Funding strategy: Boards must not get distracted by the macro
In the latest Startup Snapshot study over half of all founders polled said they were "very stressed about the future of their startup." And 60% of founders agreed that the main source of this stress is "the ability to fundraise." With every headline claiming a much tougher capital-raising environment compared to 2021/22, it's not hard to see why anxiety levels are running so high. But the reality is that the prospect of funding success is not universally worse for every startup. Instead, it now varies significantly depending on stage, sector, and geography. These were not factors that played such a significant part in 2021/22 when all boats rose on the highest of tides. But now they are. As we head towards 2024, we are experiencing a far more nuanced financing market. Yes, many areas of the funding landscape still look dire compared to 2021/22, but certain others are now coming to the fore. Dealroom's recent report on European Venture Capital highlights some key areas of opportunity. For example, while investments in 'late-stage' businesses have fallen steeply, 'early-stage' dealmaking (pre-Seed, Seed, Series A) will likely absorb a record amount of capital this year. Round sizes here have continued to rise 'post bubble' and the signs are that valuations are holding steady - and are even on the rise for the most sought-after deals. And perhaps the biggest shift: "Europe has pivoted to physical tech" and away from the heady levels of investment in SaaS, Marketplace and eCommerce of recent years. Businesses that manufacture real things are back in favour. Ironically, the biggest losers through 1H24 could be those startups that are currently holding out for better times, unaware that they may already be sitting on a highly investable proposition. In some of these cases, boards have not just put external funding on hold, but have bridged with (heavily) discounted convertible loan notes, storing up unnecessary founder dilution.
At the height of the market in 2021/22, late-stage SaaS mega-deals dominated the headlines. 'Growth at all costs' was the VC mantra, especially from the big US VCs that had come hunting in Europe. Huge rounds at eye-watering valuations fuelled aggressive customer acquisition strategies. But then, high levels of churn - driven in part by sudden changes in the macro environment - undermined many business plans. Late stage valuations took a massive hit, decimating returns for some VCs. Now, as we see from the latest market data, demand for capital-efficient businesses addressing the core elements of the emerging economy is ramping up. One prime example; early stage, steadily growing, DeepTech businesses in verticals such as ClimateTech and BioTech, are finally attracting the level of global investment interest they deserve. This includes hardware tech startups, which may be more capital-intensive in the early years but deliver more sustainable valuation growth later on. This dramatic change in emphasis by VCs has been met with a wry smile from the DeepTech founder community. Many of these entrepreneurs, particularly those that are building economically sound businesses addressing the critical industrial challenges of our time, find it somewhat ironic that certain VCs are now taking it upon themselves to espouse this 'new', back to basics mantra - as if they had suddenly invented it. This is exactly the mantra that many of these DeepTech founders have been following for years. One founder we spoke to this week recounted how in 2021 most of the VCs he approached just didn't want to know. Because his business didn't fit the hyper-growth model of the time, many didn't even respond to his initial approach. 2 years down the road, one of those (well-known) VCs that did take an initial look but then just ghosted him, suddenly reached out last week. Hearing that he was fundraising they were now "very keen to talk" about his "exciting, capital-efficient business". VCs like this may have short memories. Founders do not. This is one investor that won't be getting a call back.
The debate over funding strategy remains top of the agenda for many startup boards. In particular, do we raise now or do we delay? When weighing up the odds, anecdotal data points and the broader investment market headlines mentioned above, driven mainly by the dramatic valuation swings at late-stage, provide little real guidance. Boards must not get distracted by the macro. The real value lies in understanding how the market is responding to startups at their specific stage, in their particular sector, and in their geography. Then, which investors are active in that space? What types of investment proposition are they looking for? Are valuations and deal sizes holding or perhaps even growing? These are all critical insights needed to shape the funding strategy. One certainty across all these variables is that deal-making timelines have extended. In the funding process there are now more investor discussions and more due diligence (DD) analysis than we experienced in 2021/22. What we are witnessing in DD is essentially a reversion to 2019. Most founders are now acutely aware that the investment preparation phase will take longer and are allowing at least 1-2 months to cover all the preparatory topics highlighted above. Then, into the campaign itself: Gone are the 2-3 month rapid-fire deal timelines of 2021. Allowing at least 6 months from initial outreach to money in the bank is once again necessary and prudent. Those in a rush will always be forced to compromise on deal terms, especially if the runway is looking tight. As a result, many founders aiming to close deals by mid-2024 are already in preparation mode with a view to starting outreach early in 1Q24. In sum, 2023 looks like it will be 3rd largest year on record for VC in Europe and 2024 looks set follow. The market will be much more selective, but those with the right stage, sector, and geographic credentials, now have everything to play for.
Seed VCs still competing for the best deals
Just as founders are out raising capital in turbulent markets, so too are the VCs themselves. Tracking VC fundraising progress gives founders an important window onto their own prospects for funding in 2024. VC firms have raised $91B globally in new funds as of the end of Q3, according to Dealroom. In 2022 the surge in the number of $1B+ funds pushed overall fundraising to its all-time peak of $216B. But even though the 2023 figure will fall well short of this record, mainly due to the collapse in the number of these mega-funds, dry powder levels remain high. This is due to the much lower levels of deployment, especially into late-stage companies, over the past 18 months. Closer to home, capital raised by European VC funds in the first nine months of 2023 amounted to €13.9B across 91 vehicles, according to Pitchbook. This compares to €27.6B for the full year 2022 across 270 vehicles. Whilst weaker YoY, there has been a positive uptick over recent months, with capital raised amounting to €8.9B in 3Q23. But beneath these headline figures, much is changing. To understand these important new trends we need to first look at the principal sources of venture capital (not just VC funds) and then in more depth at VC funds themselves. They are not all viewed equally through the eyes of their investors, the LPs.
As we highlight in the piece above, the startup landscape is changing across Europe. There is a clear rebalancing of sector interest towards DeepTech, Climate Tech and other 'physical tech' businesses, according to Dealroom. SaaS, Marketplace and eCommerce are seeing a reduced share of the total investment pie in 2023 vs 2022. Whilst VC funds still dominate the sources of capital by number (declining from 53% in 2022 => 48% in 2023), these sectoral shifts in Europe are attracting a greater proportion of non-VC investors, such as corporates (17% => 20%) and a broad collection of 'crossover' investors such as PE funds (30% => 32%), as we move through 2023. This is providing founders with a greater diversity of funding sources. For those that are looking to engage with VC funds, be aware that the picture is evolving here too. LPs classify VC funds into 3 primary categories. Terminology varies but broadly there are 3 buckets: First time fund managers, Emerging fund managers (launched fewer than 4 vehicles) and Experienced fund managers (opened 4 or more). In difficult economic times, LPs have a tendency to prioritise experience over ambition when making capital allocation calls. It's no surprise therefore to see the number of first-time fund managers raising capital across Europe dropping heavily (by 70%) from 76 in 2022 to 23 in 2023 to date, as we see from the latest Pitchbook figures. At the other end of the scale, whilst Emerging and Experienced fund managers are down similarly in number, Experienced managers are stealing absolute $ share. This shift in allocation is a having a dramatic impact on some investor fortunes.
Many VCs are out fundraising at present and some, especially First-time and Emerging managers, are finding the environment torrid. Given the dearth of exits through 2023 and the fact that 80% of IPOs since 2020 are trading below their IPO price, those with sub-par returns and/or decimated book values over recent quarters will struggle to raise. As a result, we will see some funds slide into 'zombie' mode. This means they won't be looking for any new investments and will simply spend their time 'managing' their current portfolio companies. Stride, the London-based early-stage VC set up by former Accel partner Fred Destin, has said in recent days it will not raise a third fund as it had previously planned, and will let go of three members of its investment team. Stride’s portfolio includes struggling second-hand car platform Cazoo, which it invested in at Seed and two further funding rounds. When Cazoo listed on the New York Stock Exchange in 2021, it was worth $8B; its market cap currently stands at $15.78M! But look further at what Destin said in his letter to LPs: “The seed market feels overheated. Bizarrely, it seems in a number of segments like the crisis never happened. We’re seeing $8-25m ’seed’ rounds at aggressive valuations being done by Tier I investors, which begs the question of whether we will ever learn.” This is a reminder to startups looking to raise at Seed that there is increasing competition amongst investors for the best deals. The balance of power at early stage still sits with founders, despite what you might have heard.
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