Jack Welch approach." Welch, former GE CEO, used a 10% mindset to cut "underperformers" in the organization.

As opportunities diminish, startups may scramble for funding, but the money won't come. Venture capital firm Sequoia Capital called COVID-19 the "black swan of 2020" and advised startup leaders to adjust their mindset during uncertain times.

"There are many tech companies you can acquire at extremely low prices because they have absolutely no way out," Corey said. "I think there will be a lot of value in the market, and our investors see it that way too."

Although it's too early to predict this year's decline, according to Gartner data, valuation multiples fell 60% within a year after the Great Recession. This decline stimulated aggressive acquirers with revenue over $250 million.

But declining valuations are not as influential as they seem, Pichinson said. "Valuations are fictional. Why does investing $200 million make something worth $1 billion? It's a theory." The market believes this theory because they see it work at companies like Google. But there are also failures along the way.

"The question is, for other companies we think are large and well-capitalized, some may feel more pressure than others."

Large organizations don't want to acquire "companies that would be a huge drag on the balance sheet unless there's a very good reason," Frank said. "Part of what looks acquirable is being a good business."

Enterprise customers want to see strong fundamentals from suppliers. Whether startups seek acquisition or not, they must prove their ability to make money under normal market conditions.

When all other options are exhausted, the board may pressure startup founders to seek a deal, but only if both parties agree.

Sometimes startups have the opportunity to partner with another company, "when there's a potentially good outcome, but it's rare and often happens by chance when you don't want to sell," Denis Mars, CEO and co-founder of digital identity startup Proxy, told CIO Dive. If startups and their investors decide acquisition is the best option, investors will play matchmaker.

Contacts often happen during recessions. "In fact, there are many such conversations right now," Mars said.

However, startups should not expect to be acquired within the next three months, Azaham said. When big tech companies decide to act, "they will try to structure the deal most favorable to the acquirer."

"Attractive acquisitions are no longer expensive, and some targets have become available," Azaham said. "We just don't know how severe this pandemic is."

Round and round

Between March 1 and March 17, venture capital and private equity deal volume fell nearly a third, according to GlobalData data. Investors cited COVID-19-related concerns as reasons for exiting deals. Private equity is often described as acquirers and builders of startups, while venture capitalists prepare them for IPOs.

Beyond seed funds and angel investors, startups advance through Series A, B, and C funding rounds. Series A is typically benchmarked by validated users and revenue, with amounts ranging from $2 million to $15 million.

"Most startups that can't meet Series A standards tend to shut down, while some are snapped up by acquirers," Mars said.

By Series B, startup valuations average $58 million. In Series C, startups are expanding, and hedge funds, investment banks, and private equity firms join existing investors.

Series C participants may outperform Series A and B peers because they have already established value and continuity for customers.

"If you need to raise funds under current conditions, then you must adjust valuation expectations and expect the funding amount to be smaller," Azaham said. If a company wants $10 million, consider raising $7 million.

In calmer markets, only about 40% of startups can leap from seed round to Series A, Mars said. Seed investors are more likely to take risks, and founders often get loans from family. Series A investors are more conservative, waiting to see a stable history of sales and service.

But the leap from seed round to Series A, while difficult for some, is not impossible. Israel's Granulate, a tech company optimizing infrastructure and workload performance, backed by Insight Partners, raised $12 million in Series A funding. Granulate's partnership with Insight began during the COVID-19 outbreak, co-founder and CEO Asaf Ezra told CIO Dive. "We believe internally there was a reassessment of funding."

Reassessments will be common. Venture capitalists are "soul-searching" to find which startups have opportunities, Pichinson said. But "it's a gentle industry," and investors will find a place for their startups.