Who will save the startups?

The runway, or dead space, between VC financing could determine a startup's ability to weather a recession — that, or an offering industry can't resist buying.
Danielle Ternes/CIO Dive

Staring down the barrel of a recession, venture capitalists are in startup population control. At this point, it's not about saving the startups — it's about who can last on the other side of an economic downturn.

Subsisting on 12- to-18-month funding rounds, startups at the end of their runway are meeting with investors, and await waning prospects. Investors will have to determine if they have stakes in the next Facebook, or something unworthy of the risk. VCs are more risk-averse; by March 29, venture capital funding dropped by 22.5%, compared to the week prior, according to GlobalData.

The runway, or dead space, between VC financing could determine a startup's ability to weather a recession — that, or an offering industry can't resist buying.

An economic slump is an opportunity for B2B startups to finance their business through new customers. If a startup can prove its value through customers subscribing to a service during a recession, it's primed for continuity or an acquisition.

For startups with a shrinking runway and dwindling capital, big tech's appetite for acquisitions in a slumping economy is another chance at survival. The last option? Perish.

"The real question is going to be, to what extent are there strong targets for acquisition out there and to what extent are they going to be in a position to, or pressured to, sell?" Blair Hanley Frank, principal analyst at ISG, told CIO Dive.

During the 2001 recession, M&A transactions dropped 23%, compared to more economically stable years, according to data from Gartner. In the Great Recession — December 2007 to June 2009 — M&A activity plummeted 34%.

In a bear market, valuations for public and private companies fluctuate. The stock of publicly traded companies serve as economic indicators for private companies. When stock prices are down, public companies will use liquid assets to acquire private companies with decreased valuation.

"I get asked this all the time, '[are] big companies that don't make it failures?' They are not failures. The VCs are extremely smart. The entrepreneur sees through time," Martin Pichinson, co-president of Sherwood Partners, Inc., told CIO Dive. It's nonetheless "very hard" to tell a startup founder it's time to close up shop, even for Silicon Valley's "undertaker." Pichinson earned the moniker for selling off parts of fledging startups since the dot-com bubble.

While Q1 2020 saw nearly 2,300 VC deals supported by exit and fundraising activity, according to PitchBook, the momentum will likely drop in the first quarter as the coronavirus derails future investments.

They are not failures. The VCs are extremely smart. The entrepreneur sees through time.

If startups can gain critical mass, they can "loosely" become a "regular company," said Pichinson. But becoming a regular business is dependent on who is at the helm. "I've been telling investors for years and no one listens: The big sacrilegious move is to make a founder in the beginning, a CEO."

With an impending recession, a potentially shortened runway, and few if any acquisition options, it's already too late for startups to restructure leadership. Startups would need a minimum of one year of runway to even consider a restructuring to survive a recession.

For other startups, Pichinson gives them six months to save themselves.

Big tech's burning wallets

Investments and acquisitions are often at the mercy of a recession. With no sense of how long the coronavirus crisis will last, businesses are hesitant to take a financial plunge. Deals decreased by nearly 20% within a week of March 29 compared to the previous week, according to GlobalData.

In 2019, there was a slight dip related to Brexit and tariffs. "What most people didn't anticipate was how weak 2020 is," Max Azaham, senior research director at Gartner, told CIO Dive. The coronavirus "completely evaporated" the first quarter, leading to a steep decline in deals.

The coronavirus pandemic caused M&A activity in technology, media and telecommunications to drop 26%, compared to Q1 2019, according to GlobalData. By mid-2020, startups running low on cash "will be highly vulnerable to potential acquirers," according to Sapana Meheria, thematic analyst at GlobalData, in the research.

While there is a period of subdued M&A activity, big tech can be bullish in volatile markets, especially when they have cash on hand. "This is going to be a perfect time to just be a buyer," Ryan Corey, CEO and co-founder of Cybrary, told CIO Dive.

Excluding the companies with cash but high debts, Gartner found 71 companies with at least $5 billion in cash in 2019. Fifty-seven of those companies with business in IT, communications services, and internet collectively carry more than $1.1 trillion of cash.

This is going to be a perfect time to just be a buyer.

In 2006, Microsoft had more than $34 billion in cash or cash equivalents, but in 2007 and 2008, the company had about $23 billion, according to financial records. Microsoft started to rebound with the economy and 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, in part, because of the $6.9 billion it spent on acquisitions the year prior.

During the Great Recession, companies, such as Microsoft, Oracle, Amazon and IBM, had balance sheets that could finance acquisitions. The number of companies Microsoft, Amazon and Oracle acquired in 2008 matched or exceeded the average number of acquisitions in a normal financial year.

Microsoft, Oracle and Amazon capitalized on Great Recession downturn, ramped up acquisitions

The number of acquisitions that each company made before (June 2006 – Nov. 2007), during (Dec. 2007 – June 2009) and after (July 2009 – Dec. 2010) the Great Recession.

Nami Sumida/CIO Dive

Even with deep pockets, the last recession tempered tech's confidence.

During the Great Recession, Google announced only a handful of acquisitions. One of the deals, involving advertising service ZAO Begun, was blocked by Russian monopoly watchdogs in 2008.

Google's ad business, its primary source of revenue, slowed during the Great Recession. The company took home almost $22 billion in revenue in 2008, but growth was stalled.

Since going public in 2004, Google's quarter-to-quarter revenue slipped for the first time in Q1 2009 because while customers were still paying for ads, they weren't interacting (read: shopping) as much. At the same time, Google was throwing itself into broader technology categories, including mobile and software solutions.

In September 2008, former CEO Eric Schmidt told Reuters Television "acquisitions are turned on again at Google and we are doing our normal maneuvers, which is small companies." Schmidt predicted Google would make one acquisition per month because 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 filing. "We expect our current pace of acquisitions to continue." By September 2010, Google had completed 37 acquisitions.

Head above water

While acquisitions might be salvation for some startups, it's not always the right answer.

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

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

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

If companies have a stable product and think they can weather a recession and hold out for a better price, it could ultimately attract more customers.

If startups can get customers to pay for a service upfront, "there's no delusion," it's revenue, said Jeff Lawson, CEO and co-founder of Twilio, on a conference call with investors and the founders of Pinterest and Shopify on April 7. "It's the best kind of money there is."

Enterprise buyers don't want to sign contracts with companies that might go out of business at the first sign of an economic downturn.

Depending on their business, customers are likely to postpone transactions, which will influence future revenue targets. "You may not be getting cash in the next few months, you're definitely not gonna be growing new customers," said Corey. "That's just a scary, scary place."

If startups aren't looking to sell but are reaching the end of their runway, some might find solace in federal relief or it just might prolong a startup's demise. "Right now everyone has this good feeling they're going to get some government money. It means absolutely nothing," said Pichinson.

Congress' $2 trillion bailout was filled with potential caveats for startups. The U.S. Small Business Administration's Affiliation Rules counts all personnel associated with a business — including an investor's workforce. If the employee count exceeds 500, a startup could lose out on a loan.

On April 3, the Treasury Department updated affiliation rules but they don't automatically eliminate startup ambiguities: Can startups, with investors, apply for a loan?

Because the purpose of the loans is to keep employees on payroll, startups have to decide if those people (and costs) are strategically imperative for enduring the downturn. If the answer is yes, startups will still have to jump through hoops to get a loan.

Startups can "get distracted and lose focus during uncertainty."

Loans are granted to those who apply for it first, so startups might rush to apply, which has "created undue urgency," and even unnecessary applications, wrote venture capitalist Mark Suster. Startups considering applying for a loan "is not something you should do just because all of your peers are telling you that you should."

Like startup founders, investors are waiting to see whether the economic impact of the current health crisis is short-lived, interest rates remain low, and the Federal Reserve's stimulants succeed. "Similar to after the Great Recession, you'll have institutional investors who will make strong returns," and will turn toward the VC market, said Frank.

Even as Microsoft bolstered its solutions and talent with acquisitions, the company laid off thousands of workers in 2009 to reduce operational expenses. By its September year-end earnings, the company suffered its "first-ever" decrease in annual revenue, according to the company.

"The issue is that for other companies that we might consider sort of large and capital rich, some of those may be feeling the squeeze more than others," said Frank.

Value on the decline

For startups, figuring out how much of their runway is left is crucial.

"If you're burning a ton of cash, you obviously need to make layoffs," said Corey. It's "the bottom 10% discussion, an old Jack Welch practice." Welch, the former GE CEO, adopted the 10% mindset for laying off the "under-performers" of an organization.

With fewer opportunities, startups could scramble for funding that just won't come. VC firm Sequoia Capital declared the coronavirus the "black swan of 2020" and advised startup leaders to adjust their mindset for an uncertain time.

"There are a lot of tech companies out there that you can purchase for probably pennies on the dollar because they're completely out of options," said Corey. "There will be a lot of value, I think in the market, and that's the way that our investors are seeing it."

While it's still too early to forecast drops this year, valuation multiples declined by 60% within one year of the Great Recession, according to Gartner. The drop motivates aggressive acquirers with over $250 million in revenue.

IT market followed stock market decline during Great Recession

Normalized stock values of S&P; 500 and Vanguard IT Index Fund (VITAX) from 2007 – 2008

Nami Sumida/CIO Dive

But valuation decline isn't as influential as it appears, according to Pichinson. "Valuations are make believe. What makes something value at a billion dollars because you invested $200 million? It's a theory." The market buys into the theory because they've seen it work with companies like Google. There were also failures along the way.

The issue is that for other companies that we might consider sort of large and capital rich, some of those may be feeling the squeeze more than others.

Larger organizations aren't looking to buy companies "that are going to be massive drags on the balance sheet unless there's some very good reason for it," said Frank. "Part of looking acquirable is just being a good business."

Enterprise customers want to see their vendors with strong fundamentals. Whether a startup is looking to be acquired or not, they have to prove their ability to make money under normal market conditions.

Boards might pressure startup founders to seek deals when all other options are exhausted but only if the two parties are in agreement.

Sometimes there are opportunities for startups to partner with another company when "there's a potential for a good outcome, but it's rare, and usually happens serendipitously when you're not looking to sell," Denis Mars, CEO and co-founder of digital identity startup Proxy, told CIO Dive. If a startup and its investors decide an acquisition is best, the investors will play match-maker.

Connections often happen during a recession. "In fact, there are a lot of those conversations happening right now," said Mars.

However, startups shouldn't expect acquisitions in the next three months, according to Azaham. When big tech companies do decide to take action, "they're going to try and structure the deal that works best for the acquirer's side."

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

Round and around

Between March 1 and March 17, VC and private equity deals dropped by almost one-third, according to GlobalData. Investors cited coronavirus-related concerns as a reason for stepping back on deals. PEs are often described as the acquirers and builders of startups, while VCs prepare them for exits onto the market.

Beyond seed funds and angel investors, startups progress through Series, A, B and C funding rounds. Series A is typically a benchmark by proven users and revenue and ranges between $2 million and $15 million.

"A majority of the startups that can't meet that Series A criteria tend to close up shop, while some are snapped up by an acquirer," said Mars.

By Series B, startups' valuations on average reach $58 million. In Series C, startups are scaling and hedge funds, investment banks and PE firms join existing investors.

A Series C player is likely to beat out their Series A and Series B counterparts because they have established their value and continuity for customers.

"If you need to raise capital at current conditions, then you've got to revise valuation expectations, and you have to expect that funding amounts will be smaller," said Azaham. If a company wants $10 million, consider raising $7 million instead.

Each funding round takes 20 months on average

Average number of months between VC rounds in the US during 2015 – 2020

Nami Sumida/CIO Dive

In a calmer market, only about 40% of startups make the leap from seed funding to Series A, said Mars. Seed funders are more likely to take a risk and founders often secure loans from family members. Series A investors are more conservative, waiting to see a stable history of sales and services.

But the leap from seed to Series A, while unattainable for some, is not impossible. Israel-based Granulate, a tech company that optimizes infrastructure and workload performance, was backed by Insight Partners to raise $12 million in Series A funding. Granulate's partnership with Insight began during the coronavirus outbreak, co-founder and CEO Asaf Ezra, told CIO Dive. "We believe that there was an internal re-evaluation process of the funding."

Reevaluations will be common. VCs are doing "soul searching" to find what startups will have a chance, said Pichinson. But "this is a gentle business," and investors will find a place for their startups.