I recently wrote a blog post, where we mentioned the COVID-19 pandemic (which, of course, was not a pandemic back then) as a macro threat that may disrupt the venture and startup ecosystem. Unfortunately, it has become painfully clear, that we were right to a degree we could not imagine. 

However, it’s good to keep in mind that the financial crisis triggered by COVID-19 is by no means unique. We’ve passed through similar kinds of situations before. 

Expect to learn:

• What did the 2000 Dotcom Crash and the 2008 Credit Crunch affect Venture Capital?
• How did the situation differ between Europe and the US?
• How was Nexit Ventures able to keep their head above the water during each recession?
• What should be done to avoid the death of Venture Capital, startups and innovation during the COVID-19 crisis?

US VC funding from 1997 to 2019 (PWC MoneyTree)

Tale of Two Crises

Nexit Ventures, one of the oldest VC companies in Finland, has fought through two major financial crises: the Dotcom Crash in 2000 and the Credit Crunch in 2008.

While these crises were quite different in nature, they shared many common features. All stock markets came crashing down, and the valuations of venture capital funded companies went down accordingly. As a result of the public market crash, the exit market for startups and VCs came to a stop. The investors behind VC funds (i.e., Limited Partners, LPs) slammed their foot on the brake, and fundraising for new VC funds dried up in an instant. The Corporate Venture Capital activity dropped to a fraction of the level prior to the crisis. Furthermore, VC funds concentrated mainly on follow-on funding their existing portfolio companies to protect their investments. 

All in all, there was a significant shortage of VC money – and the minimal funding still available became extremely expensive. 

The two crises differed in a significant way, though: The challenges of the year 2000 continued for a long time, all the way until early 2003 in the US, and even longer in most of Europe. However in 2008, most of the problems were over relatively quickly, limiting the level of destruction substantially – at least in the US.  For Europe, the prolonged euro debt crisis made VC funding ramp up relatively slow in most of the countries creating many unnecessary startup corpses. 

The Year 2000 Crash

From 2000 to 2003, the impact of the market disturbances in the VC and startup ecosystems grew to a much larger scale. In early 2000 there was an all-time high amount of uninvested VC money around, but it soon disappeared. After the crash, many VC funds had to scale down because of a strong push from the Limited Partner, LP community, since a significant portion of the dry powder just disappeared. 

Some fund LPs even defaulted, which meant that they did not pay up their commitments when the money was called up, diminishing the amount of dry powder even further. In the Nordics, nearly all VC funds exited the market in a few years as they ran out of money. What made the situation increasingly worse for European startups, US money concentrated purely on US deals and escaped totally from the European market.

If an entrepreneur was somehow able to raise additional capital in the midst of the crisis, it meant drastic dilution. First of all, a rock bottom valuation (at least -50% down round) topped with 2X liquidation preference was a very regular occurrence – even up to 4 to 6X liquidation preferences were often seen. Alternatively, companies were blatantly recapitalized by new “whitewash” funding rounds where old shares and loans lost practically all value, and accordingly, the old shareholders were wiped out. Some key management team members were usually compensated with new options so that they would be incentivized to stay on board.

For the vast majority of entrepreneurs and their VC funded companies, there was simply no way forward. So, vast amounts of entrepreneurial and VC investments in innovation and growth were destroyed.

The European view of Dotcom Crash

In 2000, the European VC and startup ecosystem was still very young, thin, and immature. Unlike in the US, the Europeans lacked the steady flow of entrepreneurial VC success stories from the ’80s and ’90s.

After the bubble burst, it took much faith from Europeans to follow the very distant Silicon Valley entrepreneurial role models. In reality, thousands of European entrepreneurs lost their faith in startups, and VC funding for good – a lost generation of entrepreneurial power was generated.

Unlike in the US, the Europeans lacked the steady flow of entrepreneurial VC success stories from the ’80s and ’90s.
(Dow Jones Venture Source)

Nexit’s Approach

During the year 2000 crisis, Nexit took the following approach: We formed a picture (a brutally realistic one) of the portfolio funding needs and exit potential in different scenarios. We calculated the ratio of our full financing responsibility against our remaining capital (in practice, many syndication partners had to drop out, and our responsibility grew). We reacted early and decisively by dividing our portfolio into three groups:

1. 1. Ones that should not be funded further
   2. The ones we could support a little – to help them fight their way to positive cash flow and to somehow survive while waiting for better times
   3. The most potential ones that we could and should still seriously fund

The results were the following: One-third of the portfolio had a successful ending, and we got some very good exits, mainly in the US market. Acquirers included companies like Nvidia, HP, Google and Sybase. One-third of the portfolio eked out a living for a few years. About 50% of these companies finally went down, and the other half managed to find a decent exit. One-third of the portfolio went relatively quickly bankrupt as their funding dried out

The most unfortunate thing for Nexit was that the fund size was reduced by one third, and we lost half of our remaining dry powder. With the new smaller fund, Nexit could not fully defend its position in some high growth companies that required a lot of further funding. Two Nexit investments, in particular, were painfully diluted: Mobile365 (which Sybase acquired for $425M) and Bitfone (which HP acquired for $155M). Regardless of this, Nexit became a positive exception in the year 2000 VC fund vintage and returned a significant share of the capital to its investors.

What Is the Endgame?

It is still too early to say how the COVID-19 crisis will play out: will we hit a prolonged slump á la 2000 or worse, or will the ecosystem recover relatively fast like in the US after 2008? Both previous crises were L-shaped in the European venture ecosystem while U-shaped or even V-shaped in the US. 

We know that the US economy is just much more agile than European economies in general – for many cultural, legislative, and political reasons. It is not just a VC specific phenomenon. The European venture ecosystem today is also much more developed than it was in 2000 or 2008, and there is a lot of dry powder, i.e., available capital, out there. While some permanent changes will remain for sure, I’m hoping this might be a quick shock as the liquidity programs by the different governments are helping in keeping the innovation ecosystem running. 

Industries like SaaS business models, especially when combined with mobile-first, and cloud infrastructures, which were not very common 20 years ago, might prove to be more resilient in crises. In turn, digital advertising budgets are being steeply cut. Overall the crises will boost a few companies that are able to thrive through this different operating environment, but many will find extreme scarcity in customer budgets and available funding. The need for digital transformation is significantly amplified in these crises, and AI will likely be the technology to turn to in search of efficiencies.

The critical question still remains: how LPs, VC funds, companies, and government policymakers should work together to make this a short disturbance and avoid the 2000-2003 type of total nuclear winter killing the VC & startup ecosystem?

We are anxious about the potential adverse outcomes. We fear the loss of entrepreneurial spirit and serial entrepreneurs – the engine for new economic growth and innovation. We also think this could be a serious setback in VC funding volumes – the fuel for the engine. 

The business opportunities and exciting new technologies are still there: digital transformation, cloud collaboration, machine learning, artificial intelligence to name a few. It is up to us all to be wise and decisive and make this a short slump.

One last advice for startups: hope the best and prepare for the worst, think hard, and move fast. If you can raise funding or grow your margins, try to do that asap. 

Nexit is taking part in relevant discussions and studying related initiatives to be an active part of the rapid startup and VC ecosystem recovery. Be in touch with us if you want to discuss this further.

Stay safe!

Markku Mäkeläinen has founded, launched, and advised numerous high-growth technology companies focusing on disruptive business and global scaling. Before appointed as Nexit Ventures’s General Partner, he worked as director, partnership solutions, and operations director at Facebook.