This week on the startup to scaleup journey:
Europe VC investment down 54%
Funding into Europe-based startups fell by an alarming 54% in 4Q22 (€12.8B) compared to the same quarter a year ago (€27.9B). This is the lowest investment quarter since 2Q20, according to the latest figures from Pitchbook. As concerning as these figures are they are not quite as dramatic as the 61% collapse in the US market over the same period. But the comparison of 4Q22 with 3Q22 shows a much more significant quarter to quarter drop in deal value in Europe (38%) compared to the US (23%). This suggests that the European market 'correction' is running approximately one quarter behind the US. Deal count decline across Europe is not as marked as the value decline, with provisional figures showing a 43% drop in deals in 4Q22 v 4Q21. This is likely to improve after many smaller Angel and Seed stage deals are finally reported for 2022 over the coming months. Still, these numbers are truly sobering for founders looking to raise capital in 2023.
During the first half of 2022, when public market alarms were sounding, there were signs that European venture markets were proving remarkably resilient. Even into Q3, we were seeing only a modest slowdown. In fact, 2022 full year figures of €91.6B only represent a 15.9% year over year value decline compared to the record set in 2021. But the latest quarterly figures demonstrate that the European VC market is now in very sharp transition. The impact has been felt equally across major European countries. UK & Ireland-based companies accounted for €27.0B through 2022, equivalent to 29.4% of European deal value. This region has generated the largest deal value figure every year during the past decade as outsized late-stage rounds have helped push valuations and round sizes to new heights. But these valuations have now been severely hit, especially at late stage. For example, London based payment specialist Checkout.com completed a €883.8 million round at a €34.5 billion pre-money valuation in 1Q22. In December 2022, it was reportedly slashing its internal valuation to €11 billion.
As VCs reassess their funding strategies and triage their portfolios, founders are more actively searching for alternative capital sources. Nontraditional investors, which Pitchbook defines as Corporate VCs (CVCs) and financial institutions including investment banks, private equity (PE) firms, sovereign wealth funds, hedge funds, and pension funds, among others, are being evaluated. These investors have increasingly participated in VC rounds during the past decade. This involvement remained solid in 2022 as VC deal activity with nontraditional investor involvement reached €71.1B, equivalent to 78% of all European deals by value. CVCs can be particularly attractive as they can bring a lot more than money and will often invest for strategic reasons, not just financial return. However, most CVCs prefer to 'follow', so founders may still need a VC to ultimately lead an investment transaction. Even so, we are seeing signs that CVCs are looking to invest in younger companies in long-term industries that are several years away from an exit. This provides a springboard for the future and insulates from near-term volatility.
Exits collapse but VCs still raise more capital
European VC exit activity fell back down to earth in 2022, final year figures from Pitchbook now confirm. After a record €138B in 2021, exits collapsed to €38B in 2022. Breaking this down: Public listings dropped from €107B (207 transactions) to €13B (63) in a reaction to dramatically worsening macroeconomic conditions hitting stock prices. Acquisitions were down marginally from €25.3B (832) to €22.6B (701), showing some resilience as corporates started looking for bargains and valuations came under increasing pressure. PE buyout value was cut in half from €5.4B (228) to €2.3B (216), although this route has rarely been the optimal path of value release for VC-backed businesses. Overall, 2022 was a year of two halves: In 1H22, exits hit €29.6B, whereas only €8.6B was logged in 2H22. The further we move away from the remarkable records set in 2021, it is increasingly apparent that this truly was an outlier year for exits in the European VC ecosystem (and elsewhere), which may not be eclipsed for several years to come.
Over the course of 2022, nearly $3.8 trillion in public market cap was lost. Although such companies are separate from the VC ecosystem, their revised valuations, revenue multiples, and profit margins serve as a benchmark when determining the value and long-term growth prospects of venture-backed businesses. Late-stage companies that had been planning exits in 2023 now face dire market conditions. Those that raised at lofty valuations in 2021/1H22 and need to come to market again soon are expecting severe valuation haircuts. Some will try and slug it out by cutting costs and bridging from current investors but that will still come at a price. Markets will eventually rebound, but recessionary fears and slower growth rates make this timing very hard to predict. In the meantime, corporate acquisitions are rising in prominence. In some cases, similar entities may feel that combining resources and sharing knowledge will better serve customers, ensure long-term survival, and enable growth against rivals.
During 2022, European VCs themselves raised €25.4B, remaining flat on 2021 (€25.3B) and 2020 (€24.4B). But the number of new funds declined significantly to 212 vehicles, down sharply from 2021(305) and 2020 (339). As a result, average fund sizes have shot up and are now more concentrated within a smaller group of fund managers who are now taking a much more cautious approach to portfolio growth than they did in 2021. Investment cycles with startups are lengthening as more time is being spent in due diligence. Those fund managers that did not make outsize returns to LPs through 2020/21 - and as a result are now predicting capital-raising challenges of their own - are heavily protecting reserves within existing funds to support their current portfolios. Pitchbook believes that VC fundraising will flatten in 2023 as LPs recalibrate allocations, primarily due to the denominator effect. Even so, experienced VC fund managers now sense the beginning of a new value-creation cycle and are working ever harder to find the next crop of winners.
Develop your customers, not your product
As the MVP takes shape, founders seek out the first early adopters. The objective is to test the core elements of the value proposition, to obtain feedback, to learn. The proposition is built from the special insight the founders have and the MVP is the first serious test of this proposition. Selecting the right early adopters is vital, especially in B2B models. Some will share the founder's vision - they are living in that future now and can already feel the pain. The MVP provides the pain relief they so desperately seek. But some early adopters will not necessarily share the founder's vision. They may be more conventional thinkers that live in the present. Their mindset is to provide a shopping list of enhancements they want to see before they will consider the MVP. Many of these requests won't relate to the creation of the new future that the founders seek. They don't flow from the special insight that the founders have. These customers will just become a liability and should be avoided. This selective approach is the essence of the Customer Development process. To some founders this seems counterintuitive: After all, we were brought up with the notion that customers select us, not the other way around.
Mike Maples Jr. is co-founding partner at Floodgate, one of the most prolific seed and early stage VCs in the US. Before becoming a VC, Mike himself was a founder. In a recent interview, he describes how he would approach prospective early adopters. He calls this 'going for the no'. "This may not be a good use of your time, but we do this [explain what we do]. If you don't need software that does this then I can save you 45 minutes of your time." Unless the customer then tried to pull him back in, to sell him on why they should work together, he would step away. He says bluntly, "You can't waste any of your energy on people who don't value your advantage." Qasar Younis is co-founder of Applied Intuition, a Floodgate portfolio company. Maples cites Younis as a CEO that fully embraces this counterintuitive approach. His thought process is: "We're not going to try to convince customers to buy from us, we're going to pick our customers based on their fitness to the different future we are designing. We're going to select them and convince them to move with us." Maples adds; "You are building what's missing for them in that different future. It's going to give you a huge learning advantage and an acceleration because they tend to be bellwethers for other customers."
As a VC, Maples is drawn to founders that espouse the customer development credo. In his investment evaluations he starts with the 'secret', the special insight the founders have that underpins the customer proposition they are building. If this is utterly compelling (he describes the moment he gets 'the shiver') he interrogates the inflection points; the points of convergence that demonstrate the timing is now. He then wants to see which early adopters a founder has chosen to target. What research has been undertaken? Why have they been selected? Why do we believe they will share the same vision of the future? Picking the right early adopters is not easy. A direct conversation is needed to carefully qualify and often it requires more, such as a demo. But then their intent must be clear and they should be starting to sell you on working together. The real test is will they pay for the privilege, for a product that is far from complete? If they will, then you are over the first major hurdle. As Maples would say, "You have started to bend the arc of the present to a different future".