To be a venture capitalist is to be a perennial optimist. Optimistic that the best is yet to come. That no problem is too big for brilliant entrepreneurs. That technological innovation will make the world a better place.

But as the US economy slowly begins reopening, it is clear that the pandemic is testing the resolve of optimists across the industry. It has prompted many VCs to flip the script and rethink their strategy, or at least their top priorities.

The coronavirus-driven turmoil isn't only an existential threat to the emerging crop of successful, young founders-turned-investors. Even seasoned general partners, battle-hardened by crises like the dot-com bust and the global financial crisis, are reassessing their approach.

Post-pandemic, the new playbook for venture investing calls for a slower and more defensive approach—a sharp about-face to years of frenzied dealmaking, often at lofty valuations. It will also redraw the lines around areas of opportunity, picking winners and losers for a world that has changed dramatically in the short term, and in some ways permanently.

"Coronavirus is going to break the time-series data. It's going to throw off all the charts," said Rob Stavis, a partner at Bessemer Venture Partners. "I think the only time I remember that happening was in 1987, after the stock crash."

Economic fallout from the pandemic has been astonishing, from widespread business shutdowns to historic levels of unemployment to stalling deal flow. And it remains uncertain how long the disease and its economic impact will linger.

Venture investors guarding reserves

Facing an array of unknowns, many venture investors say they expect to write fewer checks well into next year. For a wide range of VC firms, their own fundraising cycles are likely to be delayed or endangered as their limited partners grapple with liquidity problems or other disruptions to their allocation models.

"(VC investors are) going to tighten up on making sure that every dollar of reserves that gets invested and deployed is the right decision, and to avoid the risk of throwing good money after bad," said Gautam Gupta, a partner at M13, a venture firm that invested in food-delivery startup Thrive Market and scooter-sharing company Bird.

Even as many portfolio companies have struggled, investors are holding on to cash needed for follow-on rounds and bridge financing to support those that still show promise. Unprecedented curbs on travel and face-to-face interactions are encouraging investors to focus on the entrepreneurs and companies they know well.

But the bar has also been raised for which assets seem viable—and not all startups are passing muster.

Early in the current crisis, New York-based Corigin Ventures did "full triage sessions, every single portfolio company, voting on them from top to bottom about where we want new dollars to go," said David Goldberg, general partner at the firm, which invests in consumer, marketplace and real estate-focused tech startups.

Cost cuts by portfolio companies underscore a more cautious approach to capital deployment. From March 11 through the end of May, 244 VC-backed startups in the US had laid off more than 17,450 workers, according to estimates by Layoffs.fyi, a project that tracks tech layoffs.
 
Retail shops like this shoe store in Glendale, Calif., have begun reopening with some restrictions. (David McNew/Getty News)

Some nontraditional investors—often dismissed by venture capitalists as "tourists"—may reduce their allocation to the venture market as a way to limit risk. Corporate venture arms, in particular, get more jittery about how every dollar is spent during an economic downturn.

"Many corporates are in a difficult situation and are struggling financially," said Max Brickman, founder of South Bend, Ind.-based Heartland Ventures, which invests in startups looking to expand in the US Midwest. "Their venture capital arm is one of the first things they're going to cut."

Concerns over the availability of VC funding have been tempered somewhat by historically high levels of dry powder. The amount of cash on hand for investments reached $184.8 billion as of last October, according to PitchBook research.

But funds have been calling down those dollars at increasingly higher rates over the past decade. For funds launched between 2012 and 2015, investors had called down 70% to 75% of the capital after just four years. As the prospects dim for raising new funds, VCs are likely to pump the brakes on their deployment of old ones.

"I think we're headed into a period where capital is going to be a lot more scarce," said Ravi Mhatre, co-founder of Lightspeed.

Bargain buying

"Never let a good crisis go to waste" is an adage attributed to Winston Churchill, and later invoked by Rahm Emanuel, President Barack Obama's chief of staff, during the mortgage meltdown. With today's crisis giving it fresh relevance, the line has become something of a mantra among venture investors, ever in search of opportunities to back game-changing innovations.

The recession of 2008-09 killed many businesses but also gave rise to Airbnb and Uber. For opportunistic investors, falling valuations now represent a chance to buy into promising startups at a steep discount—allowing investors to claim their desired ownership stakes at prices not seen in many years.

Indeed, this crisis has thrown an array of industries into a tailspin, especially those that require face-to-face interactions. Looking ahead, investors are angling to ride out the downturn by betting on startups that can adapt to the new reality. Some are bullish on the future of vertical SaaS, including startups that enable traditionally analog industries such as insurance and real estate to move toward digital transformation.

That has resulted in more existing incumbent software companies being pushed to do business using state-of-the-art platforms, digital signatures and video conferencing.

"What's really being changed by (the pandemic) is that we're suddenly deskless workers," said Alex Niehenke, partner at Scale Venture Partners. "Many small and medium-sized businesses will be challenged, and that destruction will create an opportunity for new companies to enter the markets."

Startups that allow people to use their mobile phones to get access to office buildings might experience a blip in business operations during shelter-in-place orders. But to prepare for a post-coronavirus world, Niehenke said companies are desperate to find safe ways to allow employees to get in and out of buildings, such as elevators and doors that can be operated by smartphones or other remote controls.

And some companies are poised to build on that trend. Proxy, a creator of keyless entry technology for workplaces, raised $42 million in March from investors including Scale Venture Partners and Kleiner Perkins. Last year, Apple added several US universities to its program that enables students to access campus facilities via Apple Wallet.

One of the most searing outcomes of the crisis has been an unprecedented wave of layoffs. But Brickman, from Heartland Ventures, said he's optimistic about the next big shift in labor—when millions of people eventually will go back to work in the same quarter. Human-resources business software could be an avenue for VCs to scout startups geared toward connecting candidates with employers or using AI to vet job applicants.

"You can overtake people on the curves, not on the straightaways," said Lightspeed's Mhatre. "An environment like this represents a hairpin curve. … Businesses have to adapt and get creative."

Tilting the scales of power

For several years, investors have had to hustle to win deals—often doing so under founder-friendly terms while capital was abundant. In the months leading up to the pandemic, however, some VC investors began to reassert control, and the tables may now be turning.

Since the crisis began, a growing number of startups find themselves in dire financial straits, accelerating a shift in the dynamics of dealmaking.
 

A crowd of capital-hungry companies may soon be competing against each other to tap the venture market at an inopportune moment. As of early May, an estimated 7,200 US startups were either due to raise or soon would be seeking new funding based on the time of their last round, according to PitchBook data.

"Most external opportunities coming our way are of companies who are in really tough situations and are suddenly being forced to raise," Niehenke said.

The number of follow-on funding rounds for VC-backed companies has been declining since March, PitchBook data shows.

Already in this economic crisis, investors have begun flexing their power by demanding deal terms designed to limit risk.

After years of doing all-cash funding rounds, investors and entrepreneurs can expect to see more contingencies built into deals, such as earnouts that are pegged to financial milestones, said Fiona Brophy, a partner at law firm Perkins Coie. They're also seeking anti-dilution preferences as a hedge against future down rounds.

Some venture capitalists have sought to further protect their investments by securing veto powers for board members, strengthening operational controls and, in rare cases, instituting pay-to-play incentives to prod other investors to participate in current or future funding rounds, said Rachel Proffitt, a partner at the law firm Cooley.

The overall goal isn't to punish founders or fellow investors, but to gain more oversight of spending and to ensure others are aligned around a direction for the company. As Proffitt put it, "Investors may feel like they want a tighter finger on the pulse."

At the same time, some venture capitalists are wary of bringing back the draconian terms seen in previous economic downturns, such as full-ratchet anti-dilution preferences, which give early investors protection against downside risk in the event of a future down round.

"In a lot of ways, (onerous preference terms) really harm businesses in the long run to raise capital," said Larry Aschebrook, managing partner at growth-stage firm G Squared, which invested in 23andMe, Instacart and Lyft. Rather than imposing such terms, he said, investors may prefer to finance companies with convertible equity, which can act like a discount to a future round.

In the near term, investors say they are shying away from companies whose business models have been upended by the pandemic, such as those serving restaurants or the travel industry.

More broadly, the outbreak has hastened the pace of a host of long-running business trends, like the rise of remote work, the proliferation of cloud computing and the demise of brick-and-mortar retail.

In the startup world, the crisis also has added fresh urgency to an already-increasing emphasis on concerns like sustainability and profitability rather than growth at all costs. Under pressure from investors, companies have extended their runway by cutting costs and taking a hard look at their unit economics and path to profitability.

"In the pre-COVID environment, there were some companies that succeeded with really aggressive growth models where the business models were really unprofitable, but the businesses reached scale," said Lightspeed's Mhatre. "And then they figured out a way to raise more capital and ultimately drive some convergence. But that's not a winning strategy in a post-COVID world."

Featured image of San Francisco International Airport (Justin Sullivan/Getty News)

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