Weekly Briefing Note for Founders 7/9/23

11th September 2023

This week on the startup to scaleup journey:

  • August tech funding beats expectations
  • VC funds are not the only source of venture capital

August tech funding beats expectations

August 2023 was a remarkably strong month for capital raising across the European tech ecosystem. The latest monthly report from tech.eu says that August now goes on record as the busiest month of the year in terms of the total amount of capital raised, reaching €6.8 billion across 307 deals. This is an increase of around 40% compared to the previous month (€4.7 billion raised in July) and an increase of around 35% YoY (€5 billion raised in July 2022). These figures were enough for analyst Dan Taylor to comment: "While it might be too soon to call it, the numbers are encouraging, and we could be looking at the early signs of a recovery of the European tech ecosystem." In August, 88 exits were recorded, up 24% on the prior month. This included 83 acquisitions, 4 mergers and 1 IPO. Many believe that the leading indicator of a VC market recovery will be the resumption of the IPO market. But it won't be what's happening across European exchanges: All eyes are now on US public markets as the IPO pipeline continues to fill with high profile names that are just waiting for the right moment to move.

Pitchbook's latest Global Markets Snapshot provides an upbeat assessment of equity markets YTD. The Nasdaq composite has posted a return of +34.9% YTD, while the Nikkei 225 is up 26.5%, and the S&P 500 is up 18.7%. Meanwhile, the FTSE 250 is up a paltry 1.0%. The long-awaited listing of Arm Holdings may finally be upon us, filing its application on August 21 to list on Nasdaq. Tech firms Instacart and Klaviyo have also submitted S-1 filings, making for a trio of highly anticipated IPOs that could potentially break the current log jam. These listings will provide more clarity about what private companies are worth. Since the tech downturn started in early 2022, founders and investors have been in a huge debate over valuations. Venture investors have been leveraging the valuation hits of previously VC-backed public companies, but soon we will see how newer IPOs will price. This will primarily impact late-stage private company valuations but inevitably there will be a trickle-down effect to the earlier stages.

Against this backdrop, US analysts have been busy trying to predict when startup investing will return to normal. The consensus seems to be that round counts should revert to the mean sometime in the second half of 2023. All of this could potentially bolster European deal activity. As we pointed out last week, European Seed and Early-stage valuations have remained remarkably resilient, rising again in 2Q23. Founders that had been holding back funding campaigns as valuations tanked in 4Q22 have seen the bounce-back and are now revisiting their plans. With greater uncertainty over Series A rounds - where investors have become far more discerning - there has been an increasing focus by founders on 'runway extension' rounds at Seed. But for these to be successful, founders are having to be increasingly diligent in their preparation. If you can't demonstrate a viable plan to reach Series A readiness and the scaling that should then follow, you'll present too high a risk profile. This requires founders to have a clear, milestone-based plan that investors will strongly resonate with. These are discussions that might not have happened until a Series B round during the boom period. How times have changed.

VC funds are not the only source of venture capital

David Clark of VenCap has just published some remarkable insights on VC returns. VenCap is an independent investment advisory firm that invests in VC funds across the globe. An analysis of 11,350 companies backed by 259 funds they invested in between 1986 and 2018, has revealed: Over 6,000 of these companies (53.2%) have produced less than 1x return. Of these, more than 2,500 (22.6%) were complete write-offs. A further 2,157 companies (19%) were marginally successful returning between 1x to 2x the capital invested. 1,813 (16%) were moderately successful returning between 2x and 5x. But just 1,342 (11.8%) returned at least 5x and an even smaller number of 614 (5.4%) returned 10x or higher. Finally, the so-called 'fund returners' - those that returned 100% or more of the committed capital of the fund that backed them - just 121 companies (1.1%) hit this mark. These outliers are vital for VCs to hit their overall fund return targets - typically 3x. This paradigm led Peter Thiel to declare 2 rules for VC funds: "First, only invest in companies that have the ability to return the value of the entire fund. This leads to rule number two: because rule number one is so restrictive, there can't be any other rules."

Thiel said of rule number one: "This is a scary rule, because it eliminates the vast majority of possible investments. Even quite successful companies usually succeed on a more humble scale." This is a salient reminder that not all companies are great candidates for VC funds. But they may be great candidates for another form of venture capital. Here, the term 'venture capital' is used more broadly to refer to the stage of the company. In a similar way, we might use the term 'growth capital' for companies at a later stage of their evolution. Venture capital, in this context, can include a wide array of other investor categories that are not VC funds, but still invest at venture stage. For example: Angels, Angel Groups, Asset Managers, Corporates, Family Offices, Government/Sovereign Wealth Funds, certain Hedge Funds and Private Equity funds, plus a wide array of other private investment vehicles that are not beholden to Limited Partners. In our recent article. "How we find well-matched investors", we highlighted that not every startup is right for 'mainstream VC', so they must seek out alternative categories of venture investor that court different aspirations and expectations. We described our own approach to identifying investors that will have the greatest alignment with those of a particular startup.

Going back to the VC fund category, there is another factor that can determine suitability, and that is fund size. The bigger the fund the higher the expectation for absolute returns. A $500M VC fund looking for each company to 'return the fund' will have dramatically higher exit aspirations than a much smaller $50M fund. Provided the amount of investment sought aligns with the capital allocation strategy of the smaller fund, this may be a better fit for a startup that is operating in a more 'constrained' market - i.e., Thiel's 'more humble scale'. For example, the market size ($TAM) could be constrained by geography: Large funds will expect startups to have global market aspirations that will almost certainly include the US. Smaller funds may be content with startups that are addressing regional or country-specific markets. In the aftermath of the boom years, David Clarke's view is that "the gap between the top 1% and the rest of the market will become increasingly wide". This is why VC funds have become more selective, with the number of deals dropping markedly over the past 12 months. And this is also the reason that valuations, especially at Seed stage are showing resilience. The big takeaway from this research is that only 1% of investments make the big returns. But it is also a reminder that venture capital is not a monolithic investment category where only VC funds operate. Where necessary, founders should assess other investor types to ensure the best long-term alignment.

Happy reading!

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