European funding drops in Q2 but Seed stage resilient

As widely anticipated, European venture funding dropped in 2Q22 as investors scaled back their appetite for late-stage deals. Funding reached $23.7 billion, the lowest amount recorded for a single quarter since the beginning of 2021, according to Crunchbase. This represented a 24% drop from 1Q22 and a 38% drop compared to the same quarter a year ago - a $14 billion decline. Remember though that 2021 was a record year. 2Q22 sill exceeded every quarter in 2020 by $10 billion or more. Late-stage was most severely hit due to the influence of public market comparisons, down 28% quarter over quarter and only half that of a year ago. Early-stage (typically Series A and B) fell by 19% quarter over quarter and by 9% year over year. Seed was the least impacted, down 19% compared to 1Q21 and flat quarter over quarter. All stages suffered a sharp decline in deal volume.

Looking at the monthly figures reveals a micro-trend in the ongoing investor enthusiasm for Seed-stage deals. In June, according to Dealroom, 251 companies secured Seed-stage funding, up from 227 in May and 184 in April. This amounted to €595m invested, a big step up from the €442m in May. There was also a noticeable jump in the average Seed-round size, up from €1.9m in May to €2.3m in June. Analysis by Sifted shows that UK Seed funding actually increased in June, hitting €187m, up from €145m in both April and May. The UK also led Seed-stage investing across Europe, with France at €102M and Germany at €85M in June. This resilience in Seed-stage investment is in part being driven by 'Seed-extension' rounds from startups that had previously been planning on Series A rounds at this time. With the bar being raised considerably at Series A through Q2, many founders have been forced to take a more conservative approach to round positioning given tougher market conditions.

So, where do we go from here? As long as the IPO window remains closed, exit values will remain depressed and this will have a knock-on effect, especially at late-stage. US data brings this into sharp focus: In 2021, nearly 86% ($667.1 billion) of the record exit value ($777.4 billion) was generated through public listings of VC-backed companies. But what makes this picture so difficult to read is the opposing force of the almost record amount of dry powder now sitting in VC coffers. Many established VC fund managers are continuing to close out new funds, pushing this number ever higher. For now, the immediate impact is that the initial deployment cycle for new funds is reverting rapidly to the mean, from around 18 months (in the heady days of 2021) to nearer 3 years. This means the rate of deal-making will continue to reduce accompanied by longer due-diligence cycles. The dividend for those in the formative stages of company creation in hot sectors will be bigger deal sizes. For founders, this increasing competition for capital now demands the highest level of preparation to ensure investment readiness.

Preemptive rounds can be a deadly lure

As Q2 results have confirmed, venture investment momentum has slowed dramatically. Deal count in particular is down strongly. Does that mean that VCs are meeting with fewer founders? No - quite the opposite. VCs must keep their deal funnels full so they miss nothing, even if fewer deals are making it through the finer filters now set. There is no lack of capital out there - dry powder levels are at record highs. As a result, VC's have retained large investment teams that are doubling down on their search for the hottest companies. As a consequence, founders are experiencing increasing levels of inbound from investors and some are being lured into preemptive round discussions. But all that glitters is not gold.

The prospect of a 'quickie' round from a new investor who has reached out unexpectedly is nearly always attractive at first sight. Surely a cash top up in the current market has to be a good thing? Maybe. But beware, this is ego stroking at its extreme and there is no guarantee that such a round will happen on good terms and quickly. It may never happen at all. In a rapidly changing market where the CEO needs to have both hands firmly on the wheel, such an unplanned distraction will inevitably take the focus away from other priorities. And with such a low likelihood of conversion, this is high risk. It also breaks one of the fundamental rules of capital raising for founders, which is the need to drive competitive tension amongst a number of interested parties in parallel. This is the essence of a properly constructed funding campaign.

The cousin of the preemptive round is the premature round. This is talking to investors about a planned round before you are fully ready to launch your funding campaign. The trigger for this is sometimes existing investors, trying to be 'helpful' by facilitating early meetings for a founder with other investors in their network. On the face of it a warm intro is a wonderful thing, but timing - as always - is everything. The CEO should be firmly in control of the starting gun. Having all prospective investors beginning the race in unison is critical to building FOMO and creating that competitive tension. Talking to some investors ahead of the real race - either in a preemptive or premature round - where a deal doesn't quickly emerge, will just feed the VC rumour mill that there has been a 'failed round' and this can be deadly. Only start the investor push when you are ready.

How long is your target investor list?

A founder's 'insight' is the core ingredient for startup creation. It's the thing that they know but others don’t yet know. The insight reveals a unique market opportunity that the founder believes they can exploit before others jump in. The startup's first product embodies this insight. To fund the startup, founders must find investors that will fully embrace this insight and buy into the vision to create a high-growth company around it. This alignment creates a common bond. The frothiness of the 2021 venture market seemed to suspend this accepted norm. Investors jumped into deals they barely understood, often just following the pack to get a share of the spoils. No alignment of vision necessary. But we all know the world has now changed. We are back to a normality where the search for properly aligned investors requires significant effort and many conversations. Experienced founders know it can take dozens of approaches to find that elusive investor match. The latest market data tells us that this will also vary by stage.

The encouraging news of strong investment momentum in the UK at Seed stage may lead us to think that nothing much has changed here. But the key indicator is deal volume: Despite rising investment levels in June, deal count is now trending down quarter by quarter. Our guidance now for Seed stage campaigns is to double the target list of prospective investors compared to 90 days ago. If you were planning on reaching out to say 30 to 40 VCs, better to now plan on at least 60. At Series A, think more like 3x. Beyond that it's whatever you can muster. Late-stage investors almost seem to be in a state of suspended animation. Here, many investment committees are still in portfolio triage mode - nothing new is really getting a look in and if it does, expect a big valuation hit. Take Klarna, once Europe’s most valuable private tech company, that just closed a $800M round at $5.9B pre-money. Compare this to their $639M Series H round a year ago at a whopping $45.6B post-money. Many companies who rode the ecommerce boom during the coronavirus pandemic have also seen severe repricing.

But it's not just the numbers game. Founders that are expanding their investor target lists must maintain the discipline of only including well-matched investors. This means those that minimally have the right stage, sector, geography and business model profile. They need to have this proven proven track-record as well as the funds ready to deploy. Founders should be particularly sensitive to (well-meaning) boards compiling lists of investors that they can intro. This often leads to the classic 'wild goose chase' funding campaign - lots of random meetings but no real interest due to poor fit. Far better for a founder to compile a qualified target list first, then ask the current investors to make intros to names they know on that list. Not only is this likely to improve the odds of conversion, it also shows that the founder is truly ahead of the game. Whatever method, founders must now plan on kissing many more frogs and extending campaign timeframes to accommodate.

Happy reading!