Duet Partners
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Weekly Briefing Note for Founders 24/8/23

29th August 2023

This week on the startup to scaleup journey:

  • Seed-stage valuations show resilience
  • Why VCs have to better understand hardware

Seed-stage valuations show resilience

VC valuations have declined sharply in recent quarters but new data reveals that deals at the very earliest stages have bucked this trend. Pitchbook's 2Q23 European Valuations Report shows that valuations at Angel stage and Seed stage have shown great resilience, hovering close to their record highs, whilst Early stage and Late stage have continued their decline. Europe's Angel-stage valuations have remained strongly insulated from market uncertainty in the first half of the year, registering a 10% increase from 2022 to reach a median of €3.1M. Seed valuations have held flat with 2022, at €5.2M. On a similar basis, Early stage (typically A and B rounds) was down 11% and Late stage (Series C onwards) was down 13%. Analysts say that Angel and Seed rounds have been less impacted by volatility in the public markets due to their distance from exit, and any price recalibrations are likely to come much later than they would for Early- and Late-stage companies. But have we already witnessed this recalibration? A closer look at the quarterly data through 2022-23 paints a fuller picture: Angel-round valuations have held more or less flat since 4Q22, when they hit their all-time peak of €3.2M. They don't seem to be budging. Meanwhile, Seed-stage valuations hit their all time peak of €6M in 3Q22, then dropped alarmingly to €4M in 4Q22 before moving back up to €5.1M in 1Q23, and then up again to €5.4M in 2Q23.

A second key indicator that Angel and Seed deals are showing real resilience across Europe can be seen in deal sizes. At Angel stage, the median deal size in 1H23 was up 29% to €0.6M, compared to 2022 overall. In fact, 2Q23 was the all-time high recorded at €0.7M. Angel deals are funded by high net worth individuals, with an increasing number of former founders writing big cheques, fuelled by the exit spree of 2021/22. On the same basis, Seed deal sizes were up 12% in 1H23. Again, 2Q23 was the all-time high quarter for Seed deal sizes at a median of €1.84M. By contrast, Early and Late stage deals were more or less flat in 1H23 compared to 2022. And at the regional level, UK & Ireland is fairing well, even compared to other strongly developing regions such as France & Benelux. Looking at combined Angel and Seed stages, median pre-money valuations have continued their upward trajectory in 2023 so far, hitting €4.6M for the UK (€3.2M France) compared to €4.2M in 2022 (€3.9M France). Computing 10-year CAGRs for the 2013-2022 period shows that the Angel and Seed stages are the fastest growing financing stages across the European VC ecosystem with the median pre-money valuation in the UK & Ireland growing 17.4% per year for the last 10 years ending in 2022; and 15.2% per year for France & Benelux. In the UK it is notable that whilst Angel & Seed median valuations have continued upward to €4.6M in Q2, Early stage has remained flat at €5.6M, further indicating where current investor enthusiasm lies.

The final piece of the puzzle is deal volume. Here we can see the dramatic shift in overall dealmaking momentum that has occurred over recent quarters. Comparing 1H23 with 1H22 across Europe, Angel deal volume is down 57% and Seed stage is down 50%. These numbers will improve in the coming months due to deal reporting lag. Even so, this decline is severe and reveals several key trends: First, new company formations and first-time financings are down as founders become more cautious about even entering the market. Many of these startups are now falling short of elevated investment criteria and boards are fearful of valuation haircuts or failed rounds. Runway permitting, they will delay the next round until they make more progress. Second, there is a contingent that are confident that the time is right and are launching funding campaigns. This group broadly splits into 2 camps: 1. Those that had been considering a Series A round in 2023 but realise that this has become a rarefied space for all but the most exceptional propositions: Many have decided to recast the A round as a further Seed round instead, and 2. Those that have bolstered their Seed credentials in recent months. Many have reworked their storylines - based on more capital-efficient strategies and clearer risk-reduction steps - to fit a more conservative investment market. As a result, valuations at Angel and Seed are holding strongly as investors compete for a smaller number of higher-quality opportunities. In the UK, this is resulting in some encouraging figures: VC investment overall bounced up to £4.3B in 2Q23 from £3.6B in 1Q23, according to Pitchbook, which is the first sequential increase for 5 quarters. This seems like a rare moment of positive news for UK founders planning Angel and Seed rounds in the coming months.

Why VCs have to better understand hardware

The spectacular rise in VC over the past 2 decades is heavily aligned with the growth in the software sector. But just as the dot-com bubble reset the sector in 2000, we are seeing a similar reset from the bonanza of deals in 2021 and 2022. According to Pitchbook, software deal value across Europe dropped 71.8% YoY in 2Q23, more than any other sector. In fact, software went from representing 40.2% of total deal value in 2022 to 29.3% in 2023. In contrast with the drop in software, we have witnessed much greater resilience in other sectors that are less cyclical in nature, such as biotech, pharma, and IT hardware. Whilst software still dominates other sectors in absolute terms, the importance of hardware in high-growth markets such as Climate and Healthcare is becoming clearer. This presents new challenges for venture investors, who have previously depended so much on software alone and must now comprehend a more complex world. In DC Palter's recent blog, he brings this into sharp relief by contrasting the business model extremes of Software and the Life Sciences sector. All other sectors lie somewhere along this spectrum, so analysing the endpoints throws light on where investors may feel capable of participating. This will depend heavily on their perception of the associated risk/reward scenario.

The standard venture capital funding model is strongly aligned with the lean startup principles of software businesses. As Palter says: "The product is less important than the market and marketing. Building the core of a software product takes maybe $1M. Getting that product in front of customers, with teams of salespeople and through distribution channels, and the advertising to build the brand costs a hundred times more. Most startups fail, not because the product doesn’t work but because the market isn’t big enough to generate a large acquisition." The funding pathway for software runs through well-trodden stages, starting with Angel and Seed funding. As revenues grow, validating the size of the market, venture capital funds write increasingly larger cheques to expand the marketing and help the company grow until it eventually reaches critical mass and is acquired by an industry giant or goes public in an IPO. This means that 'software VCs' heavily focus their diligence on the market and how the product fits into that market. Life sciences, as well as some other DeepTech sectors, flips the standard venture model on its head. "Success is 100% about the product. Unlike software, there’s no need to consider market size. If the product solves a common problem like heart disease or a common form of cancer, there’s a market of tens of billions waiting for the winner." Other emerging technologies that can solve pressing global problems in such areas as climate, health, mobility, and food production -  to name but a few - will also catalyse huge new markets.

To pursue more hardware-centric investments, VCs will have to overcome their perceived fears associated with low margins, time to revenue, capital intensity, and slow iteration cycles. To help this, there are some powerful mitigating forces now increasingly in play. For example, specialist manufacturers and global channel partners are enabling more efficient, disaggregated supply chains. Additive Manufacturing, in particular, has become a complete game-changer in reducing costs and complexity. An analysis by VC, Third Sphere, as part of a major project looking into hardware for Climate startups, has also contrasted the outcomes of software businesses versus mixed hardware/software companies: "If you look across a lot of these metrics, how long it took to get to a billion dollars, how much funding they raised, how many years it took to IPO, there's no difference. It's just a different path to create value." They conclude: "This doesn’t mean we expect VCs to suddenly fall out of love with software, but it does mean many VCs have been and will continue to look beyond software to other business attributes. We suspect one of the most important will remain the possibility of creating a moat. And hardware companies, by virtue of being hard, offer the possibility of deep moats." Many software companies that experienced the extreme levels of churn in the Covid aftermath can only dream of moats that enable product life cycles that can easily span 5-10 years. VCs nursing hefty fund write-downs from recent quarters would also love to see more portfolio companies enjoying this degree of stickiness. If they can better understand the realities of hardware, there's no reason why they can't.

Happy reading!

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