The Impact of COVID-19 on Start-ups
Startups had become an important part of the modern economic system. Most of the companies which have achieved billion-dollar valuations in the past few years have come out of the startup ecosystem. Companies like Uber, Twitter, Facebook, and Airbnb are testimony to this fact. The startup system has often been viewed as a risky place. However, investors were willing to take risks in lieu of the high returns earned by investing in start-ups.
However, that was all happening in a time when the economy was booming. The past month has completely changed that. The world economy suddenly finds itself in the greatest recession since 1929. The speed at which the present scenario has changed has left investors gasping for breath. Many venture capitalists and private equity firms have already started tightening the leash on companies in which they have invested money.
The startup ecosystem has been severely impacted by the coronavirus crisis. This is because the cash position of the investors, as well as their confidence level, are about to take a major hit. These details have been explained in this article.
Cash Burn: For the past several years, investors have not hesitated while investing in companies that have a negative cash flow. For instance, companies such as Facebook and Twitter had negative cash flows for a very long period of time. Similarly, companies such as Uber and Lyft still have negative cash flows. However, all of these companies have seen generous valuations from the investor community. Basically, investors were looking forward to investing in a ground-breaking idea even if that meant losing cash for some time.
However, these investment strategies worked at a time when cash was available in plenty. Hence, even if an investor wanted to cash out of a company experiencing negative cash flows, they were able to do so. This is unlikely to continue in the future. This is because if the World Bank and IMF predictions are to be believed, the world may be looking at a major cash flow shortage in the near future, and private equity investors may not continue with their generosity.
Delayed Exits: Venture capital and private equity investors were willing to invest large sums of money in companies with negative cash flows since they had an exit plan. They could either exit by selling their stake to other investors, or they could exit with the help of a public listing. The stock markets have been at their peak in the past few years. This meant that whenever a company such as Uber or Groupon tried to list their shares, they would receive a hefty premium. This meant that the underlying investors who bought a stake in the company when it was at the nascent stage made a lot of money by selling to an investor on the exchange. Right now, the global stock exchanges are in turmoil. Many of these markets have lost close to 40% of their market capitalization within the past month. Also, if experts are to be believed, this lull in the stock market may continue for a while. As a result, private equity and venture capital firms who had planned to exit companies via the public issue route will have to wait longer. They will either have to accept lower valuations or will have to wait longer till the market regains confidence.
Downrounds: The inability of investors to exit previous investments is likely to hit start-ups hard. Since they are no longer able to exit, their money would be locked in. As a result, there will be less money to offer in future valuation rounds. Many investors are expected to skip making any further investments. Even if they do make an investment, the valuations are likely to be much lower than what they received in the past. In startup parlance, this is known as a downround. Up until now, it was frowned upon and viewed as a sign of failure. However, going forward, it may be viewed as a regular occurrence.
Gig Economy: Many start-ups that have come up in the recent past have relied upon the idea of a gig economy. This meant that the companies would not keep any workers on their payrolls. Instead, they would simply hire subcontractors. The benefit was that companies did not have to provide the workers with mandatory retirement benefits and health insurance. Up until now, workers were willing to work on these terms. However, gig workers have been the hardest hit during the COVID-19. These workers have found out that they have no safety net to fall back upon when the going gets bad. Hence, they are unlikely to continue working on the same terms. Startups may have to sweeten the deal and provide more benefits to their workers in case they want to retain them.
Less Demand: Lastly, many sectors of the economy, such as aviation, retail, and travel and tourism, are going to be shut down for a while. Even fintech is likely to face a slowdown for some time. Therefore, if a startup functions in any one of the above-mentioned domains or services other start-ups which work in these domains, it is likely to witness muted demand for some time. Not only will there be less demand, but there is also a possibility that some of the old bills may not be honored. Hence, cash flow problems are also likely to arise.
The bottom line is that start-ups will see a lot less funding flowing towards them. The old start-ups will not work in the post coronavirus era. Going forward, start-ups will have to become leaner and more resilient.
Authorship/Referencing - About the Author(s)
The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.