A shortage of investment-ready startups is creating VC anxiety

13th November 2020

Founders that are building future growth stories will be in great demand

VC as an asset class has outperformed in recent years. Investors (known as Limited Partners or LPs) have been piling in as valuations have moved relentlessly upwards. Huge new funds have been raised to support companies staying private for longer and there is a record amount of dry powder in VC coffers.

But these upbeat trends disguise a steep decline in deal numbers, made worse by Covid. Lack of quality deal flow and increasing competition is starting to cause investor anxiety and may pose a threat to the very existence of certain funds over the longer term. This presents an opportunity for founders.

First time fundraisings at a new low

Even before the pandemic deal numbers were slowing. With greater uncertainty over the macroeconomic climate and a glut of deals over recent years, investors were already taking stock. There was a deliberate shift away from early stage to growth stage and late stage businesses.

Larger funds sizes over recent years fuelled this trend and enabled investors to focus on less riskier bets. Then the pandemic hit and acted as a huge but unplanned accelerant to this strategy. Funds are only now starting to appreciate the longer-term implications.

Through Q2, VCs dramatically slowed down new investments and concentrated on their portfolio companies, shoring up balance sheets to provide extended cash runways. During Q3, investment volumes (the actual amount of £’s invested) began to recover and in the UK were down only down 1% on Q3 2019, according to Beauhurst.

But in Q3 deal numbers declined to their lowest point since Q4 2016. A total of 402 deals were announced in the UK during the quarter, a 12% decrease from the previous quarter and a 7% decrease from Q3 2019. The number of Seed stage deals dropped 20% from Q2 2020, and first-time fundraising fell to a new low. Just 87 companies announced their first fundraise in Q3 2020, down from a high of 214 in Q2 2014.

Just 87 companies announced their first fundraise in Q3 2020, down from a high of 214 in Q2 2014.

Covid has had a dramatic impact on the volume of investment-ready propositions. The pandemic has certainly weeded out many of the weakest but there has been significant collateral damage too. Many excellent businesses were caught in the wrong place at the wrong time. Big swathes of transportation, retail, and hospitality have suffered badly. For many others, depleted revenue streams have set companies back months.

This brutal thinning out of the opportunity pipeline for VCs has been fast and furious. On the other hand, for those businesses accelerated by Covid, especially in cloud-based service sectors such as healthcare, remote working, payments and education, there has been no shortage of investment interest. This has ramped up competition between the top investors, who must now factor in the impact of a vaccine across all these sectors.

VCs facing tougher competition

The big brand name funds have been especially active over recent months. They are generally the first port of call for founders whose businesses are taking off. But as we move through Q4 there is now less low hanging fruit and investors, especially new funds and aspiring second-tier funds, are having to work harder to find a place at the table on hot rounds. Securing returns over the next few years is going to get tougher.

International investors, sometimes with huge multi-stage funds to deploy and only a Zoom call away, are also becoming more active in the UK. This is heating up the competitive environment for local VCs. For now, expect UK investors to stay patient and play the long game. Whilst many are becoming increasingly anxious about investment momentum, they remain incredibly wary about making bad choices. Predicting success is a tough game at present. Too many failures could kill a first-time or mediocre fund.

As we move into 2021 this pressure will build. Anxiety over returns, especially for Seed funds, will increase and competition for the best opportunities will intensify. Founders bringing forward strong, investment-ready propositions will be sought after. That doesn't mean the bar on investment criteria will be lowered, but it could mean that deals happen much faster.

Monitor your investor’s progress

We often talk about how investors religiously monitor portfolio performance, but companies should also be keeping an eye on investor performance. This is especially important for any young or first-time funds that are still building their track record. As a founder, if such funds are on your cap table, you will be relying on these investors to continue investing in your business. Their long term health is important to you.

Companies should also be keeping an eye on investor performance

Some of these younger funds will have a testing time through 2021 and beyond. The quality of their investment decisions through Covid will gradually start to emerge and begin to impact fund performance. Whist this won’t deplete their firepower in the short term, it will influence their ability to raise fresh funds for future deployment.

On new raises founders must also be especially vigilant and, where possible, target fund managers that have a solid track record. Doing your own diligence is vital. Building a quality cap table has never been so important and will be key to attracting bigger investors in the future as the business expands.

Revitalised businesses will emerge

One of the harshest lessons for first-time founders is the realisation that VC’s don’t invest because you’re running out of money. They invest because they believe their equity stake will be worth a lot more in the future. Rushing out prematurely, when the investment proposition is undercooked, results in wasted campaigns that can pose an existential threat to startups. Speed kills, especially if you cut corners.

Even in good times, investment preparation is a great forcing-function for getting founders and Boards to think deeply about the business and where it’s going. Like an iceberg, the real story lies beneath the waterline – the stress testing of the entire business model that is the bedrock of the investment proposition. An evaluation of investment readiness that mimics the analysis that investors themselves will undertake, should provide the highest degree of confidence that the business will get funded.

Many founders that have successfully navigated their way through the past 6 months will emerge even stronger. The pandemic has forced difficult choices and a great deal of soul searching. Pivots have been undertaken and new business models have been developed. Many of these are now being tested. Investment propositions are being sharpened. Over the coming months a gradual flow of revitalised businesses will start filling investor funnels once again.

Will yours be one of them?

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