Proptech Faces a New Coronavirus Reality

It's a venture capital world now: With capital drying up for proptech, the balance of power has shifted to investors.

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The seven fat years are over. 

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Up until March, it was a proptech founder’s world. Entrepreneurs could demand tens of millions for their flexible office startup, or amenity management software, or smart home integration product, and there was so much money splashing around that they would probably get it. 

But the balance of power has shifted. With the economy suddenly ground to a halt due to the coronavirus outbreak, capital has quickly dried up, valuations are dropping, and investors are raising the bar as to where they’ll put their money. 

In proptech, the pullback is especially brutal, because real estate is being so badly hammered by the shutdown. With their core business at risk, real estate firms are going to cut expenses where they can, with innovation and external investments likely to be the first victims, according to founders and investors who spoke to Commercial Observer. And since real estate companies are both customers and investors, it amounts to a double whammy.

For venture-backed startups, that could prove fatal.

“VCs are making decisions about, ‘Who do we back? Who do we let die?’” said K.P. Reddy, the founder of seed investment firm Shadow Ventures. 

In the immediate term, venture firms like Shadow are focused on helping their portfolio companies weather the storm, but not all companies are worth saving. While every venture firm has cash reserves, most are not prepared to deal with a crisis of this scale, Reddy said. “No one ever anticipated every one of their portfolio companies needing funding, and at the same time,” he said. “That’s not something we planned for.”

Of course, the level of exposure varies greatly among startups, depending on what stage they are up to in the growth cycle, their financial health prior to the onset of the pandemic, and how much money they burn each month. But despite the range, all startups are recalculating. They’re revising their budgets, pushing their benchmarks out six months, rethinking priorities, pivoting to new products, and watching their valuations drop.

Chris Yip, a partner with RET Ventures, said their near-term priority is triaging the impact in their portfolio. RET, which focuses on tech for the multifamily sector, divided their companies into three groups: the least impacted firms, generally enterprise software companies; a middle group that will require support to bridge the next couple months; and the hardest-hit startups, those with exposure to travel and leisure, that will need significant intervention.

It also matters how much cash a startup has on hand. “We’ve told our companies that fundraising is going to be very difficult for the next six to 12 months,” said Jim Kim, the founder of venture firm Builders VC. “And as a result of that, if you have to fundraise within that window — don’t.” The alternative is to find existing investors who are willing to work with you, he said.

A startup that just closed a funding round will have to revise its timeline but will likely have the resources to survive, while startups expecting to raise funds this spring could be facing extinction. Similarly for venture firms, their strategy could largely depend on where they are along the timeline of raising or closing funds. 

Toronto-based Lane, an office management software company, may be one of the lucky ones. The 6-year-old company was finalizing a Series A round just as everything began to unravel. They expect to close even though some of their strategic partners — institutional real estate companies — pulled out of the deal, according to Lane’s founder and CEO Clinton Robinson.

“Commercial real estate firms who invest in tech are waiting to see what happens,” said Robinson. “They all have tons of money to deploy, but investing is not top of their list right now.”

Robinson said Lane, which helps facilitate engagement between landlords and tenants, has pushed all their projections out a quarter when they hope to have more certainty over what comes next. But as the economy rebounds, he expects to see a massive shift in the way companies use office space. Enterprise companies that were already experimenting with flexible space for some of their workforce will expand that model, and landlords will work directly with them rather than through third-party companies, Robinson predicted.

“Flex office companies will disappear, and landlords will step in,” he said. “[The flex companies] are all losing money at insane rents. They’re all venture-backed, and they’re not going to be able to get funding over the next couple months.”

It’s clear that flex office providers are being pounded by the crisis, though it may be too early to sound the death knell. Knotel is in talks to give back 20 percent of its portfolio, or roughly 1 million square feet, and has laid off a third of its New York workforce, as CO previously reported, while WeWork skipped April rent for some of its locations and is actively renegotiating its leases. 

But while Knotel and WeWork are getting hammered because of their rent bills, software firms that focus on the flex space feel that the ground had shifted in their favor. 

“The return from this is going to be messy and complicated,” said Jamie Hodari, the CEO and founder of flex space company Industrious, who expects a very different leasing landscape when people return to the office. “We’re already weeks into conversations about the return to work.”

In early April, Industrious laid off or furloughed around 25 percent of its workforce. Though their finances were in good shape, they needed to prepare for the lean year ahead, and refocus their resources, Hodari said. In the short term, Industrious locations are empty and new leasing or management contracts have dried up. But in the medium-to-long term, Hodari expects to see an uptick in the adoption rate of workplace-as-a-service platforms like his. 

And that made the staff reductions, which ranged from layoffs to salary cuts for the executive staff, a delicate balance. “You need to retain your team,” he said. “The danger is in a moment of crisis you cut too deep.”

Whether startups are flush with cash or about to run out of it, the landscape for proptech capital has undeniably darkened. The founders and investors who spoke to Commercial Observer had all seen term sheets pulled, valuations dropped, and coffers tightening. Kim explained that there were a number of factors that were leading to the dramatic rebalancing. 

The first is the amount of capital at play. With the money flowing, founders could shop their startup to the highest bidder, but now those same founders will have to work harder for funds at lower valuations. 

“I think we’re still in the phase where entrepreneurs are still shooting for those lofty numbers,” Kim said. “If you want to get started now, maybe take a little bit of a haircut on that, and come to a more reasonable understanding, you can get something done.”

Secondly, while investors understand that the coming six-month period is an anomaly, and won’t punish startups for missed benchmarks, that doesn’t change the facts that startups will be burning through cash over that period. As a result, they’ll have to raise funds again, thus diluting the investor’s ownership stake, making it less valuable. 

Third, the risks have broadly gone up across the board because it’s unclear what environment companies will be selling into when the economy restarts. If rents drop because of oversupply on the supply side, or lack of demand, that will impact whether real estate owners have the cash to spend on technology. 

That being said, there are plenty of deals to be done for venture firms with dry powder, and some experience with the previous booms and busts of the venture capital landscape. Not to mention that distress serves as a siren song for opportunistic investors, as is being seen in the broader real estate market. 

Already, firms with resources are eyeing opportunities. CoStar drew down a $745 million facility last month in order to close its pending $588 million acquisition of the residential marketplace firm RentPath, and for other strategic acquisitions, the company reported to the SEC.

However, venture firms with recently closed funds have another concern given the capital call structure of venture funds. Strategic partners may have only invested a portion of their full commitments, and could potentially renege on those commitments. Reddy, who experienced the dot-com burst and the 2008 recession, said that historically that’s what happened. 

For a real estate firm that’s invested only 20 percent of a $10 million capital commitment, it may be better to abandon the $2 million and keep the rest, said Reddy. “Or if you have Marriott as an LP, how does Marriott justify sending you money when they’re laying off people en masse?”

That’s why he’s readying a fund that will step in and buy out those investment stakes.

“It’s Adult Swim,” said Reddy. “The people that know how to move in this environment have been through three or four cycles. In the end, the adults will do fine.”

Update: This story has been updated to reflect that Lane is a tenant engagement app, and does not facilitate flexible leasing.