Winners and losers in the big VC reset
Following the funding bubble of recent years, tech founders are coming to terms with a significantly more constrained funding environment. This is not a blip where everything will quickly revert back to 2021 highs, but a full-on correction reminiscent of the more sober times of 2019 and before. The investment frenzy of the pandemic aftermath created a mirage of unsustainable valuations. Now this hard reset is starting to reveal the winners and losers as all startups must eventually refuel with the cash needed for survival. As serial entrepreneur and investor, Elad Gil, stated in his recent blog, the likely losers now sit in an 'overhang' of companies that either (1) lived without product market fit and survived well past their natural expiration point, or (2) hired way ahead of progress and burned large sums with high valuations and now are stuck with little progress per dollar and a large preference stack. These overhang companies now face severe problems in raising capital. And the winners? "If your company has good underlying economics, can grow at a good rate, and is not dramatically overvalued, this could be a golden period for you as you soak up amazing talent and land great customers." Such companies are now eagerly sought by investors.
But if you are stuck in the 'overhang', what are the options? Gil assesses 3 scenarios: 1. Keep going. For those with the means, push on in the hope that you can find a way to hit elevated investor expectations and/or grow into your last valuation. This is heavily dependent on cash runway but there are other factors. What are these new expectations? For example, to what extent is product/market fit now a threshold even for Seed investment in certain sectors? How much of a valuation haircut may be necessary to draw in new investors (and provide upside to the stock option pool)? This all has to be palatable to existing investors who will want to see a highly credible plan. If not, then the options reduce. 2. M&A. Again, provided the runway is available, a sale of business may be possible. But as we pointed out in our recent piece, Is the M&A window closing for startups?, this pathway is getting narrower by the month. In 1Q23, European VC exit activity sunk to a 10-year low of €1.6B, reflecting a 70% QoQ decline. This included just €950M of public listings, only €650M of corporate acquisitions, and a paltry €50M of buyouts. Substantial VC exits effectively ceased in Q1 as unfavourable macroeconomic conditions and weaker valuations dampened exit appetite. Now we are moving into 'get what you can' territory.
Finally, if the opportunity to keep going or sell the business seems out of reach, it may be time to draw the line: 3. Shut downs. As Gil says, founders may have spent many years of their lives on a company that is not going to work. But rather than spend another 2 or 4 years waiting for the bank accounts to drain through multiple layoffs and venture debt drawdowns, it might be better to accept reality and throw in the towel. For a founder (and their employees), those 2+ extra years may be amongst the potentially most productive years of their lives. The opportunity cost of not going to work on something better is too high. And to be able to do so without a cap table overhang, with a new team that fits a new product, may be a better way to proceed than continuing to grind on something that is not working or pivoting with the wrong team and cap table. Again, the major investors will need to align behind this decision, and that's where you might get surprised. Different investors can be driven by very different incentives. If one is using the last round price of your company to raise a new fund (“look LPs-my investment track record is working!”) they may be dreading a reset on valuation, or worse, an outright failure. Don't get blinded by the moment: Whatever your plan, take nothing for granted as you line up all stakeholders for this big decision.
European VC valuation trends 1Q23
Pitchbook analysis this week confirms that valuations of venture-backed companies, particularly at later financing stages, have largely plateaued as a result of a major market correction over the past 12 months. The investor mix has also changed, with non-traditional investors stepping back sharply in 1Q23. Unicorns and other highly-valued late-stage companies with high burn rates will continue to show signs of duress if current market conditions hamper growth. The VC exit market remains subdued, where acquisition activity remains more resilient compared to public listings. In all, startups across all financing stages are experiencing one of the toughest financing environments in recent history. As investors have become more selective in their approach to capital deployment, due diligence processes have been extended and deal rate is down. With a focus on profitability instead of growth at all costs, and measures to improve capital efficiency in place, startups across Europe have now reset funding expectations for 2023/24. Few are expecting any appreciable bounce back in private markets: For the foreseeable future, 2021 will continue to seem like an extreme outlier. But there are pockets of some resilience and these depend on stage, sector and investment strategy.
Looking at 'stage': Angel round (aka 'pre-Seed') valuations remained robust through 1Q23, with a median of €3.7M, above the €3M median of 2022. With companies here in the very formative stages, deals are often more detached from broader market trends. At Seed, the median valuation was flat at €5.5 million in 1Q23, while the median deal value ticked upward marginally to €1.7M, up from the €1.5M full-year figure logged in 2022. Startups that receive seed funding are usually years away from an exit, and capital is typically used to establish product-market fit and a go-to-market strategy. Thus, startups tend to be lean and less affected by near-term uncertainty from poor growth rates. At early-stage, often associated with Series A, median valuations dipped to €5.5M, a 15.4% QoQ drop and the third consecutive quarterly decline. At late-stage, valuations increased 26.9% QoQ to €13.4 million. This unexpected uptick was due to one big outlier deal (Enpal, a supplier of solar panels in Germany, raised €215M at a €2.2B pre-money valuation), otherwise the late-stage market was flat. Overall, in 1Q23, the proportion of European down rounds moved upwards to 18.8%, having finished 2022 at a decade low of 15.3%. It is likely that the real figure was higher as investors and startups are often less enthusiastic about down round disclosure!
Whilst startups can usually do little to change their sector profile during investment preparation (unless undertaking a pivot), they are far more able to adapt their funding strategy to align with market conditions. This could include 'stage repositioning' as investment criteria become harder to attain for every funding stage. Other key considerations are the go to market strategy, the use of funds, round timing, quantum and structure of the round, and, most importantly, the investor types to be targeted. For example, during 1Q23 nontraditional investor involvement collapsed, falling 65% YoY. In particular, certain Asset Managers and PE firms have found themselves overexposed to the VC asset class and urgently need to rebalance their portfolios. On the other side of this coin, corporate investment has shown real resilience. In 1Q23, 45.2% of European VC deal value consisted of deals with CVC participation, slightly above 2022’s 44.5%. Median deal value in 1Q23 hit €5.5M, 21.4% higher than 2022 levels. Median pre-money valuations for CVC investments followed the same trend, up 31.9% in Q1 compared with 2022. Founders looking to raise capital in 2023 should seek to align their funding strategy with the very latest market conditions in their sector and keep this under (very) regular review.
Growing opportunity for DeepTech VCs
Analysis by Dealroom into European VC investment across Q3 & Q4, 2022 vs 2021, showed a widely reported overall drop of 46%. But a sectoral breakdown revealed that DeepTech funding demonstrated real resilience, only dropping 9%, compared with FinTech (-45%), Health Tech (-35%) and Food Tech (-60%). DeepTech came second only to Energy which decreased by just 6%. And when LPs were asked what the most promising themes were for future investment in Europe, DeepTech was ranked 2nd highest, just behind 'Planet Positive'. How do we square this seemingly strong 'demand' with the challenges DeepTech founders face every day when raising capital? Fundamentally, it's about (perceived) risk. DeepTech refers to those technologies that are based on high tech innovation in engineering, or significant scientific advances. DeepTech applications aim at achieving real improvement in human lives and society, rather than business improvement. They are instrumental in tackling todayʼs biggest challenges, from climate change and food security to intractable disease. As we explained in our recent piece, Understanding the DeepTech investor playbook, DeepTech companies come with greater technical risk (often due to hardware innovations), but once this is understood and the breakthrough validated, 'market demand' risk is often far less of a challenge.
Unlike traditional startups, DeepTech companies are then able to create deeper competitive moats due to their technology edge, IP portfolio, and the depth to which they become embedded in bigger industry solutions. With greater defensibility, often across a broader set of industries than more mainstream software companies, they are generally less affected by hype cycles or momentum. But one of the most underestimated facets of DeepTech compared to mainstream software is the relative revenue contribution. According to the analysts at IDC, over the next five years 60% of revenue in “Technology” will come from hardware, with only 40% coming from software. But if we look at total VC investment in the past 5 years, 90% went to software, with only 10% going to hardware. This 'opportunity disparity' is partly explained by degree to which other 'investors' are active in supporting DeepTech companies. This ranges from Universities and research institutes (often acting as incubators), to Government funding (e.g. Innovate UK), to big corporate sponsors. But such institutions can only go so far. A small band of dedicated early-stage DeepTech investors across Europe then come into play, often punching well above their weight. But the real gap appears when companies look to scale. Our indigenous European investors just "don't have the firepower to lead at Series B+", says Dealroom.
David Leftley, CTO of Block Ventures, says that the European ecosystem of DeepTech co-investors is relatively small, often with only a handful of options available to entrepreneurs building solutions in complex and specialised markets. "There are many reasons for this: the product-market fit journey for DeepTech companies can be long and expensive; the technical due diligence involved requires a scientific understanding of the technology; and the network required for an investor to support DeepTech companies effectively takes decades to build which is a real barrier for most generalist investors." These are all real challenges. But as many mainstream software sectors now show their inherent vulnerability to wider market pressures, DeepTech suddenly looks more attractive. Yes, there is greater technology risk and this does require more patient capital in the early stages, but once commercial efficacy is proven the upside can be huge. We are seeing this already where key technologies in such areas as computing, energy, AI and advanced materials are enabling innovation in high growth verticals like Climate Tech, which represented 34% of DeepTech funding across Europe in 2022. The bigger, more generalist European investors have the potential within their thematic strategies to focus in on DeepTech much further and make this a real priority. And with the growing symbiosis between DeepTech and the future of our planet, the return potential seems greater than ever before.
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