If someone had used ‘lockdown’ or ‘social distancing’ in conversation six months ago, it would have been unheard of. Now, these concepts have changed the way we all work, do business and transact deals.
In April, I posted about how the situation may affect raising venture capital. In this blog, I share insights from investors and lawyers that we as a team are close to and speak to regularly. Those contributors operate at different stages in the funding cycle and have taken time to explore with me how the process of doing deals has changed during lockdown and how the pandemic may change the ecosystem as a whole.
According to Beauhurst, there were 1,906 deals done in Q1 2020 involving UK companies and/or investors, a 57% increase on the same period in 2019. What some of you may find surprising is that Q2 also saw an slight increase compared to 2019. There were 2076 deals completed representing a 7% increase. This could be for a number of reasons, but the most obvious seems the impact of dry powder in the market.
Our discussion covered a lot of ground and issues. These include the impact of the Future Fund, digital-only processes, investor appetite for different sectors, the increased importance on taking research and references, how valuations and terms have changed and the importance of company performance.
Future Fund impact
We think it’s safe to say that the Future Fund has been well received and well taken up, with over £320m already deployed by the UK government, and over 320 UK start-ups benefitting from the scheme. This has really helped companies get through such a difficult time, as well as allowing companies to postpone priced equity rounds so they are not forced into doing them at a time of weakness, therefore negatively affecting dilution and valuation.
Aaron Archer, Emerging Companies and Venture Capital partner at the law firm Cooley LLP, represents both companies and investors. Aaron notes that the impact of the Future Fund, for which he was part of the select task force to advise on the Future Fund, notes the positive effect the Future Fund has had on the UK start-up market, and the positivity in the market generally - will have suppressed the number of Venture Capital deals announced in Q2. This is because companies preferred to take on short term debt rather than putting them in a position of raising a new round at time of weakness, therefore negatively affecting dilution and valuation...
“On the whole the emerging companies and venture market in the UK has been very active since the start of the COVID crisis, with many early stage companies actually thriving, whether that be due to the business model itself, or because of the creation of an opportunity to pivot into areas they would not have been able to previously.
Although we have seen a large number of ‘breathing space-buying’ bridging convertible rounds and the UK government’s Future Fund in particular has been great for the market in this regard. Priced rounds were, and are still, getting done at an impressive rate - not dissimilar to what we were seeing pre-COVID.”
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One of the main risks of deal-doing during lockdown, was the necessity for investors to transact a deal having run a virtual process. It is not yet clear what the real long-term impact will be. Ben Leslie, investor at Puma Private Equity that invests between £2m and £10m into Series A and B companies, explains;
“Most deals that are done are usually a result of us tracking the company for a number of months and, therefore, it is highly probable that we will have met at least one of the management team. We’re able to get comfortable with the rest of the management team through video calls, especially as going through a process allows you to see them perform in a number of different situations.”
Another point that Ben Leslie made was that investors are looking for companies that have managed to successfully navigate the current climate. More than ever, funders need to have confidence in the management team and in their ability to work through any future tough times.
David Wrench is Investment Director at YFM who have been investing in small businesses across the UK since 1982. He commented that although investors are not adverse to a digital-only process, face to face meetings with management are still important. Meetings enable YFM to get comfortable with an opportunity and YFM have been able to have them in socially distanced ways for the last few weeks. His opinion is that;
“As sector agnostic investors, our value add is that we are there to help management teams to overcome the challenges they are facing face and getting to know them properly allows us to assess cultural fit and whether each way of working will go together well. It, therefore, increases the importance of us being convinced by the management team and as a team we feel that face to face meetings help with that.”
Aaron Archer’s view is that “VC funds appear to be looking long-term here and the opportunities that may be created from the dislocation created by the crisis. VC funds have also been able to work through initial concerns over the inability to meet founders in person and, like the rest of us, have been able in most cases to get very comfortable with largely virtual relationships.”
Damien Lane a seed stage investor partner at the prominent investment fund Episode 1, in seed stage companies. He hasn’t seen a drop off in activity but what he has also seen is the quality bar being raised. Damien puts this down to a number of reasons. Digital-only processes have meant that funders have looked for more references on management than they would have previously.
It is not just processes that have become more digital. The investors we spoke to have notice more pro-active knowledge sharing made possible by digital channels of communication. This includes portfolio CEO and CFO WhatsApp groups and webinars with external experts which Ben Leslie has said Puma Private Equity has accelerated over the last few months.
So there really is no right and wrong answer, different investors are taking different views on processes. However, the level of scrutiny that management teams can expect during a process has, if anything, increased.
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Sector Focus and investor appetite
Some management teams may worry that the pandemic means that investors will focus on some sectors and not others.
David Wrench says that YFM’s stance is, and always has been;
“We back management teams first rather than being sector-led, so if a management team in a struggling sector were able to pivot and stabilise and demonstrate a plan for creating value, there’s no reason why YFM wouldn’t consider an investment.”
Ben Leslie, Puma Private Equity, broadly supported this view. He thinks that although COVID-19 proof businesses have an obvious appeal for investors, so do truly proactive management teams. There will also be more of a focus on underlying profitability with less tolerance for y/o/y loss with no clear path to profitability.
A recurring theme was that many investors will look for businesses that can sell and support virtually and for products that are discretionary e.g software that increases efficiency will still be attractive.
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The importance of research and references
Taking investment from a VC is often compared to a marriage; you are in it for better or worse and generally for a number of years. How an investor acts in the bad times tells you a great deal about them as a partner. Ben Leslie says that Puma Private Equity have always encouraged potential investee companies to take references from their existing portfolio companies. They are rarely taken up on that offer. For management teams, the pandemic has reinforced the importance of taking an investor up on access to those references!
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In the current climate it’s inevitable that investors will look to protect their downside. However, Damien Lane noted that due to the higher bar that investors are placing on making investments, there hasn’t been a notable change in overall valuations.
Daniel Turgel a corporate law Partner and co-head of the EMEA fast-growth practice at White and Case LLP, noted that one company he worked with received multiple term sheets from the same set of investors starting from an effective down-round to a significant increase in valuation. In his opinion, a great learning for founders is that they should do everything possible to extend their runway before jumping to take more cash on terms that they do not think fairly value the company. This includes engaging with their investors proactively on how to navigate the choppy waters ahead.
Many investors that we spoke to said that the best way to support their portfolio companies was not necessarily through injecting further funds right at the beginning of lockdown. The general feeling was that with their support, companies could pivot and stabilise before suffering unnecessary further excessive dilution
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There have been some positives for companies during lockdown. Founders have had to assess their costs and many have found that they can operate off a smaller cost base. Damien Lane mentioned that many of his portfolio companies have managed to reduce their cost base at no detriment to technology development by focusing on productivity.
On the other hand, sales cycles have slowed because clients are deferring purchasing decisions. Damien Lane also remarked that it’s been more difficult to get large corporates to trial or beta test a start-up’s offering;
“Start-ups are by nature agile but many large enterprises are not. Some are still struggling with whether they can ‘work from home’ which makes their decision making around trialling new technologies even slower”
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Aaron Archer summed up the general consensus on terms quite succinctly by saying;
“There were concerns at the very start of this pandemic that we would see more aggressive terms creeping into investments such as multiple participating preferences and full ratchet anti-dilution protections. But other than a few potentially company-specific cases, we have not seen any material change from the balanced market standard terms we have become accustomed to in recent years.”
This has been really encouraging and demonstrates the long term, bigger-picture view of investors. They appreciate that the manner in which they invest and support their companies in tougher times is a key factor for founders in choosing investor partners during headier times. In general an investor will show more understanding and patience when a macro market issue impacts a business rather than performance being impacted by poor execution.”
Aaron Archer has also collaborated with Fred Destin of Stride VC to write this article setting out the sorts of terms he is talking about.
An example of the more extreme investor terms that Daniel Turgel has seen includes investors requiring a reprice of a previous round before putting in new money. Other than in very specific situations, it appears that founders have largely managed to overcome these demands.
Turgel also notes that investors are placing more importance on their alignment with the founder and management team there has been a trend towards less secondaries, the amount of cash that a founder can take off the table on day one or outside of a lock-up including without going through the transfer pre-emption process, as well as a focus on (re)vesting of founder shares.
David Wrench brings this back to the type of investor that you take investment from;
“We don’t make a habit of putting out lots of offers or offer up racy terms to win exclusivity as we value our reputation of doing what we say we will and making investments to back teams we like. We want to be a stable and supportive partner throughout the process – and this most importantly includes the offer stage. We want to be able to stand by our reasoning for investing in a company in good times and in bad and not feel that we have to change the goal posts because we we’re too aggressive at first.”
Damien Lane pointed out that in general there is a lot more scrutiny on investors now with websites such as Landscape (“Glassdoor for VC”) whereby management teams leave feedback on their experience with VCs. This give investors less room to be too aggressive on terms or valuation.
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The overarching view from Aaron Archer is that we aren’t out of the woods yet, and it remains to be seen what real effect the past few months will have on the UK’s emerging companies and venture market. So far the local venture market has fared pretty well, and he remains very positive about it as we emerge from lockdown and move forward.
The investors and lawyers that we deal with have continued to execute on deals and there is clearly an appetite to do more. Yes, there have been some changes but not all of them drastic and a lot of them for the better. The clearest theme revolves around people; investors are placing more importance on management teams and their ability to pivot and adapt. In turn, management teams should be placing even more importance on the people behind the money.