Changing Dynamics of Venture Capital Financing in COVID-19 Era
[Poojita is a student at National Law Institute University, Bhopal.]
As we cross the half-year mark, the full-fledged ramifications of COVID-19 on the venture capital (VC) market have started to unravel. When the economy takes a downturn, there are usually a few consequences that follow like reduced cash flow, increased unemployment rates, lower incomes, and lost opportunities. Further, when a pandemic like this hits, with no foreseeable end in sight, it massively deteriorates the public and private capital markets. For many startups and other early-stage companies, this might come as a severe blow to raising capital for their sustenance.
VC investment trends in 2020
Despite the economic and political uncertainty in the world, the first quarter of 2020 saw total global funding of $61.0 billion raised by VC-backed companies across 4,260 deals, according to the KPMG’s Venture Pulse study. The study reveals that in India, the EdTech sector won big with Byju’s raising $400 million, Unacademy raising $110 million and Akash Educational announcing its acquisition of Meritnation. However, beginning March, each month has seen fewer deals with smaller funds being raised. Travel constraints and lack of meetings in person have greatly slowed down the transactions that have already been underway. As stated in the E&Y report titled COVID-19: Projected Impact on Indian PE/VC, the private equity and venture capital investments are projected to see a reduction of ~45% to 60% in the coming months of 2020 on account of the pandemic and restrictions in business activity,.
Another major factor that will impact fundraising deals in the country is the fact that India receives substantial VC investment from international firms and corporates with the greatest chunk coming from China. For several new and emerging Indian companies, aiming to become "unicorns," i.e., unlisted startups valued at $1 billion or more, Chinese internet companies and VC funds have been a crucial part of their funding strategy. Indian unicorns with Chinese partnerships include well-known names such as Paytm and Big Basket, backed by Alibaba Group Holding, and Ola and Byju’s, being backed by Tencent Holdings.
Apart from the effects of COVID-19, further damage to the prospect of receiving funding from China is caused by India’s amended FDI policy and a more recent anti-China sentiment gaining ground. In an effort to prevent opportunistic takeovers or acquisitions, the Indian government enforced new procedures requiring regulatory approval for equity investments made in domestic companies by a country sharing its borders with India. This was followed by a border skirmish between Indian and Chinese soldiers in mid-June which sparked an intense outrage among Indians to the point of boycotting Chinese products, companies, and apps.
While these trends surely present a worrisome state of affairs, analysing the change in VC industry patterns and behaviour can help companies redraft their growth plans and emerge as winners from this crisis.
VC investment strategy in the future
Leading VCs opine that there is a fair amount of capital waiting to be deployed. If one takes cue from previous economic uncertainties, this is a good time for investing. The dislocated markets and periods of low liquidity often offer more investment opportunities, as great companies have always emerged during such periods. However, while one can be optimistic about the large reserve of funding available, if the VC industry alone attempted to fund the currently VC-backed companies at the same rate, it will soon run out of funds. Therefore, the industry is seeing a slowdown in its intensity of investments and change in capital distribution to protect its reserves till the pandemic continues.
Current portfolio companies take precedence
One of the reasons for decreased inflow of funds is that investors are likely to remain focused on their existing portfolio companies and support them through the adverse effects of the crisis. While some companies may have found profitability or already have strong balance sheets or have exited, often times companies are left with no other alternatives than to rely on its VC funding. Thus, VCs feel responsible to save their reserves at the disposal of such struggling portfolios that might help offset the losses with higher stakes in the company.
Focusing on hot sectors
The pandemic has caused a shift in consumer trends and are now seeing value in sectors like edtech, digital entertainment, video conferencing, remote working, health, biotech, pharmaceuticals etc. Resultantly, investors are now inclined to bet their money on these winning sectors which have shown their ability to survive the current economic environment and propose sustainable growth models for the future. In the same vein, investment activity in sectors like real estate, infrastructure, and non-essential consumer goods and services has taken a back seat during the crisis given their dispensable nature of business.
Inclination towards benevolent investments
While many companies struggle to survive in these challenging times, companies which are working on developing vaccines, treatments, or innovative ways to deal with COVID-19 have seen a surge in philanthropic and benevolent investments from the VC funds. For example, the Bill and Melinda Gates Foundation, working with Wellcome and Mastercard, committed up to $125 million to accelerate the response to COVID-19. In the UK, the Coalition for Epidemic Preparedness Innovations has invested $23.7 million in companies like Moderna, Invivo Pharmaceuticals and Novavax (Oxford University) that are working to develop a vaccine for COVID-19.
In India, Bexley Advisors, a boutique investment bank has set up the COVID-19 Action Fund as bridge to capital for innovators on the frontlines of the pandemic who are creating solutions to fight the challenges of the virus.
Alternate tools for raising new funds
Generally, venture capitalists create a fund comprising of capital collected from high net-worth individuals, hedge funds, institutional investors and other sources, and then invest this money into a number of early-stage companies for seed financing or Series A through D funding rounds of the company. However, in the present economic turmoil these sources can often pause their investments into the fund, leaving only big established investors like institutional investors as the primary capital source for funding companies. This in effect may lead the VCs to double down on only one channel to raise funds so that their existing portfolios could give better results with the VCs retaining their credibility in the market.
Further, to replenish the depleting capital reserves, VCs might opt for methods like fund recycling (i.e. reinvesting proceeds from portfolio company exits) to help maintain a steady flow for supporting their current portfolios, at the very least.
Takeaways for what the future holds
The COVID-19 pandemic has brought unprecedented disruption in the economic world. The scenario does not propose a very promising year for the venture capital industry or for the growing companies. There seems to be a new-found conservatism among the investors who have preferred to be in the “wait and watch” mode till the uncertainty around COVID-19 continues. Nonetheless, by looking at the changing VC dynamics certain inferences can be arrived at for the sustainability of the companies.
First, in addition to relying on funding for its survival, early-stage companies must also focus on the feasibility of their growth and business model. The companies should be able to maximise outputs while adjusting to the changing environment. For example, their priorities should include risk assessment, downsizing, business continuity, cash burn, extending runways and liquidity.
Second, in the current climate government assistance is a good option for startups to make it through the crisis. While many companies may already have emergency capital, it typically would not allow long-term survival. Therefore, if the company is eligible for any type of state finance or support, it should take it. The Government of India has collaborated with different stakeholders to offer support to startups in the form of grant opportunities, financial assistance programs by SIDBI, knowledge platforms etc.
Third, advanced planning with strategies formulated for any type of change in the current scenario can be highly rewarding but is often disregarded. Since it is difficult to gauge how long this pandemic will last, businesses will need to quickly modify their product timelines, sales strategies, and revenue targets. This will necessitate a new operating plan, which if already thought of, would allow for a smoother and more efficient transition for the company.
At the end of the day, in the COVID-19 era, companies still need to raise money and investors still need to invest. The global VC markets still have a lot of money waiting to be deployed and invested in the entrepreneurial ecosystem, giving a ray of hope in the turbulent sky. However, early data paints a grim picture for the VC industry.