Weekly Briefing Note for Founders 9/5/24

8th May 2024
CATEGORY:

This week on the startup to scaleup journey:

  • Founders raising capital have a new puzzle to solve




Founders raising capital have a new puzzle to solve

Founders planning their next funding round have a puzzle to solve. Making sense of a very uncertain venture funding market has now become top priority.

On one hand we have seen two years of sharply declining investment into startups. On the other, we are witnessing record deal sizes and valuations.

Some investors are piling money into hot sectors like AI, whilst others have withdrawn from the market altogether. Some think the market will 'recover' as soon as IPOs switch back on, whilst others think we still have a 5-year slog ahead of us.

To help unravel this, there are 2 trends to watch. The first is the headline data on the number of startup investments, deal sizes, and valuations. For a summary of the latest trends read our State of European Venture 1Q24 article. Bottom line: deal count is at a 6-year low but deal sizes and valuations are now hitting all-time highs. We set out why.

The second category of trend data relates to exits, investor fundraising, and the value of current investor portfolios. These data points - and the factors that influence them - provide a much greater insight into current investor sentiment. We dig into the latest trends below.

Of this second category, the most challenging to assess is 'current portfolio valuations'. For many investors - especially those operating at late stage - this has a significant bearing on how they think about the future. It affects their returns (when companies exit and the real valuation is crystallised) and consequently impacts their ability to convince LPs to invest in their new funds.


Exits

At the peak of the market in 3Q21, European exit value hit €74.9B across 337 deals, according to Pitchbook's Q1 2024 European Venture Report. By 1Q22 this had collapsed to €14.6B (328 deals), freefalling even further to €3.4B (261 deals) in 1Q23. In 1Q24 it almost halved again to €1.9B (245 deals).

Most Q1 exits were acquisitions as European public listing markets remained dormant. The run rate of total exit activity, if maintained, implies 2024 would sit 46.4% lower YoY. The biggest driver of any recovery here would be faster and deeper interest rate cuts. Pitchbook's analysis is more cautious regarding this and any impending impact it will have on IPO markets. 

There have only been 4 significant IPOs from venture-backed businesses since the start of the year. Most of the IPO activity has been from more mature and profitable PE-backed companies. Pitchbook notes a much-debated disparity between the US and Europe, where listing markets in the US not only appear to be showing more resilience but also less of an aversion to unprofitable tech. 

Out of the top 10 exits in 1Q24, 8 were strategic M&A and only 2 PE Buyout/LBOs. Only 4 of these transactions exceeded €100M (2 in Biotech/Pharma, 2 in Software). Over 95% of all acquisitions and buyouts had exit values below $10M. This is a reflection of many boards (i.e. current shareholders) deciding that, in the absence of new funding, the only way is 'out'.

Following Software, Biotech and Pharma have comprised the most meaningful part of exit value in Europe, holding an average of 22.0% over the past decade. Public equities within the industry have rallied through the year, providing perhaps more favourable valuation benchmarks for private players exiting, which could lead to the sector gaining share of exit value. 

Bottom line: The start of 2024 has shown “more of the same” from 2023 when it comes to exit activity. Investors are not yet banking on a big IPO recovery in 2024.


Fundraising by VCs

European VC fundraising has also followed a steep downward path in the past 2 years. From a high of €33.2B (429 funds) raised in 2021, to €30.6B (348) in 2022, to €19B (172) in 2023. In 1Q24, capital raised amounted to €4.6B.

This improved run rate of activity in Q1 implies that, if maintained, 2024 could end the year with levels matching those of 2023. And as Q1 brought 47 new funds to market the implied annual run rate could exceed the total number of funds from 2023. 

Unlike the US, activity is not being driven by a few large firms. In the European top 10, the largest fund raised was €400M and in 10th position the fund size was just €138M. The vast majority of European funds fall below the €100M mark with around 25% below €50M.

This modest figure confirms that fundraising was dominated by emerging fund managers in 1Q24. In 2022 and 2023, the majority of capital raised was allocated to more experienced managers with proven track records. This is an encouraging shift, especially for startups seeking Seed stage funding.

Emerging firms (those that have launched fewer than 4 funds) are now coming to the fore, accruing 57.6% of capital raised in Q1. In fact, 14 of the 47 closes in 1Q24 were by first-time funds, evidencing that new firms are still emerging despite harder financing conditions. 


VC portfolio valuations

Whilst exit and fundraising trend data is public for all to see, the valuations of existing portfolios is a closely guarded secret for VCs. Shared only with their LPs, this is the key metric of fund performance. Given that these are private valuations, VCs have a lot of discretion in how they 'mark' their books.

To highlight the current disparity between book values and true market values we just need to look at the number of unicorns - companies valued at $1B or more. The term 'unicorn' was first popularized by venture capitalist Aileen Lee in 2013.

In 2012 there was just 1 unicorn. In 2013 there were 3. By 2015 this number had risen by a further 25-30 and by 2018 the number of new unicorns was in the 50-60 range. At the height of the market in 2021, 749 were minted in just 1 year! As of March 2024, there were over 1,200 unicorns around the world.

In a recent interview, eminent US VC Mark Suster, Managing Partner of Upfront Ventures, claimed that 1,000 of these private market unicorns (that were funded at the peak of the market) are currently so far below this valuation that they will never achieve an exit value of $1B or more.

In other words, many late stage and growth investors are still sitting on portfolios with massively inflated valuations. According to Suster, 60% of these deals were marked by just 4 firms: Softbank, Tiger, Coatue, and Insight. This is a tidal wave of write-downs waiting to happen. It will draw in 100's of other firms that participated in those rounds. Returns will (eventually) take a huge hit. LPs are already very anxious.


Time to unwind

The problem is not just with unicorns but with 1,000's of other late-stage businesses that raised at the peak. This has created a huge pool of 'zombie' companies who will never be able raise again at those prices. Unless valuations (and stock option prices) are reset, employees will also figure this out and leave, making each company even more of a zombie.

The most brutal reset is often realised in M&A where the market reality hits. There are now many examples of this, with the latest being cloud security platform, Laceworks, valued at $8.3B in November 2021 (after raising a total of $1.9B) reportedly being offered around $200M in a recent M&A bid.

Suster quotes some fascinating figures from the aftermath of the Dotcom bubble. This was preceded by the bull market of the late 1990s, driven by a surge in new internet-based companies. The value of equity markets grew exponentially, just like it did in 2021. The bubble burst, resulting in a 77% drop in the Nasdaq, which had previously seen a five-fold increase between 1995 and 2000.

From 1998 it took top quartile VC funds a mere 2 years to go from 1x to 3.3x returns. After the bubble burst, they fell from 3.3x to 1.4x. But it took 5 years for the VC industry to mark valuations down to this level.

In Suster's view, the highs of 1998-2000 are nothing compared to the overvaluations of 2021. He says: "We are 2 years into the correction. I think it's going to take another 5."


Hope value

It's clear to see why investors are proceeding with great caution. But from the gloom there are pockets of real opportunity for startups. There are 2 dimensions to this; stage and sector.

Early-stage startups currently have an advantage. They are still many years away from exit so by the time this happens exit markets should have recovered. Investors know this and it's why we are seeing record deal sizes and valuations not just at Pre-Seed, but at Seed and Series A (as highlighted in our earlier report).

There are a number of hot sectors that investors are pursuing, led by 'everything AI'. Suster's analysis is that investors are already paying a 44% 'AI premium' at Seed right now, compared to enterprise software generally. By the B round the premium is 200%. The window for big returns may therefore already be closing.

Investors are looking for other powerful macro market events that are creating big discontinuities. These have the potential to enable outsize returns, sometimes in the most unlikely of places. For example, one of these, Space, is being enabled by the SpaceX Falcon rocket. This has decreased the payload cost per kg of launching into space by a staggering 90%.

On the back of this innovation and others, there have been over 100 spinouts from SpaceX to date, raising over $10B so far. About 30% of this has been focused on space including satellites, communications, earth observation, media, and telecoms.

Many new 'use cases' for Space Technology are also emerging, from mineral extraction to zero gravity manufacturing. For example, SpaceX spinouts also cover energy, CleanTech, and many other areas of DeepTech.

Overall, DeepTech is growing in prominence, driven by an increasing number of industries that are being disrupted as we highlighted in our recent article: Why DeepTech founders must think differently about funding strategy.


In summary

Following 2021 highs, many investors are still sitting on portfolios with inflated valuations. It may take another 5 years for the VC industry to fully correct.

European exits are still in the doldrums. If the run rate of exit activity from 1Q24 is maintained, 2024 will sit 46% lower YoY.

Against this uncertain backdrop, deal count in venture is at a 6-year low. But if you have a truly compelling proposition, deal sizes and valuations are hitting all-time highs.

Emerging managers sense opportunity. The number of new European VC funds has seen an uptick in 1Q24. The implied annual run rate could exceed the total number of funds from 2023.

Founders that can leverage powerful macro discontinuities to create compelling propositions will (always) have an advantage. Hot sectors, like AI, continue to attract premium valuations.



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