How has the lockdown crisis affected startup financing?

By: Katelyn Godoy
A person reading a newspaper

By Manisha Barnwal, MBA ’20

Has the lockdown crisis locked the financing of startup ecosystem? A question that has been confounding Entrepreneurs, VCs (Venture Capitals), and investors alike. Having founded a seed-funded startup, I have experienced the tremendous impact of macro issues such as demonetization in India on my startup financing. Crisis brings uncertainty but whether uncertainty is good or bad for financing is a debatable topic in the world of transformational entrepreneurs – VCs have been notoriously famous for performing better in crises. The financial crisis of 2008 is an example, yet the crisis today is like no other. The sudden decline in global economic activity over the last three months is unprecedented. IMF has projected a whopping decline of 3% in global GDP in the year 2020 compared to a decline of 0.1% in 2009. The projection of GDP growth ranges from as low as -6% for the US to +2% for India. Overall, emerging economies are projected to perform five times better than developed countries.

World map chart showing GDP growth rate across countries

Interestingly, the crisis spurred by the global lockdown impacts the startup ecosystem contrarily than it does the GDP growth, as discussed previously. According to a report by PwC/CB Insights, startups in emerging economies have witnessed twice as much decline in deals compared to developed economies, q-o-q. The largest deal declines of 28% occurred in Asia, compared to declines of 10% in North America and 14% in Europe in Q1 2020 against Q4 2019. Globally, the number of deals in VC funding has declined by 18%. The decline in investments in emerging economies can be attributed to currency risks as investors move their cash to countries with a stable currency. Nevertheless, behind the cloud there is sunshine.

Chart Deal decline across NA, Asia, and Europe

Which stage wins the funding race?

While the number of deals has declined in the last quarter, there is a simultaneous surge in total funding amount. In the US, total investment increased from $24 bn in Q4 2019 to $27 bn in Q1 2020 (12.5% increase) and from $14bn to $16bn in Asia (14.29%). The decline in the number of deals coupled with the increase in total funding amount skews VC financing towards mega-rounds. In the US, mega-rounds as a share of total deals increased from 32% to 45% in the same period and total value of mega-funding increased from $7.4 bn to $12.0 bn in the same time period.

Charts Seed deals see steep decline in Q`20 and chart 45% of all deals in Q1`20 were mega-rounds
Charts Seed deals see steep decline in Q`20 and chart 45% of all deals in Q1`20 were mega-rounds

The growth in mega funding has rendered early stage startups devoid of funding. Globally, there is a decline of 22% in seed funding amount and 8% in deal volume. The slope is steeper in Asia with a 37% decline in funding amount and 24% decline in deal volume in Q1 2020 compared to Q4 2019. “Seed and early-stage funding will drop to a fraction in the next quarter. Few small funds, early-stage funds in the country today are in the position to follow through on open term sheets. It is fair to assume that there will be some refreshing in the terms sheets, delay in cash disbursements, and a re-look at valuations.” says Anand Lunia, founding partner of early-stage fund India Quotient. [Source: LiveMint]

Chart Asia-based seed funding on track to decline and chart Global seed funding projected to fall steeply
Chart Asia-based seed funding on track to decline and chart Global seed funding projected to fall steeply

As VCs and investors wait for the market to go up the ladder before deciding their next investment, startups are positioning their balance sheet to breath longer. According to a survey by Statista, 29% of startups in developed countries including Sweden face disruptions in their business due to issues with their current or planned financing round while 36% of them wrestle with loss of income due to decrease in sales. On the other hand, 80% of startups in developing economies such as India witness fall in cash flow, as per a survey conducted by Ficci.

The most pressing issues for startups in lockdown crisis

What is driving the funding slowdown?

While there are predictable factors such as reduced consumption that have weakened the investment in lockdown crisis, the funding crunch can be potentially explained by three primary challenges faced by startups in the post-COVID 19 world – lower networking opportunities, loss of sales and growth due to decreased consumption, and investors pulling out their money amidst fear and uncertainty in the financial markets.

Firstly, COVID-19 has brought distances in networking opportunities that would impact the pace of startup funding. For instance, $1.4bn of startup funding in India came from China last year. With international travel restrictions in place, founders are limited in their opportunities to connect with investors. Shalil Gupta – Chief Research Officer, VCEdge says, “General reluctance to engage in in-person discussion is going to limit the networking opportunities and poses a big risk to the funding activities as networking/events provide entrepreneurs access to investors.” In my own experience as an entrepreneur, I have realized the importance of connecting to the investor network for startup financing. Raising seed funding for my startup involved numerous face-to-face meetings with investors in networking events, cafes, and their offices. The question is whether connecting virtually will be a new way of networking and connecting with investors in the post-COVID world. Can Startups that quickly adapt to the virtual universe have an edge when it comes to networking?

The second challenge for startups looking to raise funds is the lockdown-driven decline in consumption. Unlike other recessions, the COVID crisis has rendered the economy in a unique situation where the government is taking measures to curb, rather than boost, consumption by individuals and production from businesses amid social distancing. With limited consumption, it is difficult for startups to revive growth, creating another obstacle for founders looking to raise funds. I personally encountered this very phenomenon when I started planning the second funding round in 2016, the year demonetization took place in India.  The demonetization led to a decline in the demand of luxury goods due to limited availability of cash and resulted in double-digit drop in revenue for my startup operating in the pre-owned premium fashion tech industry. As a result, VCs shifted their focus away from the fashion industry and eventually I had to wind down my business. However, the picture of the current crisis is not all bad if we break down the ecosystem into industries. For instance, according to Quartz startups in analytics, artificial intelligence, health-tech, ed-tech, and online grocery are already booming and could find even more takers.

Finally, amidst all the lockdown-driven uncertainties, investors look for safer bets and VCs themselves experience a liquidity crisis as private capital funds pull out their money from VC funds due to the closure of exit markets. “Fundraising for new funds in 2020 and 2021 might prove to be more difficult as asset managers think about rebalancing their portfolio and/or protecting their assets from the current volatility in the market. This means that VC investing could slow down in 12 – 24 months after the most recent wave of funds (i.e. 2018 and 2019 vintages) are fully deployed,” as per a recent Forbes article. Furthermore, VCs could slow down their investment as it becomes increasingly challenging for them to value assets in periods of severe market dislocations.

Has the lockdown crisis locked startup financing?

There is no one right answer to the question of whether the lockdown crisis has locked the financing of startup ecosystem. The impact of this crisis on a startup varies greatly with its scale, industry, region, and adaptability of operations. The large-scale startups with sustainable business model could continue to have more financing as investors follow the stickiness-to-relationship model in economic uncertainty while the early stage startups that adapt their business model to meet the needs of users in COVID-19 crisis and operate in industries growing in the time of corona could have better odds!

About Manisha Barnwal, Two-Year MBA ’20

Manisha Barnwal

Manisha will be joining Amazon as a Senior Product Manager – Tech. Prior to her MBA, she founded a seed-funded startup ‘Envoged’ in the consumer tech industry and worked as Product Manager for all mobile platforms at Pepperfry, after Envoged was acquihired by the series-F company. Manisha also has two years of experience in the Finance industry. She worked at Bank of America as an Investment Banking Analyst in the US Healthcare sector. She holds a degree in Metallurgical Engineering from Indian Institute of Technology, Kharagpur in 2013.