Weekly Briefing Note for Founders

6th June 2024

This week on the startup to scaleup journey:
  • Why is DeepTech on the rise?

Why is DeepTech on the rise?

European DeepTech funding is demonstrating greater resilience than mainstream VC markets. Analysis by IQ Capital using Pitchbook data, shows DeepTech investment has risen by 79% in the past 3 years compared to a 2% decline across others sectors.

There is a significant influx of investor interest, including generalist investors now looking to participate in emerging technology areas that are impacting the way we live. From climate to health to new areas of computing, new sources of energy, and new opportunities in space, to name a few.

But DeepTech is a very different investment prospect to mainstream software. For those investors that see opportunity, this will require a different approach. The investing playbook will need updating.

One of the biggest hurdles with DeepTech investing is perceived risk. But much of this is misplaced. Today, we review the core attributes of DeepTech and how investors are looking at this area with fresh eyes.

The numbers

European DeepTech VC investment hit $11.1B in 2020. In 2023 this had grown to $19.8B (+79%). Meanwhile, European investment excluding DeepTech went from $12.9B in 2020 (higher than DeepTech) to $12.6B in 2023 (-2%).

The 2020 and 2023 data sits either side of the the 2 big outlier years, 2021 and 2022, when all sectors hit new peaks. The 2023 numbers represent a reversion to a more normalised, longer-term trend.

Interviewed on the EUVC podcast about these figures, Max Bautin, co-founder and Managing Partner of IQ Capital commented on the breakdown by stage, saying there was not much skew by mega rounds or even AI rounds. Growth has occurred at all stages.

On the type of investor, he noted that that there were more corporate investments occurring here. They have not retracted since 2021 peaks as they have done in other sectors. Corporates are starting to see the real outcomes of implementing cutting edge tech in their own value chains. Many are now learning how to balance internal agendas with external innovation.

The investing playbook is changing

Many VCs are currently nursing huge paper losses as valuations have fallen dramatically from the highs of 2021. The software investing playbook, the typical model of mainstream VC, has not been able to mitigate this downward spiral.

Software investment is based on the premise of only taking market risk. This is the inverse of the DeepTech playbook where investors are predominantly taking technical risk (and little market risk - if they're doing it right).

For mainstream investors, assessing market risk is an easier proposition than assessing technical risk. For example, SaaS investors have reduced the process of commercial due diligence into a series of standard metrics. This enables them to compare and contrast SaaS investment opportunities across a whole range of sectors.

DeepTech does not lend itself to the same 'commoditisation' of metrics. It could be argued that technical risk should be based on science but assessing this risk is far from formulaic. This creates a greater illusion of risk for generalist investors.

But the risk profile is changing and becoming more palatable for some. Looking at the classic risk assessment areas vs mainstream software (as profiled in Dealroom's 2023 European DeepTech Report) we note how these 5 areas of DeepTech are evolving:

1. Capital intensity is higher

Due to the longer initial research and development phase, early costs are higher. The time to first product is longer. But what is the impact?

Dealroom's analysis showed that DeepTech startups take at least 35% more time and 48% more capital than traditional startups to reach revenue levels of $5m+, resulting in more capital required to reach product/market fit and more dilution for founders and investors.

Surprisingly, however, they actually take around the same amount of time (approx. 2 years from the Seed round) to reach revenues of $1m, and only 11% more capital to reach $10m revenue, suggesting that this discrepancy may narrow over time.

And the gap continues to close. Bautin says: "Some of the things that made software a more attractive investment opportunity 25-30 years ago are starting to happen in hardware. More rapid productisation, rapid prototyping and faster iterations.

"A great example is the SpaceTech sector, which is booming. Launch costs are decreasing and there is a growing acceptance of new technical approaches."

2. Technology risk is higher

Building novel, breakthrough technologies has inherently higher risk than using well established technology.

But scientific advances in areas such as machine learning, computational biology, materials, and advanced engineering have created a platform for companies to build, test, and iterate DeepTech products more quickly and cheaply – driving value in such areas BioTech, space and aerospace, and robotics, amongst others.

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.

3. Team risk is higher

The biggest challenge for DeepTech founding teams is to complement their technical abilities with business acumen and a commercial mindset.

Teams have to pre-empt product/market fit from the very earliest stages. For this they need the deepest insights, often driven by a technical mind, that will likely originate from first-hand experience in the sector.

Why the need to pre-empt? it is virtually impossible for DeepTech companies to do a hard pivot. They need to get the market right from day one.

Experienced founders understand the importance of having commercial expertise from the earliest stages. For example, a key objective is to have early adopters pay for proof of concept (PoC) and pilot projects. Ensuring these engagements are structured correctly is critical. Bad contracts that undermine future value can put investors off.

Bautin observes that startups have become better at breaking into the complex, global supply chains of ‘old’ industries, which are in turn more open to incorporating new third-party technologies. As a result, early PoC contracts are trending larger, and for multiple years.

4. Competition risk is lower

Due to their strong technological edge DeepTech startups are typically able to build a defensible moat against competitors. But the cornerstone for this is rarely patents, at least not over the longer term.

Champ Suthipongchai is a co-founder and general partner at Creative Ventures, a method-driven DeepTech VC firm. In his recent TechCrunch article, he says IP means nothing. Business lock-in means everything."Sure, IP buys you time, but it’s hardly a means of defending a company’s long-term advantage." Implementing DeepTech is an audacious process that requires countless proof-of-concepts and pilots, not to mention an even more audacious rollout plan."

In emerging technologies and markets, product development and early commercial rollout often require skills that are scarce. The real competition here is for talent. This compares to traditional startups that rely more on the virality of the product, such as network effects, as their main competitive edge.

Early institutional funding in DeepTech is therefore often used to secure a land grab on talent. This is happening in AI right now.

5. Market risk is lower

Deep Tech startups rarely have comparable products in the market primarily because they’re solving a large problem in a brand-new way. Their underlying breakthrough technology unlocks huge market opportunities and often creates entirely new markets.

Regardless, both DeepTech and traditional startups require product/market fit to succeed, and DeepTech startups must avoid the trap of becoming a ‘technology looking for a problem’.

DeepTech does not usually work well at first, and scaling a solution right away can be costly from both an implementation and maintenance standpoint. There are just more steps. The upside, however, is that once a customer is committed, they’re usually there to stay.

And once product/market fit is confirmed and the market is unlocked, DeepTech startups often see a period of growth (and associated value creation) that can accelerate even faster than their mainstream software counterparts.

A very different approach needed for successful portfolio construction.

The Tech landscape is changing. 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.

And there is another incentive for investors to look at hardware. Compared to mainstream software companies, DeepTech exits don’t take nearly as long. They also tend to be smaller and usually happen through M&A with incumbents with deep pockets and a distribution channel. For the acquirer, DeepTech companies are successfully commercialised R&D.

Once a company has proven that its product works in the market (at some reasonable scale), they’re likely to be scooped up by companies that can leverage their existing sales channels to push the products out.

Suthipongchai says that counting on one or two companies to return the entire fund (as is done in software) is not only foolish, it’s a good indication of an investment team that shouldn’t be investing in DeepTech.

A good number of companies within the portfolio must perform well, and follow-on investments must be much more diversified. The upside here is that if you bet on plays where there is little or no market risk, then growth can look more like a step function than a smooth curve. Valuations will then shoot up in response, creating returns that - in aggregate - are just as compelling as mainstream software.

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