Which Business Models Do VCs Invest In During Economic Crises?
We’ve all heard that Airbnb, Groupon, and Uber became successes in the wake of the Great Crisis of 2008. Which startups are favored by VCs now, and why?
Experienced investors will tell you that the best deals are made during economic crises. It stands to reason: lame ducks go bankrupt, valuations go down, and exceptional Founders are tested. Only the strong survive, removing many items from the due diligence checklist.
How about the business models? What are the differences between a counter-cyclical and a resilient one? What are the common characteristics these babies born during economic crises share?
We’ve conducted an in-depth analysis of the deals closed recently and compared to data from past crises.
Why Crises Are Good For (Investors’) Business
One of the most shared aphorisms in business says: “Buy low and sell high.”
Economic crises tend to occur every seven to ten years. It is also the average time an early-stage VC firm holds shares in startups. It makes sense, therefore, for investors to go on a shopping spree early into the crisis (buy low), to be able to exit at the height of the next bubble (sell high.)
Let’s pick an example from the last crisis. The list of companies to choose from is quite long.
Take a startup that defied the odds and became a market leader during a time of crisis: Airbnb.
Right Time Right Place
Airbnb was founded in August 2008, just a month before the collapse of Lehman Brothers, which sparked the Great Crisis. (Financial markets had been in turmoil since the year before, but the Lehman crash sent world economies in a downward spiral.)
The story of Airbnb is part of StartupLand lore: how they got into Y Combinator, how Paul Graham couldn’t convince Union Square Ventures’ Fred Wilson to invest, how Sequoia put the money instead.
How much equity that $600,000 seed round bought Sequoia is not clear, and later fundings undoubtedly diluted it. Still, it must be around 5% to 10% today, given how elite VC firms like Sequoia operate.
Airbnb is currently valued between $18 billion and $31 billion (give or take the health crisis, which will subside over time). Whatever the final numbers are, the initial Sequoia stake is probably now worth north of $1 billion, more than 2,000x the amount of the initial check.
The Darling of Crisis Times
All the rags-to-riches startup stories ring similar, but what makes Airbnb special and investors notice, is that it captured the Zeitgeist of a time in which people were willing to share stuff and pay less. Airbnb is a pillar of the so-called Sharing Economy that sprung up in the context of the 2008 Crisis.
People losing jobs were relieved to find a way to make money at a minimal extra cost by renting out their apartments for short-term stays. Those who wanted to travel could minimize their accommodation budgets and benefit from residents’ tips to go around town.
As we will further analyze in this post, Airbnb’s business model is a typical counter-cyclical one, which explains its success.
In 2008 we were raising $150,000 at a $1.5M valuation. Here’s the response. Think of this next time you’re rejected. https://t.co/wZEnQSn0Eq— Brian Chesky (@bchesky) July 12, 2015
Note that Airbnb’s Seed Round investment was announced in April 2009. Given how these deals work, it is safe to assume that Sequoia was looking at the opportunity in late 2008, mere weeks after Lehman’s collapse.
As the tweet posted above suggest, Airbnb’s Founders had been on the fundraising road since the summer of 2008.
Fast forward to 2020.
Investors know good opportunities will come around now that six months have passed since the Coronavirus crisis outbreak, and its first economic consequences are being felt. Many fledgling startups have gone bankrupt, and VCs have ample material to gauge a founding team’s quality by analyzing their last semester’s behavior.
What Are VCs Investing In Right Now?
We thought we’d start with the data.
We went to our favorite VC database, Crunchbase Pro, and pulled all the deals announced in the US since September 1st, 2020, then filtered them for stage (Pre-Seed and Seed Rounds) and size (>$100,000 to exclude accelerators’ investments). We capture only deals made in the COVID era, excluding those announced since the outbreak but which had started before.
There are 131 deals for c.$360 million raised in total.
We then manually re-coded the industry those startups are in, using data from Crunchbase and the companies’ websites when necessary. Here’s the split of the number of deals (volume).
Note: the same graph ranked by money raised (value) would roughly look the same, with the Biotech/Medtech category higher as expected (11% in value vs. 7% in volume), primarily at the expense of Software (41% in value.)
Unsurprisingly, Software represents the largest category, as it does for Venture Capital overall. Software business models often present crisis-resilient features.
We isolated the Biotech/Medtech category because it tends to fare well regardless of the economic climate, although the health crisis may have favored it recently.
Consumer Deals Aplenty
The Consumer category is dominated by startups operating in the financial sector. The largest raise in that category was done by Collective, a startup helping self-employed entrepreneurs to manage their tax and accounting declarations. As more and more people will find themselves out of a job, it makes sense to back startups targeting those who will set up their own business.
The other Consumer sub-category that’s high in VC firms’ lists at the moment is Leisure, primarily sports. Flick and Buzzer both raised north of $4 million to develop their apps helping sports influencers connect with their followers or fans get live event information. There are not many live events going on due to the health crisis, but we observe this trend in many countries worldwide.
VCs are piling in on value propositions that seem favored by the current environment, whether economic or social-related. More on that below.
Resilient Or Counter-Cyclical Business Models Are Top Of The List
We described in a previous post what resilient and counter-cyclical business models are (see point #8 in our guide on how to manage cash).
In a nutshell, resilient business models resist the crisis, while counter-cyclical ones thrive in dire economic environments.
Software is a typical resilient category provided the startup’s offer presents a few features:
- High proportion of annual payments vs. monthly ones. Although most startups now reimburse their clients on a pro-rata temporis basis, clients who already paid for a year tend to let that subscription go to its time limit;
- Low subscription amount for the client base. This one stands to reason: if the software license costs a few dozens of dollars per month and the startup targets companies with sales over $10 million, the likelihood of cancellation is low;
- High switching costs. Startups licensing out software integral to their clients’ success, or which is highly integrated into their systems, will be hard to replace. The risks may be too significant compared to the cost of letting it run.
With that in mind, let’s look at a couple of software deals in our database.
Roam Raises $9 Million
The largest transaction in the Software category belongs to Roam, a startup offering an online note-taking tool to researchers and executives collaborating online.
Roam presents some of the resilient features we mentioned earlier.
Not only does Roam incentivize its clients to pay annually in advance, offering an 8% discount if they do. They also have a Believer scheme for five years, which saves customers -45% on the list price, equivalent to paying $8 per month.
If you’re a researcher or an executive, whom Roam targets, those $8 a month become difficult to cut down, especially when all your notes are in the app. The switching cost is high.
Another characteristic that may have helped Roam raise so much money at such a high reported valuation is its product’s counter-cyclical nature.
In a post-COVID era, working remote and sharing ideas with teams will most probably accelerate. Roam’s seed round investors certainly bet for that trend lasting in the long run.
MacroMeta raises $7 Million
MacroMeta realized the second-highest fundraising in the Software category. It offers a programmable edge cloud platform to help its clients run event-driven applications anywhere in the world.
As any developer of such apps will tell you, this is not the kind of service you change overnight. Again, the switching cost is high.
Besides, MacroMeta possesses another advantage for VCs looking for potential winners during a crisis: its cost-efficiency. The company claims it can deploy its solution “while reducing cloud costs by 70% or more.”
This is counter-cyclicality at its best.
The Main Features of Counter-Cyclical Business Models
The main question Venture Capitalists ask when they analyze the counter-cyclicality of a business model is: how will this startup benefit from the current economic environment?
The counter-cyclical nature of a product or solution can express itself in several ways:
- Increase productivity. Any startup helping its clients produce more output with the same amount of input, or produce the same output with less input, will gain from a crisis environment. Companies are typically looking for an optimal husbanding of resources and will consider new ways of achieving that goal;
- Save costs. Somewhat linked to the previous point, cost-saving solutions will also soar during crises. Think Airbnb for accommodation, or Zoom for corporate traveling;
- Adapt to changing times. It has been repeated ad nauseam, but the two Chinese ideograms for the word crisis are “Risk” and “Opportunity”. Things change during troubled times, as people revisit the way they do things. There is room for creative startups helping customers shift and adapt. The Sharing Economy is the best recent example.
Let’s illustrate this point with a couple of startups in our database.
Conjure Raises $4 Million
Moving into a new home is costly at many levels, one being the need to buy furniture. Conjure helps spread that cost over time thanks to a three- to twelve-month lease. They also claim that their customers will pay, on average, half of the retail value of their furniture over the time of the lease.
Once the lease ends, you can either buy out the pieces of furniture at their residual value or start a new lease with a new set.
OnePointOne Raises $12 Million
OnePointOne devised a new way to produce organic food in cities. Their website describes the solution as follows (highlighting is ours):
“Our solution is significantly more efficient, high-tech and flexible than existing farming systems. Using artificial intelligence, LED lighting, high-pressure nutrient spray and a controlled atmospheric environment, our automated facilities have the ability to deliver perfect produce in any location – with far fewer resources than traditional or other indoor farms.”
Not only does OnePointOne provide a solution to a long-term issue that will attract some VCs, but it also has short-term productivity advantages.
Startups with counter-cyclical offers also help their clients increase their sales and distribution (more output.)
Or they cater to the current needs of a whole new category of the population, as Zoom did. The video conferencing company has benefitted from lockdowns worldwide (health crisis) and the corporates’ need to reduce costs, including travel expenses (economic crises.)
Ditto for home-delivery services, which are sought after to reduce the risk of virus infection. When they also save costs and the planet, these startups become attractive to VCs. ZeroGrocery, which raised $3 million, is the perfect illustration.
VCs try to assess how temporary those bets are. Experienced VCs are unlikely to invest in a startup that will benefit from a cycle for just a couple of years, as they will not be able to exit at a high price over a five- to seven-year horizon.
One More (Unexpected) Category VCs Like
Our database of 131 pre-seed and seed deals announced since September 1st points out to another category that VCs like during crises: anything that will help people no think about the troubled times or help them cope with it on a personal level.
We’ve already mentioned sports-related apps Flick and Buzzer, which both raised north of $4 million. Many more services are offered to disconnect users from the grim realities (health & economic crises combo) we’re living in.
Gaming startups such as Artie, which raised $3.6 million and doesn’t even have a running website yet post-reboot, are getting second looks given the surge in video gaming spending that has occurred worldwide since lockdowns started in most countries.
Startups helping people deal with the physiological and psychological impacts of crises have also caught investors’ eyes. DirX (raised $5 million pre-launch) and Silk+Sonder (raised $3.6 million) have very different services, but both address a need that is no doubt being felt more pressing.
Silk+Sonder leverages positive psychology and self-help books to help users boost emotional health and achieve mental wellness.
What You Can Do If You Want To Raise VC Money, Too
Strictly speaking, the term “business model” refers to how a company makes money, such as subscription, freemium, licensing, and advertisement-based.
In this post, we expanded the definition to incorporate the characteristics VCs were looking for in startups’ offers at the moment.
Having a resilient or counter-cyclical value proposition will be favored by investors for the next twelve to twenty-four months, at least. As established above, experienced VCs are on the lookout for promising investment opportunities because they know the best deals are made at the beginning of economic crises.
We routinely tell Founders investors don’t decide what they should do, which companies they should start, or how they should grow them. But if you’re looking for VC money, you need to analyze your offer and business model and present it in a frame that investors recognize – and value.
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