In 2018, venture capital investment in Europe reached a decade high, but for many early stage businesses the headlines have masked an underlying trend that spells concern. Whilst investment is up again to a record €20.5 billion, deal numbers have continued to plummet, according to Pitchbook’s 2018 Annual European Venture Report. Deal count declines have especially impacted earlier stages companies, as larger transaction sizes have pressured investors to become far more selective. Investment propositions are under ever increasing scrutiny as venture capital seeks out the next ‘category winners’.

26% decline in deal count across Europe

Whilst investment value increased 4.2% year on year in 2018 deal count was down dramatically, a 25.9% year on year decrease.

This was the third successive year of declining deal count, down a startling 35% from the post financial crisis high in 2015. As a result, median early-stage deal size increased dramatically by 86.9% YoY driving increased valuations for the lucky winners. But for the majority, the higher expectations of more selective investors - especially at early stage (late Seed, Series A, B) - are becoming much harder to meet.

Investor mix is also changing

Analysis of the 2018 figures reveals increasing participation by US investors and Corporates in the European market, reaching decade highs in deal value.

More than one fifth of European deals included a US investor in 2018 as we can see from the graph below:

Pitchbook reports: “This current uptrend is partially a function of the capital availability and elevated valuations among US startups driving the search for attractive assets into Europe and other geographies.” Whilst deal count from US investors was flat in 2018, the percentage of deals with US investors has risen to over 20%, well above the typical 11-14% recorded since 2008.

We concur. We keep a close watch on US investment and M&A trends as many of our tech clients eye the US market as the most likely future exit route for their businesses. The US tech market is often an early indicator of emerging trends we will see later in Europe. We have some unique insights through our US associate company, Harvest Management Partners, a Silicon Valley based investment banking firm that specialises in cross border transactions into the US. Their M&A pipeline from Europe is currently increasing as more young businesses evaluate early exit opportunities – in some cases as a contingency against failure to fund.

US deal counts also tracking down

Following on from 2018 record VC investment levels, 1Q19 was the second-highest recorded quarterly capital investment total in the last decade. Worryingly though, just as we have seen in Europe, deal volumes in the US have continued to shrink. As a result, early stage median deal size jumped 36% quarter on quarter, according to Pitchbook’s 1Q 2019 NVCA Venture Monitor report. This in part is being fuelled by the emergence of a greater number of mega-funds ($500M+) competing for ‘category winners’.

Claire Lee, Head of the Early Stage Practice at Silicon Valley Bank, recently commented that as deal sizes in the US swell, new sources of capital are being drawn into the early stage asset class, including micro VCs, sovereign wealth funds, family offices, hedge funds and PE firms as well as increased participation by Corporates. Noting that Corporates have historically favoured late-stage investments and acquisitions in the US, Lee says more are now driving incubator and accelerator programmes and even claims “Corporate Venture is the new R&D”.

The UK equity investment market in early 2019

Beauhurst’s recently published Q1 2019 Report confirms a similar trend to the US. Whilst the amount invested has risen again by 10% quarter on quarter, the number of deals is down by 17%. This is the lowest quarter for deals in the UK since Q3 2014. Deals numbers fell at the seed, venture and growth stages although remained level at the established stage.

Of particular concern to Beauhurst are the seed stage numbers in Q1 2019, stating; “there were only 142 announced seed deals this quarter (compared to the record of 209 in Q2 2016). Since late 2017 the number of seed deals has been converging with the number of venture deals. This will be storing up a problem for the future: if the earliest stage businesses don’t get funded now, there’ll be fewer growth deals to be done in the future.”

What we are therefore seeing is more than a temporary slowdown in investment activity, it’s a dramatic reshaping of the early stage market both in terms of deal volume and investor mix, that looks set to continue.

Pressure on all stakeholders is rising

For the increasingly smaller cohort of companies that manage to secure investment, capital will have never been so readily available. However, for those whose propositions fall short, even by a small degree, this will seem like the most unforgiving funding environment.

Founder teams and their Boards are having to rethink their approach to funding at early stage, especially if they have been out of the market for the past couple of years. The market has changed dramatically, and some will have not yet witnessed these new conditions. This is impacting on all aspects of the startup to scaleup journey, requiring updated thinking on business strategy as well as funding strategy.

As investors continue to tighten criteria at all stages, businesses will need to raise their game in this battle of the fittest. For market savvy founders that are reading the trends this means a greater focus on preparation, more robust testing of the business model and a degree of financial rigour previously associated with much later stage companies. This can all take time and incumbent investors may need to support the business through additional ‘interim’ rounds until the proposition has been sufficiently strengthened to attract larger funds.

For those that have the means to stay the course and prove the model, the prize will have never been greater.

About the author: John Hall is CEO and co-founder of Duet Partners, a corporate finance firm that provides specialist funding support to high growth technology companies. His 30 year tech career began with major US semiconductor and software companies, and was based in the Valley during the late '90's. Before Duet he was CEO of a VC-backed consumer electronics company, sold in 2009 following several rounds of capital raising. In the past 10 years he has advised dozens of founders on the startup to scaleup journey and is a retained Board advisor to a number of UK technology companies.