Global economic crises often become extinction events for startups. The COVID-19 crisis has been no exception, and many startups across the globe remain perilously close to the edge of closing up shop. Young companies and founders remain on edge, knowing that things can change in their communities seemingly in an instant.
Policymakers should be aware that startups contribute meaningfully to both local communities and to the global startup economy as a whole. With that in mind, they should be laser focused on helping startup companies and the wider ecosystem get through the COVID-19 crisis intact.
There will of course be a time down the road where COVID-19 is no longer a threat to our health and our economy. The famous adage, “This too shall pass” comes to mind. When the threat subsides, many facets of life we’ve come to know will likely return, including in our economy.
But what if startups don’t survive the turmoil? We believe there is much to be done by government agencies and organizations in order to save startups and keep them humming along until things go back to “normal.”
Why Policymakers and Leaders Must Act Now
With so much happening around the world, it can be difficult to track the impact of COVID-19 on startups. But the data, of which we have been collecting since March through our COVID-19 impact survey, is clear — startups need help now and if policymakers don’t work to support them, the economic effects will be dire.
Startups in Serious Trouble
While big-name startups may have lots of cash on hand or have been in the press for “pivoting successfully” during the COVID-19 crisis, many startups are struggling. Global venture capital funding has dropped roughly 20% since the onset of the pandemic in December 2019, creating ripple effects throughout startup ecosystems.
According to our COVID-19 Survey, as of mid-2020, more than 40% of startups globally are in the “red zone” when it comes to cash, meaning they have 3 months or fewer of runway. Basically, if these companies do not change their cash flow situation and are unable to raise additional funds soon, they will fold. When it comes to funded startups that have raised Series A or later rounds, a third have less than 6 months worth of cash, creating a danger zone because fundraising is simply more challenging now.
Startups Can Improve the Economic Recovery
Policymakers may wonder if it’s OK to not intervene at all and let these startups in the red zone perish, following the theory of letting the strong companies survive and letting the weak business fall off. While this may be attractive in some circles, it’s a short-sided gambit that underestimates the value of startups and threatens the future.
For many years, startup ecosystems around the globe have proven to drive productivity. This is because startups not only are a good engine for jobs, but without startups, there’s less innovation at larger corporations and at small- and medium- sized businesses (SMBs) as well. Startups also play a role in pushing the public sector forward by providing huge efficiency gains in governmental organizations and public services, and by helping establish competitive regulatory environments.
Many governments have already assisted in the creation of knowledge economies, so in many ways they also need to protect existing ecosystems in which they’ve already invested. Governments must act now to help startups affected by COVID-19, and they have good reason for saving jobs and businesses.
As we argued in our recent white paper, governments actually stand to make money by injecting at least 6 months worth of cash into technology startups. Even with a negative 10% return on equity, the cost per job saved is 41% lower for startups than for SMBs, respectively costing $14,766 or $24,928 per job saved. It simply costs less to save a job in a startup than elsewhere.
Technology startups offer a higher job multiplier because they often pay high wages, they export more frequently, and attract foreign direct investment (FDI) from international investors. Startup jobs are also more “future-proof” as the economy transitions to more digital services, as people working these jobs will have more in-demand skills down the road.
Startup Ecosystem Size Matters for Growth
Outside of protecting startups, what other incentives do policymakers have to protect the innovation ecosystems impacted by COVID-19? As academic Michael Porter has postulated for traditional industries and Startup Genome has demonstrated for startup ecosystems, the size of an industry cluster greatly matters for its overall performance. Because of network effects, the economic impact of each additional startup grows as the ecosystem grows. As Startup Genome research shows, the larger the ecosystem, the higher the performance and average value of each startup.
For instance, in an ecosystem with 1,000 startups (approximately the size of the Montreal ecosystem), each startup adds on average $5.1 million in economic value while at 2,000 startups, each startup adds an average of $6.9 million. For 3,000 startups, the figure hits $8.7 million per company, and at 4,000 startups (approximately the size of the Boston ecosystem), value per startup jumps to $10.6 million on average. Another way to look at this: an ecosystem that is three times larger (1,000 vs. 3,000 startups) produces five times more economic value. And indeed the opposite applies. Reducing the number of startups would slash the value of an ecosystem exponentially.
As such, preserving the number of startups in an ecosystem helps protect overall economic value. Policymakers should never forget this.
Startups Help Post-Crisis Economies Remain Competitive
Global crises always accelerate the adoption curve of new technologies. COVID-19 has wildly increased adoption of relatively young companies such as Zoom, Slack, and Shopify. All three were startups not long ago that went public and now they play an important role in keeping companies connected and relevant in the age of COVID-19.
Startups provide competition to entrenched players in virtually every industry. Without startups, technology, finance, healthcare, and other fields would be stagnant. Who wants to live in a world where the banking system is only dominated by only a few players and businesses and consumers don’t have ample choice of how they manage their money?
And when startups do bloom and become important industry players, that adds more prestige and value to the ecosystem in which it operates. What would Seattle’s startup ecosystem be like if Microsoft and Amazon were founded in different cities?
Learning from the 2008 Economic Crisis
If policymakers are still skeptical about why they should invest in startups affected by COVID-19, then they should look at the 2008 economic crisis and the following recession to further understand its importance.
Startups funded during recessions, including those 2008, fare better than funded during normal times, on average. For example, several successful gig economy startups were funded during that time and have later grown into large entities, including Uber, which had its seed round in 2008 and its Series A funding in 2011.
Additionally, startups are better structured to reap the benefits of sudden behavioral changes while large corporations often have to focus a lot of time on restructuring existing operations. Simply put, startups can pivot and make changes much faster, and this is seen today with some startups in the COVID-19 era.
Venture capitalists and local economies that worked to save promising startups in 2000 and 2008 reaped incredible benefits in the next economic cycle. Look at the businesses that raised VC money in 2008 and it’s an impressive list: Facebook, LinkedIn, Dropbox, and Palantir. The fact that these companies were able to raise money during a recession is obviously not the cause of their success. But the strong returns of their cohort of recession-funded startups suggest that other would-be innovators were never realized because of the restricted capital environment.
What Ecosystem Leaders Should Do Now
While it’s clear policymakers and ecosystem leaders need to act, there’s bound to be some disagreements about the best approaches to take. Let’s shed some light on what governments and business leaders should be doing now to help startup ecosystems.
Governments Are Not Taking the Right Actions
Governments around the world are taking actions to help businesses during COVID-19, but they aren’t doing enough to assist startups. Government relief programs typically have strict eligibility rules and emphasize companies with revenue, profitability, and collateral. But this leaves a lot of startups out in the cold.
As a result, Startup Genome’s data shows that 39% of startups globally are not receiving assistance and/or do not expect to be helped by national or local government relief measures.
Additionally, 16% said they are not currently receiving help but expect to be helped by a policy measure soon, as of June 2020.
More work must be done to enact policies that will help startups with policy measures, which will in turn prepare economies for growth, steady jobs, competition, and innovation June 2020).
Among the actions that policymakers can take now, funding startups should be the top priority. Without providing funding, many jobs and innovations will be lost.
The first goal should be to inject capital quickly to save at least 80% of startups that are at risk of folding in 2020. The second goal should be to inject capital to increase the rate of new seed and Series A investments over the next two years, to ensure these types of investments do not drop as dramatically as they did during the 2008 recession and to ensure we don’t lose an entire generation of founders. Achieving both of these goals will lead to startups having the opportunity to close their next round of funding when things stabilize.
Designing Effective Funding Vehicles
Startup Genome asked founders in our global COVID-19 survey about what type of support policies they would find most helpful. By far the greatest number, 31%, reported that they would like to see grants to support company liquidity, while instruments to boost investments (17%) and support for employees (15%) were the two other most popular policy measures.
Governments should instead use existing equity funding instruments, such as convertible notes, and guarantees for equity investors, to inject new capital that directly benefits existing VC funds. Additional capital invested can be offered to investors at a fraction of each fund’s original investment. The amounts invested should be enough to provide at least six months of runway to about half of startups that are in need of funds.
By only providing a cash runway to half of startups, investors will then be forced to concentrate capital to save top startups and future returns, and will use their own capital if more is needed. This type of program does not work as well for seed-stage and pre-seed startups, so consider adding investor tax credits to complement it.
Currently the only example of a well structured government equity support fund in 2020 is the U.K.’s Coronavirus Future Fund. It specifically targets U.K.-based pre-revenue and pre-profit companies that rely on equity investment and provides government convertible loans ranging from roughly $150,000 (£125,000) to $6 million (£5 million). Future Fund loans are subject to at least an equal match in funding from private equity investors. Germany announced similar ambitions, but the details of the funding vehicle have not yet been fully announced.
Funding Best and Worst Practices
Policymakers hoping to implement new funding programs to help startups should follow a few best practices while avoiding a few worst practices.
- Promote risk sharing between public and private investors, with the public acting in a way to share risk and leverage private money.
- Align incentives through equity or convertible debt to equity.
- Consider a big increase in the investment ratio, such as 5 to 1. Signal that this is a good startup and remember it costs less than saving a large corporation for the same number of long-term jobs saved.
- Allow different types of investors (including angels and VCs) to inject capital to save the best startups and scaleups.
- Allow investments in new ventures that can help address problems created by the COVID-19 crisis, including healthcare, ecommerce, and online services, which also seeds the sub-sectors that can be successful in a post-pandemic world.
- Do not encumber investors and startups with a new instrument, such as a convertible note when startups already have a preferred-share structure. If a government wants to offer the option to reimburse the investment, offer a redemption clause. And if a government wants to add an interest rate, then add it to the redemption clause.
- Don’t change the instrument completely. Strictly invest in the same exact instrument and preferably at the same conditions as the last round, so nothing needs to be negotiated. Keeping it the same ensures speed, prevents gaming the system, and keeps it easy for startups and investors.
- Finally, do not create a task force — whether government-led or privately led — to decide which startups to save. Even if a so-called task force is full of experts, this is a costly process and it’s unlikely they will achieve better results than established investors can.
Policymakers and ecosystem leaders also have the gargantuan task of both preventing existing talent from leaving and attracting new talent while the threat of COVID-19 disruptions persist. Considering the many years and resources spent building a startup-experienced talent pool, it is important to preserve this talent and to keep attracting non-local talent.
On a domestic level, recessions typically cause significant delays on employment for new graduates and they cause subsequent long-term impacts on lifetime earnings, savings, and socio-economic advancements. Policymakers must counter these effects with targeted actions to keep talent from moving to other startups in nearby ecosystems that offer more benefits. They also should be working to extend visas so foreign talent does not immediately leave if they are furloughed or laid off due to disruptions. They also should try to avoid startup talent from being snapped up by large corporations because this can add “brain-drain” to the ecosystem.
A few examples of smart talent retention actions include:
- United Arab Emirates — The UAE took the bold step of automatically renewing residency visas and IDs that expired on March 1st, 2020 without additional fees, to ensure foreign talent could stay during the crisis.
- Germany — The German program Kurzarbeit allows employers to furlough employees part-time, with workers agreeing to a reduction in working time and pay, and the government covering up to 67% of an employee’s lost wages for up to 12 months.
- Sweden — The government offers a “short term leave subsidy,” which allows employers to receive more than 90% of employees' salaries who have to take short-term leave due to COVID-19.
Additionally, policymakers and ecosystem leaders should be aware that this is a good time to attract affordable talent as well. If the average cost of living drops in major startup hubs, then make sure to bring more cost-averse talent into the fold at that time. It’s also an opportunity to fish for talent from promising startups and SSOPs who have folded.
Specialization Should Be Protected
Another reason policymakers and ecosystem leaders should be shielding startups from collapse is that existing sub-sector strengths that already exist should be protected. For example, an ecosystem that has a vibrant Fintech community must do what it can to fund promising Fintech startups. This will help keep these specialized clusters of companies, which compete and collaborate with each other, intact.
Startup Genome research shows that specialization is key to the development of deep-tech focused ecosystems. Our research shows that any deep-tech-focused cluster requires a vibrant startup community to ensure that patent creation and R&D make their way efficiently into commercial use.
These ecosystems, which excel in sub-sectors such as Artificial Intelligence & Big Data, Advanced Manufacturing & Robotics, and Blockchain, have a lot to lose if their promising startups don’t survive 2020. The 2020 GSER rankings have revealed the emergence of new tech innovation centers or R&D powerhouses, and it would be a shame to lose these gains.
Procurement Programs for Startups
With startups struggling to generate demand they had before the COVID-19 crisis, policymakers can step into help with the development of government-led innovation procurement programs. The overall objective of these programs would be to replace domestic and global demand temporarily. For governments, this also offers the opportunity to drive ingenuity and productivity in public services, with the aid of tech founders that are more available with private market opportunities declining.
The most effective model is demand-driven, with startups and SMEs responding to governmental department requests. A supply-driven or proposal model may be more appropriate in regions where technology is not as in-demand.
While COVID-19 disruptions and fears persist, policymakers, VCs, and angel groups can help identify more scaleups and startups that are well positioned to help with specific problems stemming from coronavirus. Startup specialties that can help during the crisis include:
- Healthcare — Startups can aid in the provision of testing, sanitation, and contact tracing.
- Social services — Startups can provide non-health related care and food delivery for the immunocompromised and elderly
- Online services — Startups can help with online platforms for education at all levels and services for businesses
Keep Working on Startup Programs
Finally, the last important piece of the policy puzzle to assist startups is to save support programs such as accelerators and mentorships. While switching to a virtual model in the near term may help organizations like these keep moving forward, they typically still need some financial support.
Policymakers have a lot of their plates now to sustain their economies, but startups simply can’t be forgotten. At the very least, they can provide short-term measures to “keep the lights on” and attempt to minimize the disruption of existing startup ecosystems. The most effective measure they can take is to use existing funding structures to quickly deploy capital using equity-based instruments.
We recognize that this is a short-term view of the current situation and the effects of the COVID-19 crisis will be long lasting. Indeed, our analysis of the prevalence of different policy instruments around the globe shows that, as of April 2020, business loans were by far the most popular measure used by governments. Equity-based funding and demand generation were the least popular — demonstrating that policy instruments are not yet aligned to the needs of a longer term recession environment.
In the medium to long term, we are facing both a recession and an accelerated move to a digital economy. Thankfully, the tech and digital-focused startups can play a role in coming back from the recession, like they did in 2008.
During this time, there will be a greater role for the government to play when it comes to industrial policy and working with startups. Without this public sector involvement, startup clusters and ecosystems will be harmed and the economies they belong to will lose the benefits startups provide. Those governments that unlock new demand generation for their startups will facilitate not only startup ecosystems but also the wider economic recovery.