Startups need government funding - now

High-growth startups are amazing creatures. They can be enormously successful and change the way we live. YouTube, WhatsApp, Uber, Airbnb: it’s already difficult to imagine life before them. But in their early days, startups are the most fragile of enterprises – money-losing machines for a while, sometimes a long while.

Governments around the world are announcing measures to support SMEs. But what does that mean for startups? Are they even eligible for SME funding? If they are, will the money be enough, and will it arrive too late to save them?

We are living in tough times, even for those of us who have lived through periods of crisis before. The coronavirus challenge is unique and ubiquitous. It touches almost every sector, everywhere, and is accompanied by the human tragedy of thousands of deaths each day. These are people we know, in our countries and our cities. It really does feel like wartime.

The effect on the economy is still to be counted. There are so many unknowns; in particular, we don’t know how long this is going to last. Many businesses have closed temporarily and unemployment is rising daily.

Governments in Europe and North America are taking exceptional measures to support SMEs, which are the foundations of our economies. But among SMEs one specific group of companies is the weakest of all: a group that is fundamental for economic growth, for driving progress through innovation or job creation: the startups. They need urgent financing, but in most cases they will see none of the funds that governments will deploy in the coming months.

By definition, a startup is a company that is still losing money. A startup might have a number of customers and earn some income, but not enough to cover expenses. At this stage it needs to grow fast, and will remain a startup until it reaches breakeven. Those at the ‘seed’ stage will have no revenue at all; they are still developing their prototype, working on a new technology that will help cure a disease, and have yet to reach the first customer. In either case, some or all of a company’s expenses and investments will need to be covered by external sources of financing.

Amazon, founded in 1994 to sell books online, lost money for a full decade. Google launched in 1998 and was fortunate to have raised enough money in 2000 to survive the dot.com crisis. Startups that raised capital in 2019 may well be able to adjust their expenses quickly, manage cash, and with a little luck still be in business after the storm is over.

The real problem is for all those startups that were looking for more funding in early to mid-2020. They were planning to secure additional financing in the coming months as their existing funds were insufficient to carry them through the next six months. What happens to a company in seed or startup stage if it fails to find the additional financing it requires?

Sadly, the moment the cash runs out, it’s ‘game over’ – and not just for the company: for the people working in it, for the innovation being developed, for the existing and future customers who would benefit from its product or service, for the communities where the startup is based.

Where business angels tread

What were the sources of finance that these startups were relying on just a month ago? Have they simply disappeared? Will they reappear as soon as we see the light at the end of the tunnel? Startups rely on equity financing, since they do not have what banks look for when offering a loan: profits and fixed assets. Two of the main sources of equity financing for high-growth startups are business angels and venture capital.

Business angels are private individuals who invest in early-stage ventures. They invest at seed stage or even earlier, sometimes when the company is still trying to define what it is going to do. The amounts are small but there are many business angels around and they are known to invest in groups or syndicates. Nobody really knows the total volume of angel investment. Estimates only take into account those investments that were officially accounted for, but these are only the tip of the iceberg. In different studies, the total value of investment by angels is estimated to be around three times that of venture capital.

So how do these private investors, wealthy individuals with a passion for startups and a willingness to take high risks, react in times of crisis? We might get a sense if we observe their behaviour in previous crises. During 2001, when the dotcom bubble burst, information about business angels was very limited. There were fewer of them, and most of them operated in the US. They continued organising investors’ forums to which they invited startups looking for funding. They still invested in early-stage ventures, and most of them were looking at newly created startups that were aiming to solve problems generated by the crisis.

The years 2009-2012, following the financial crisis of 2008, present a very different picture. The period saw incredible growth in the number of business angels, especially in Europe. Wealthy individuals did not know where to invest their money: stock markets had collapsed, the real estate market was full of toxic assets (many investors were already overexposed to real estate), and the traditionally safe market in government bonds was super risky, with countries from Argentina to the European ‘Pigs’ (Portugal, Italy, Greece and Spain) teetering on the edge of bankruptcy.

Investing in early-stage startups in times of crisis is actually a very attractive option for a business angel, for several reasons. First, valuations are very low. The forecast is negative and financial plans are reasonable. Even optimistic-by-design entrepreneurs do not see the world in bright colours during a downturn. Second, good teams are ready to work hard: this is their chance, and there are not many other jobs in the marketplace. Top-class professionals who in boom periods would be earning huge salaries in big multinationals are unemployed, and this might be their one opportunity.

Third, founders really value cash. In good times, money is a commodity that is readily available, and many entrepreneurs go crazy about spending it, trying to grow as fast as possible without thinking about becoming profitable any time soon. But in times of crisis, cash is king. Founders treasure the money they have, investing it very carefully.

Fourth, as a business angel, you can get involved and have a say in the evolution of the startup. If you invest in other types of assets – investment funds, individual publicly listed stocks or government bonds, to list a few – there is not much that you can do, apart from selling. And normally this happens when it is already too late. In a new company, the angel can play an active role and participate in strategic decisions to shape the future of the company.

While there are reasons to be optimistic about business angels, this has to be tempered by a recognition that their activity will decline initially: many angels need to focus on their own businesses (many are business owners themselves) and on their current portfolio companies (the startups they have already invested in). Additionally, it is important to remember that business angels tend to invest in new ventures, the ones that will start during the crisis, and this may leave existing startups – those already in the market – exposed when they seek further funds.

A very Darwinian market

In the case of venture capital, the total amount invested has dropped each time there has been a crisis. There are two main drivers for this. The first is that many of the new “venture capitalists” that arrive in booming markets are not really venture capitalists at all. Many investors looking at the allure of high-growth startups decide they would like to be venture capitalists: it sounds fun and easy. The result is that in boom times, even bad venture capital teams are able to raise funds from institutional investors.

Just go back a few months to 2019. There was so much money in the economy that investors hardly knew what to do with it. Investing in “good” venture capitalists is not easy, there is a long waiting list (yes, really).

Venture capital funds have a scale that relates to their investment strategy. If a fund is planning to invest €10 million in 10 startups, the size of the fund including fees and expenses might be around €120 million (with €20 million for fees). If there is a lot of liquidity available, the partners in the fund may raise €200 million and be able to scale up their investment strategy accordingly. But they cannot raise €800 million, because that would mean they need to invest in 70 startups instead of 10 (I am assuming they take a healthy €100 million for fees). They would have to find these young companies, analyse them, negotiate a deal with each one, and, if they invest, sit on their boards of directors and monitor their various evolutions. Seventy startups simply will not work.

What happens in boom markets? Everyone becomes a venture capitalist. It is easy to raise a fund and begin investing in startups... until the music stops. Why? Because some of the ‘new’ venture capitalists, those who don’t really understand startups, are in the market because it is trendy, even glamorous. They end up investing in companies that the ‘old’ venture capitalists bypass, because they are bad companies. Worse still, they invest at higher valuations, because competition is tough when everyone has money to invest in startups.

This translates into bad deals for the new VCs – very expensive ones. And when the crisis arrives, most of these newcomers disappear because most of the companies they have invested in fail. They won’t be able to raise a new fund in the future because their track record is a complete disaster. Venture capital is, indeed, a very Darwinian market.

The second effect of the crisis is that valuations go down. This is partly due to negative expectations, as we have already seen. In addition, because fewer venture capital investors are chasing deals, there is less pressure in valuation – the “new” VC investors have disappeared, and these were the ones who were fuelling inflated valuations. The sum of these two effects is that less venture capital funding is invested: the number of startups receiving VC financing in most recessions has gone down as well as the average amount invested per startup.

So what is happening right now in the European venture capital market? In the couple of weeks since mid-March, when the situation due to COVID-19 in Europe started to become critical with lockdowns across the continent, the news was mixed. Some venture capitalists who were about to inject startup funds through a new financing round kept their word, reasoning that the crisis is not the startup’s fault. Some delayed the round. And some decided to profit from the situation by forcing valuations down, making the conditions of the investment worse for the entrepreneurs involved. It is sad to see this happening, but one good thing about the venture capital market is that it is small. Everyone knows everyone else. And small is beautiful.

Top venture capitalists contacted since the crisis started say they are now focusing 100% on their portfolio companies. Many of these companies are fundraising, looking for financing to maintain their growth, and now it is going to be difficult to secure additional funds for months or perhaps even years to come. The VCs need to help the startups they are already invested in as they review their financial plans. The goal is to make sure they have enough cash for the next year or 18 months.

The future is uncertain and to count on a new financing round now is to be naive. Surviving is all that matters. But surviving in these circumstances when you are still losing money is fraught with difficulty.

Help is needed now

Accelerators, incubators, grants, research money and even corporate venture capital funds all provide alternative sources of finance to startups in their early years. So what happens to these sources during a crisis? Their own funding disappears, since most of it comes from sponsors, corporations or public finances.

In the case of the coronavirus crisis, money from various sources is available for startups that focus on providing solutions to the current problem – new possibilities for testing for COVID-19, vaccinating against it or treating and curing those infected. But startups away from this area of healthcare will find the investment climate challenging.

This is why it is now so important to make sure that speedy government financing is not confined to traditional SMEs. If the conditions for accessing money are based on a strong balance sheet and income statement, then most startups will die. This would make the already critical situation of the economy even worse, as we would be losing many of the jobs and innovations that will be necessary for economic recovery. Startups are the baby of the family, they need help and quickly.

What can be done? The solution has two components.

First, we need government funding for startups. It has to be clear that companies that are still losing money and lack strong tangible assets (or that cannot guarantee a loan) can access the lines of financing that are being approved by most countries in Europe and the US.

Second, the money needs to arrive quickly to the startups. If the process of funding goes through traditional financial institutions that do not understand the financing of startups, it is going to take too long. It is going to be too late. The money has to be deployed using the same entities that understand new ventures, their financial needs and their financial plans (including their losses).

Government funding to support startups during the coronavirus crisis should be funnelled through venture capital funds, accelerators and even business angels. They know the startups already, and will be able to act fast. This is an emergency. Banks are not well equipped to analyse startups and they will be busy looking after SMEs – and there is no time to waste.

The instrument used by governments to deploy the funding can be debt, such as convertible notes, which will give the government the option to convert if the startup increases in value at some stage in the future. So there is potential to get a good return on the money invested. Yes, some of the startups might end up failing, even with additional funding. That is the way it is: the failure rate among startups is high even when financing is readily available.

Some technologies are not as promising as thought. Customers might not adopt an innovation. But others will become the next Google, Skype, Revolut, or the healthcare startup that will find the cure for COVID-19.

In venture capital, a single good investment can be enough to return all the money invested in 10 companies with a healthy profit. The government may well get its money back – and it will help change and improve our lives.

Like the protagonists of Love in the Time of Cholera, by Nobel laureate Gabriel Garcia Marquez, high-growth innovative startups need help now: “Life would still present them with other mortal trials, of course, but that no longer mattered: they were on the other shore.”

Update: On Monday 20th April, the UK Government has announced the allocation of £250 million for high growth startups. ‘Future Fund’ will use convertible notes and will co-invest with other private investors such as business angels and venture capitalists. Find out more

Luisa Alemany is Associate Professor of Management Practice in Strategy and Entrepreneurship and Academic Director of the Institute of Innovation and Entrepreneurship at London Business School, and a leading authority on entrepreneurial finance.