As the COVID-19 pandemic triggers an unprecedented financial crisis, opposite forces seem to impact start-up valuations for months to come.
COVID-19 has had a dramatic impact on markets and start-up valuations. It remains unknown how valuations, which determine future fundraising for start-ups, might be impacted. Venture capital investors have become more cautious, slowing down new rounds of fundraising and promoting their shares portfolios, which are also impacted by the crisis. Business plans on which valuations are (often) based are being downgraded. Other valuation tools such as comparisons with market equivalents or merger-acquisitions and stock market multiples seem useless if we consider the downturn over the past few weeks and the fall of mergers and acquisitions values.
And even if the quantity of “dry powder” (cash reserves kept on hand by venture capital firms for future investments or acquisitions) is still considerable, some investors will not respond to the calls for funds to which they are committed.
Valuations down up to 80%
Some sectors will be more impacted than others. Beyond the markets directly disrupted by COVID-19, those which have already benefited from considerable investments from large industrial groups and their corporate venture capital funds are at risk of seeing any further injections dwindle, especially as CVCs are traditionally the first to be cut in times of crisis. One example is the nanotechnology sector.
Government loans will of course help companies’ short-term survival, but they will not prevent falls in valuations, as getting companies into debt in this way with state-guaranteed loans automatically causes their value to drop. And despite the virtues of governments’ recovery plans, in France and Germany for instance, the rules against future-selling of companies to non-EU countries do not make them an attractive proposition for US and Asian investors.
Venture capital funds typically build in early exit strategies: commonly, the resale of their investment to large corporations. But many of these, especially in the tourism and aeronautics sectors, are suffering terribly. Other recent crises, in 2000 and 2008, depending on the sector and geography, saw reductions in valuations of between 20 per cent and 60 per cent. To take a current example, the community electric bicycle company Lime is trying to close a fundraising round – and has had to discount its valuation by around 80 per cent compared to its previous round.
Sectors that will fare best
There are, however, a few glimmers of hope for start-up entrepreneurs. Many funds in the market do have cash to invest. In some European countries, the amount of money ready to be invested is even at its highest level historically, and it still needs to be invested. So, the most attractive start-ups, particularly those with the most agile offer and organisation, and those which are resilient and positioned in promising markets, will probably be even more sought after by venture capital funds. And that will definitely increase their valuations. Naturally, we are thinking here of start-ups in such sectors as health, connected health, automation, smart vehicles, social and environmental impact, and so on.
In addition, some non-variables of venture capital fundraising are not expected to change. Why should series A and series B seed-venture-capital investors, who traditionally like to take a minority stake in order to keep entrepreneur-owners strongly motivated, decide to suddenly take majority stakes at the risk of demotivating the team? The basic equation for the first few laps remains the same, even if the average size of fundraising rounds drops off from the levels it reached after more than a decade of continuous growth.
Finally, as typically happened during periods of higher unemployment and lower levels of technology company creation, fewer start-ups will be able to raise the funds they need. This will serve to increase the valuations of those ambitious start-ups that have the much sought-after growth capacity.
In the end, a sizeable proportion of founders wishing to raise funds will probably have to undergo a significant drop in their start-up valuations, whereas those in more sheltered or even stimulated sectors may soar.
Benjamin Le Pendeven is a lecturer and researcher specialising in entrepreneurial finance at Audencia Business School. He is co-director of the Finance for Innovation chair