The Coronavirus Investment Environment
Coronavirus (COVID-19) has ushered in a time of uncertainty. The novel virus has upended many people’s lives, as the world stays home to slow its spread. COVID-19 has caused workers to lose their jobs, small and large businesses to close their doors, and a capital flight to safe havens. The economic fallout increases as the world reckons with the severity of the virus.
As a result, public and private markets are contending with a drastically different investment environment. Unemployment has risen, consumer confidence has rapidly fallen, and monthly housing starts have precipitously declined. In response, the U.S. government passed a two trillion dollar economic relief package. As economic realities change, investors will need to adjust their investment strategy from pre-downturn to post-downturn.
This article will cover the fundamental factors investors should analyze prior to investing in private companies in this new investment environment.
The world is in a post-coronavirus investment environment. The virus will likely cause a structural shift in the economy – possibly arising from stay at home orders and how consumers and businesses manage work from home. This shift can be seen in the stock market, which has entered bear territory, and the economy, which has largely halted. Investors should recognize the following prior to making investments:
- It is still early, and as a result, there are many unknowns, increasing the risk for many investments. Many private companies will likely announce drops in revenue, spending cuts, layoffs, and emergency financing.
- Unfortunately, coronavirus will likely cause some startups to shut down. In downturns, revenue will drop more quickly than expenses, which may cause some startups to run out of cash. If emergency funding cannot be secured, these companies will enter bankruptcy or sold for pennies on the dollar.
Despite these unfortunate times, investment opportunities still exist. In down markets, the riskiness of investments increases, because the severity of the downturn is unknown. According to the risk-return tradeoff principle, as risk and uncertainty rise so does the potential return of the investment. Accordingly, investors need to internalize the risk-return tradeoff as they analyze private investments. In other words, investors who accept the higher risk (i.e., the likelihood the investment goes to zero) may be rewarded with a higher return. One way to get comfortable with the risk is to understand a company’s fundamental soundness.
Business fundamentals will determine which firms survive this down market. A fundamental analysis typically entails measuring a company’s intrinsic value by reviewing their financial statements, economic factors and consumer behavior with a short-term and long-term lens. It does not determine the value of the company based on its performance against its peers or competitors. In the private market context, though, fundamental analysis is often hampered by the lack of information, specifically regarding financial data. Nonetheless, fundamental analysis is still important for private companies.
While robust financials may not be available, a fundamental analysis can still be performed. Areas that we recommend focusing on include: 1) Total Addressable Market and Revenue Growth, 2) Operating Margins and Balance Sheet Considerations and 3) Maturity of the Business and Management Team. Additionally, these factors should be reviewed on a short-term and long-term perspective. In other words, how will coronavirus affect these factors in the next year and over the next three to five years.
Total Addressable Market and Revenue Growth
Total addressable market (TAM) is the revenue opportunity available to the company and industry. It is the most amount of revenue a company could generate if it captured the entire market by selling their products and services.
Companies cannot capture an entire market. They are typically competing with other firms, or their business has structural limits (e.g., their manufacturing facility can only produce so many products). Thus, companies typically view TAM in two subcategories: serviceable available markets (SAM) and serviceable obtainable markets (SOM). SAM is the portion of TAM a firm is targeting, and SOM is the portion of TAM that it captures.
These three metrics will help you understand the revenue opportunity for a company. In a downturn, all three metrics will change. TAM will be affected by consumer and business demand and confidence. For many industries, TAM will fall as spending is pared back. For example, coronavirus has severely affected the restaurant industry, as many were forced to close for dine-in. SAM and SOM will be affected by the competitive environment and company-specific factors.
How these factors change will translate into how much revenue a firm generates this year and in the next few years. Firms that have slower or negative growth are likely to take hits to their valuation and vice versa. On the other hand, for some firms, these metrics will increase as the new economic environment creates opportunities for them. For instance, the delivery, workplace tools and med-tech sectors have emerged as “heroes,” as they help people survive stay-at-home orders and rush to find cures to coronavirus. In a future post, we will delve deeper into which industries are outperforming in the coronavirus market conditions.
Operating Margins and Balance Sheet Considerations
In a downturn, investors should understand a startup’s financial health. Unfortunately, startups rarely disclose their financials. From press releases, interviews and news articles, investors can grasp high level financials, such as their operating margins (positive or negative) and balance sheet considerations (cash on hand and debt).
Operating margins measures how much profit (or loss) a company makes on a dollar of sales. A vast majority of startups in the past decade have operated on losses, subsidizing costs in order to fuel growth. This new economic environment, though, will require startups to change their playbook, as subsidizing costs may no longer be viable. Startups may not be able to as readily rely on fundraising every few years to cover those losses. Therefore, startups that had positive operating margins prior to coronavirus or quickly achieved profitability are more likely to survive this downturn.
Additionally, investors should recognize a startup’s cash position and debt obligations prior to investing. The more cash a startup has the longer its runway. Thus, startups that recently raised are better poised to weather this downturn. For example, Stripe, Cohesity and Via, among others, have raised mega fundraises since March, buffering their coffers and increasing their likelihood to survive coronavirus. Startups that raised a few years ago and are unprofitable may need to raise emergency funds to survive, potentially affecting their valuation.
Lastly, debt obligations can severely affect a startup’s long-term prospects. The venture industry mainly relies on equity financings, but companies may elect to raise supplementary, minority funds using debt. Thus, despite a downturn, leveraged startups will be required to pay interest on their debt. Interest payments will reduce cashflows that can be used to fuel growth and investments and cover expenses. Additionally, If the startup does not generate enough profits or runs out of cash, it risks entering bankruptcy when it misses interest payments. In bankruptcy, startups are obligated to pay off their debt first, leaving any value (if any) to preferred stockholders and then common stockholders. Thus, startups with debt are inherently riskier to common and preferred investors.
Some prominent venture debt providers include Silicon Valley Bank, Lighthouse Capital Partners, Wells Fargo and Bank of America. Investors should understand startups’ debt profile (if any) and whether the above companies have lent to them prior to investing.
Maturity of the Business and Management Team
Coronavirus may have disparate impacts on early stage startups and firms with novice management teams. Early stage startups are defined as companies that have raised up to a Series B round, have figured out a product and its market size, but are establishing a business model and are scaling. Thus, these startups are more susceptible to failing during a downturn.
As noted in the above sections, startups will have to contend with a drastically different economic environment, affecting the companies’ TAM and how they operate. Early stage startups typically invest in bolstering their product and focus on fueling growth, generating operating losses and minimal revenue. As a result, early stage startups may have to cope with slower growth and shorter cash runways.
Furthermore, startups with novice management teams may not have the experience to deal with this economic downturn. The margin for error is slimmer. In buoyant markets, startups have the luxury to use cash to experiment on new products and initiatives, because venture funding is easily accessible. In downturns, though, management teams cannot rely on fundraising, and thus, they must be certain that projects and initiatives have positive returns on investment. If a project turns out to have negative returns, management will have reduced their cash runway, moving the company closer to failing.
Additionally, management teams will need to decide where to make spending cuts, when and what funds to raise, and how to structure the balance sheet. For example, companies will need to decide if they will fire or furlough employees. Should the company raise equity or debt, and at what valuation? Are long-term contracts for potentially cheaper prices better than higher costing monthly ones? These questions have no simple answers and even the most seasoned executives will struggle with them. Thus, the strength of the management team needs to be considered prior to investing.
Coronavirus has created new economic realities for many governments, businesses and households. Start-ups will need to adapt and adjust accordingly. For some, coronavirus will create opportunities. Sadly, for others, coronavirus will be a challenge unsurmountable.
We hope the above fundamental factors give you a framework to analyze startups as you think through the secondary pre-IPO market.