How Venture Funding For Early-Stage Startups Will Change During the COVID-19 Crisis
Paul Martino, General Partner at Bullpen Capital
During our recent Dreamit Kickoff week, Bullpen Capital Founder and General Partner Paul Martino (@ahpah) spoke with our Spring 2020 cohort about the state of the VC ecosystem in the current economic crisis. Martino founded Bullpen in 2010 with a focus on post-seed, pre-Series A startups, and he led the fund’s investments in companies like FanDuel, Namely, Ipsy, SpotHero, Classy, and Airmap.
Throughout his career, he’s witnessed a number of economic crises, and he explained the two types of crisis we might be facing over the coming months, as well as the ways that VC deal terms and investment activity might change as a result. Here are the highlights:
Will East Coast and West Coast Investors react differently in this crisis?
Bullpen Capital is based in San Francisco, so we naturally kicked off the conversation by discussing the different mentality of West Coast VCs and East Coast VCs. This geographic distinction is now less about actual geography and more about mentality and style of investing of these types of firms. In New York, for instance, there are now venture funds with a West Coast mentality and firms with an East Coast mentality; the same is true for firms in San Francisco. West Coast investors tend to look for higher growth rates, put less emphasis on profitability, and tend to give more founder-friendly term sheets; East Coast investors tend to look more closely at business fundamentals, seek out more predictable revenue, and often give less founder-friendly terms when investing.
This distinction is relevant to an economic downturn because the two types of investors could behave very differently during a sudden economic crisis like the one we’re in. East Coast VCs have sometimes used redemption provisions, a feature of preferred stock, to give themselves the right to be bought out four or five years down the line, essentially allowing VCs to get their money back if a company experiences hardship. The later stage East Coast-style investors have also been known to insert onerous liquidation preferences into deal terms. In a downturn, this offers an out for investors.
West Coast-style investors, on the other hand, tend to have more conviction about the industry-changing potential of startups, usually request less onerous terms, and as a result, have more incentive to work closely with their portfolio companies to help them survive a downturn.
Will a financial crisis affect how venture funds deploy capital?
Startups should know how VCs work. At a high level, venture funds collect money from limited partners (LPs), which usually consist of high net worth individuals, endowments, foundations, and family offices. VCs look to source great investments and take 20-25% carried interest on the returns of those investments and typically take a 2% management fee. The fund's LPs retain the rest of the winnings after fees and carried interest are deducted.
For a fund like Bullpen Capital, the VCs may see around a hundred deals each month, go into deep diligence on just 10 of those deals, and ultimately invest in about 1 deal (i.e. startup) per month.
A financial crisis may affect a firm’s ability to make “capital calls.” When VCs raise capital from LPs, that money does not just sit in a bank collecting interest. A $100 million fund does not actually have $100 million in capital but $100 million in “committed capital,” essentially a legal document that states that LPs will send the fund money when “called.”
The biggest question for a venture firm is whether LPs will fail to make capital calls in a crisis. “It will definitely happen for some venture funds, but the question is how widespread it will be,” states Martino. Some LPs might not make capital calls because they are worried about the environment, and some LPs might actually no longer have the liquidity to fulfill these capital calls. This is not without precedent. LPs failed to make capital calls in the late 90s during the dot-com bubble burst, after September 11, and during the financial crisis in 2008. These crises are never the same, and no one knows right now what the current crisis will bring.
This is why it’s critical to have trustworthy, reputable LPs in a fund. A university with a $30 billion endowment will almost certainly make a capital call, but a high net worth individual might have lost liquidity. Not making a capital call is a violation of a legal contract, but if LPs don’t have the money, they cannot write the check.
Do startups need to conduct due diligence on a venture fund’s LPs?
“This is a big can of worms,” states Martino, “but it’s a legitimate question. Who the firm is, how long they’ve been in business, and who their LPs are rational questions to ask.” It would be premature for startups to bring this up in initial conversations with investors, but it’s appropriate to ask about LPs when founders receive a term sheet. Investors are taking a large risk on investing in startups, but founders should know they’re also taking risk relying on a fund for future capital. If funds cannot make capital calls, startups can be left in a very precarious position during a financial crisis.
Could VCs stop investing during this pandemic and associated economic crisis?
No one really knows this answer just yet, but “this is completely possible,” states Martino. “This is where history is very important, and we don’t yet know the situation we’re in yet.” Martino outlined essentially two types of outcomes for this financial crisis from a historical perspective:
“In 2001-2003, there was a depression in Silicon Valley. It went from 1 million employed people to 750k employed people within 18 months. eBay hosted a jobs fair in 2002 for 75 jobs and 2,000 people showed up,” states Martino. This crisis lasted for 3 full years, and there was a prevailing sense of boredom in Silicon Valley. “It wasn’t fear, it was boredom,” states Martino. VCs were basically ‘out to lunch’ and not making new investments during this time.
In 2008-2009, the financial markets seized up, and there were quarters of complete uncertainty, but ultimately VCs started investing again and things normalized. The crisis began in August 2008, but by March 2009, deal activity in venture had picked up again and economic activity in the venture ecosystem normalized.
As of now, venture funds are still investing. These funds have the capital to make investments, but this could change down the line if 6 months from now LPs are not making capital calls. There’s a huge time lag in the venture market, so it’s hard to gauge what kind of crisis we’re in at this very early stage.
Is it harder for startups to raise capital now on normal deal terms?
Deals terms will almost certainly change during this crisis. Martino gave an example of one founder in his portfolio who is currently raising capital and had a commitment from a top-tier fund in the Valley before the crisis began. As the COVID-19 crisis began to unfold, the fund told the founder they were reassessing all outstanding term sheets and then proposed a 25% lower price on the funding round. The founder negotiated with the fund and ultimately accepted a 15% lower price. While not ideal, this was certainly not the worst possible outcome for this founder. Other founders have seen term sheets completely pulled as the crisis unfolded.
VCs will likely take a stricter stand on governance requirements for startups at the later stages. Founders have grown accustomed to supervoting stock structures as VCs agree to loosen terms to get a stake in the funding event, essentially giving these founders authority over their own boards.
“I think you’ll start seeing pushback on complete board control by the founding team,” stated Martino. “I think this is the area that will fall first during this crisis.” This will be good for the ecosystem in the long term.
This crisis comes on the heels of an abnormal time for venture capital. Over the past few years, the influx of capital has led some founders to make bad decisions, with Uber serving as the most prominent cautionary tale. “The weird corporate structure of Uber got the company in trouble,” said Martino. “It’s not rational to be able to raise $4 billion from one investor on a napkin over a weekend.” This led to Uber staying private longer and shielded the founder from the scrutiny of the public markets; in addition, the founders’ supervoting shares left him unchecked and left board members powerless to reform the company.
Will founders start seeing liquidation preferences or redemption rights?
Liquidation preferences may change in later financing rounds, but probably too significantly. Martino suggested that VCs will probably not start asking for 1x liquidation preferences, as opposed to being pari pasu or having the same rights as other investors. Some East Coast-style firms may try to insert liquidation preferences, but West Coast firms and early-stage funds will probably not attempt this.
“Any firms that are asking early-stage founders for liquidation preferences are so out of alignment with founders that it would probably not even make sense for them to be investing at that stage,” states Martino. If founders accept high liquidation preferences at the early stage, all subsequent investors are going to demand those same terms. It’s not a good position to be in for founders entering into a recession. “When my companies are raising subsequent funding, I’m on the side of the founders because my shares look like the founders,” states Martino.
How should startups adjust their pitch when fundraising during this crisis?
VCs are going to be asking founders about their “post-corona strategy.” Marino joked that founders could probably make a drinking game in their own mind about when this question will come up in investor meetings. Founders should be able to answer the question of how they can survive if this crisis lasts for a few more quarters and how they’re going to get 2-4 more months more out of their existing runway?
This means having multiple plans for different scenarios to present to investors. No one knows how the crisis will shake out, so founders need to have a plan for good, moderate, and potentially terrible economic scenarios. Martino mentioned one of his portfolio companies who presented 6 plans for different scenarios: “This is how you run a company.”
What about bridge rounds in the current environment?
“The further you are away from liquidity, the more slack you get when raising bridge rounds.” This is good news for seed and pre-seed founders. Very early-stage companies will likely be inoculated from the worst effects of the crisis at least for some time. But if the crisis persists, it will affect founders at all stages. Post-revenue companies will be hit hardest by a crisis and have more trouble raising a bridge round.
Martino is careful to note that bridge rounds are not the same thing as post-seed rounds (the area of focus for Bullpen Capital), stating, “A post-seed round is not a bridge round. A bridge is made up of insiders or current investors. A post-seed round is something a new investor has an incentive to be in.”
Read Martino in TechCrunch on bridge rounds vs. post-seed rounds.
If you’re months away from launching a big new customer and have less than six months of runway, you might consider a bridge with current investors for a small amount of capital. If you have 6+ months of runway, have strong product-market fit, and want to raise a greater amount of capital based on metrics, you might consider calling up Bullpen Capital or other investors about raising a post-seed round. “Don’t go to any new investors and ask for a bridge,” warns Martino.
Final Fun Fact
If you’re looking for something entertaining to watch during your social distancing time, check out the movie Inside Game, the true story of an NBA betting scandal. Paul Martino’s cousin served time in prison as part of the scandal (he was a middle-man between the gambler and the referee). After prison, he sold his life rights to Martino. Being a consummate entrepreneur, Martino decided to turn it into a script and see if he could make a go of turning it into an actual movie. The risk paid off.
By Charles LaCalle, Director of Startup Sourcing at Dreamit Ventures