“When the market tanks like this, if you go to investors and do a capital call right now, you will have anarchy on your hands,” warns Diffuse Founder Kenny Estes.

The world is facing a major crisis today like no other. In this great time of uncertainty, certain permanent changes are taking shape across sectors, and the venture capital (VC) industry is no exception. Here, Kenny shares his insights into how the Coronavirus pandemic is disrupting the VC scene on all fronts, and what he recommends for investors and syndicators to do in these trying times.

Q: How has this crisis affected our early stage investors? 

Kenny: Across the board, everybody’s pulling back and trying to get as much money into cash, with the expectation that it’s gonna be safer if things go sideways. And they can be compliant, they can plow back into the market down the road. This applies to VCs as well. It hurts them in two ways directly: first is they can’t really call capital. If you’re a seed stage company or a seed stage VC fund, and you’re going to be going out to individual LPs and getting them to do capital commitments to you, when the market tanks like this, if you go to them and do a capital call right now, you will have anarchy on your hands. You will not be successful in the capital call and it’s going to cause a lot of issues for you.

The other thing is because they really want to be cash heavy, it’s hard for VCs to fundraise in this environment. Typically as a VC, you have one to three years where you’re actively putting money out of a fund, and then you go out and you raise another hopefully larger fund, assuming your track record is good. Those fundraisings, they’re not happening right now. Everything is on pause.

Q: How do investors decide which companies to save? Is it whoever is running out of money first, or do investors need to take a strategic approach and look at all of them, preempting some of their cash issues? What’s your suggestion there?

K: The reality is that every VC on the planet has a rank ordering of their portfolio companies which ones they like best. That’s just human nature. When you get into bed with a VC, it really is a marriage. You’re going to be working with them as a startup, or vice versa, the VC will work with the founders for 7,8,9,10 years. And sometimes, those relationships just don’t go well. You do everything you can, but sometimes you just don’t click. Things aren’t quite as hunky dory as you thought they were. So no matter what, companies that you have the strongest relationship with are going to be top of the queue.

Past that though, it really is urgency. It’s the ‘hey, this company is going to die in two weeks, this company might die in three months,’ and we don’t know what three months out is. So it’s a function of the value of that relationship. To use an old phrase, ‘it’s the squeaky wheel that gets the oil.’

My suggestion is that the money that you’re pulling now needs to go to saving portfolio companies. Secondly, since you can’t be convincing your LPs of a new investment opportunity, you need to focus on secondaries.

Q: Challenges aside, what opportunities can you see in the current situation? 

K:  When you do a fundraising round, as a VC, even if you’re the lead, there’s going to be other people that co invest alongside you. Those people are going to be experiencing the same cash crunch as the rest of the market right now. So if they’re in a distressed position, they’re going to need to get out of their ownership in the startup that you are a co-investor in already. They’re going to need to get out fast.

So it presents a really interesting opportunity where you can buy their ownership for a significant discount to what you yourself bought your ownership at on a shared price, which is really compelling. Because now, again, you can go back to your LPs and tell them ‘here’s this company. They’re doing well, they’re not distressed, and we can increase our position after having had a two year relationship with them, and actually come in at a lower cost basis than our original check.’ That’s pretty compelling. And that’s actually something you can potentially convince people of.

Q: Is that something that we can convince LPs of in general as a strategy? Or does it work only with some cases? 

K: VCs usually let the entrepreneurs know that I have either some cash or the ability to call some cash to do these secondary transactions. And you’re going to reach out to the ones that you have the most confidence in to get that done. 

But the reality is you can’t choose. You can do a tender offer or something like that, where you just go out to all investors and say, like, ‘I’ll buy back your shares at XYZ.’ But the reality is that’s not really done in this industry very often. What you can do instead is say, ‘hey, here’s this opportunity. Here’s something that we can do. If any of you hear anybody who is looking for just put us in touch,’ and the founder is gonna be more than happy to facilitate that because the last thing they want is one of the co investors just dumping their shares on something like shares post, or just getting into entrepreneurs here all the time because they’re terrified about losing their investment.

Q: You mentioned that new companies are going to be more difficult to sell into the fund. But then there’s a lot of great companies you might be halfway to closing a deal with that are now dropped in their valuation or are in a cash crunch. How do you best deal with those?

K: This points us back to the top two priorities again. We’re kind of saving the portfolio companies and then the secondaries when we’re on the primary. So new share issuance, new fundraising rounds. There’s maybe three ways you can think about this.

The first is the companies that you already have a signed term sheet and you’ve called the capital for from your investors. Those are more often than not going to get done. Because you’ve already convinced your LPs you’ve already got the money sitting in your bank account. You have a term sheet. It’s very rare to have a VC who’s willing to risk a potential reputational hit from walking away in that scenario. It doesn’t really help your name in the entrepreneurial community. Even though in this case there are mitigating circumstances, there’s usually enough inertia to get those through.

Public equity market is down about 30%. That is often not going to be reflected in that founder’s valuation. And the reason is as simple as anchoring bias. They went out to market a month and a half ago, maybe they already got a lead or they got their first few investors and they did it at a certain price. It’s gonna be very difficult for them to walk back down to a lower valuation, or potentially even a smaller raise.

So what we’re seeing more in the community is that VCs just have no interest in engaging in any company that they were talking to more than a month ago. So that is unfortunately the bottom of choice for asset allocation for VCs. Slightly above them are new companies that are coming to market now. Because, if you’re a company coming to market now, you don’t have that anchoring. You are coming in, you know that everybody is scared, you know that there’s this flight to cash out there. So you’re coming in with realistic expectations around how much you’re going to be able to raise and at what valuation and those are the ones that are much more appealing for a VC because they don’t have to have a lot of emotional inertia, emotional legacy, thinking whatever you want to call it, to overcome to get to terms that are reasonable in the current environment.

 

Kenny Estes joined the industry as a high frequency trader for nearly a decade. He started as an operator in several startups up until before they transitioned into public companies. In 2016, he co-founded venture capital firm West New Ventures, which he still sits on the board with to this day, on top of serving as CEO of Diffuse.

The COVID-19 crisis has impacted most companies across the globe. If your organization is in distress, we’re here to help. Or if you’re keen to invest in sound teams that are reeling from the pandemic’s economic fallout, please reach out to us at [email protected].