There is a chill wind blowing through the tech industry. The sunlit days of limitless funding are over and winter is coming. So how is it that hardly a month goes by without news of a leading tech venture capitalist leaving his or her job to raise a new fund in London? How can both of these things be true?
There is no doubt that life in the Valley, and not just the Valley, is a lot chillier. According to a report from PricewaterhouseCoopers and the U.S. National Venture Capital Association, funding of Silicon Valley start-ups fell 19.5% in the first quarter of 2016 compared with the same period a year earlier.
Nor is it just the Valley. The Wall Street Journal reported: “Venture-capital investments in China’s technology startups fell 28% to $1.8 billion in the first quarter from $2.5 billion a year earlier, according to Hong Kong-based AVCJ Research. In India, venture capital investors in the first quarter of 2015 pumped $891 million into tech startups. That number was off 17% at $736 million for the first quarter of this year. And in South Korea, venture capital investments fell 37% to $45.8 million in the first quarter from $72.2 million a year earlier.”
Did no one in London get the memo?
Sure, says new fund LocalGlobe’s Ophelia Brown, who quit Index Ventures to join father-and-son team Robin and Saul Klein, the winds are blowing, but it’s just not buffeting London as badly. “We are not seeing it with the severity in the U.S., where you are seeing down rounds and companies having issues raising follow-on capital.”
For once, it seems, European conservatism may have actually helped. “In Europe, fundraising has traditionally been smaller,” says Maria Wagner, Investment Director for U.S.-based investors Beringea. “Businesses have done more with their money than their respective businesses in the U.S. That is one reason the correction will not be as big as in the U.S. — people have been more efficient with their money.”
The point is echoed by Laurence Garrett, a partner at Highland Capital Partners, Europe. “The U.S. has a greater swing to it, both on the upswing and on the downswing. One U.S. investor in the Valley said to me: ‘we both go to the rails, it’s just that our rails are wider than in Europe.’ So when we have the upswing we create more unicorns than in Europe.”
Correction May Not Be A Bad Thing
Some VCs seem not merely sanguine, but actually welcoming of the correction that is coming. Balderton’s Daniel Waterhouse is typical. “What we’re seeing, which to me is a healthy thing, is a bit of a reality check as people pause and say, ‘hang on a second, we should probably look at the fundamentals a bit more.’
“In the public markets in particular, the expectation got higher and higher so that some companies, even if they deliver good results, still disappointed [the market] because the implicit belief was that they could do even better. The expectation has been baked into the valuations that, frankly, are a bit out of control.”
So Europe’s parsimony, versus U.S. hubris, when it comes to funding rounds (which historically, according to Informilo research, using data from Dow Jones Venture Source, could be anything up to 40% smaller than U.S. rounds) may have actually been cruel to be kind. But how do VCs explain the pre-Cambrian explosion of new funds?
The reason, say leading VCs, is the difference in maturity between the Valley and London. It is simply Europe growing up, says John Rosenberg, general partner for U.S. fund TCV, who moved to the UK in 2012 to head up their European operation. “What we’re seeing in the European technology markets is a natural maturation process. It is still behind the U.S., but the maturation is occurring.
“It is driven by more and more talent, experienced talent, continuing to build businesses. It is being driven by the fact that there are identified successes — real success stories that people can point to and say, ‘we can do this.’
“All of that feeds upon itself, which of course creates a better environment for the early-stage venture.”
Most of these new funds are, by U.S. standards, at least, minnows. LocalGlobe’s fund is £45 million. Andreessen Horowitz’s last fund was $1.5 billion.
Nevertheless there is concern among some VCs that while a surge of money into the London tech community is welcome, entrepreneurs have to take care. The tax incentives introduced by the Conservative government in the enterprise and seed enterprise investment schemes (EIS and SEIS) have helped drive unprecedented interest in the tech world, says LocalGlobe’s Brown, but it comes at a price.
Best Is Yet To Come
“We are cautious on EIS and SEIS,” she says. “There is a risk of bringing uneducated money into the market, especially around valuations, that could have a negative effect in the future for companies.
“We have seen crazy stuff. Entrepreneurs try to launch at £25 million pre-money.”
While such stories may ring cautionary bubble alarms, it is, according to Founders Forum’s Brent Hoberman, important not to get distracted by the number of funds. “Although it’s quite a lot of funds, is not actually that much money,” he says. “Look at it that way — one of the companies I advise is a $16 billion fund. It’s a totally different scale.”
Alex Macpherson, Head of Ventures at Octopus Ventures, agrees. “The asset allocations [to venture funds] from some of these large pension funds, endowment funds, etc., are tiny. They’re tiny compared to what these funds are doing elsewhere.” Macpherson said the best is yet to come as London and European companies start to scale and increasingly drive real returns for investors. “I am convinced that a lot of the European institutions have not yet started to look at this asset class. People are waking up to the fact that this asset class exists.”
It is also, says Beringea’s Wagner, key not to let the current gloomy weather in the west distract from the long-term position. “People are building businesses for the next 10 to 15 years,” she says. “If there is a correction in one year, I do not think it will affect that inflow of capital, knowledge or people.”
So while VCs seem excited by the prospect of more money and more funds to feed more start-ups and more success, there is some debate about where that money is needed most and whether or not a “crunch” exists.
Business Growth Fund’s Simon Calver, the ex-CEO of LOVEFILM turned venture capitalist, is just one who thinks London has seed well covered, but wonders if gaps exist elsewhere. “It needs it more in the post seed — which I think has done really well — so Series A and Series B [funding].”
Evidence Of A Crunch Hard To Find
But Calver is bullish on that too. “We are beginning to see some of the funds coming through with entrepreneurs who have had exits, and are now giving things back. That can only be good for the whole of the environment. I think that is slightly more akin to the Valley than it would be to the rest of Europe and what is going on there.”
Evidence of a crunch is rather harder to find than anecdotes supporting it. One person’s crunch (a jilted entrepreneur perhaps) is another’s market doing what it is supposed to. “For 5,000 companies that will get funded at the seed stage,” says Calver, “maybe 1/10 of that get funded at the Series A.”
So if there is a crunch, perhaps it says more about your company than the market, suggests Hoberman. “There is a crunch if you haven’t proven enough. But if you have, there are a ton of people desperate to find you.”
That, suggests LocalGlobe’s Brown, indicates that things are going to change as London continues to mature. “My prediction is that if we sit here again in a few years, there are going to be more funds for Series B and Series C because people will raise larger funds.”
In these perhaps constrained times, what advice do VCs give to entrepreneurs looking to raise funds? It comes back to one thing: the days of shooting for growth at all costs are over — instead, build profitable companies.
“When there is relatively free capital, or when capital is plentiful, it is the right strategy for a founder to not go for profit but to hit for the stars,” says Hoberman. “But clearly when that psychology changes, you cannot have that framework. Therefore they need to to do the really obvious things, like watching their cash flow.”
Brown was even more specific. “What does it cost me to acquire a customer? What is the payback? You have to be thinking about these things from the outset. Do my revenues cover my fixed costs?
Too High Valuation Could Be A Problem
“A couple of years — even 12 months — ago you could have raised a Series A where you are paying anything between £10 to £30 to acquire a customer and getting payback in three years. I don’t think investors want to fund those models today. I think investors want to see less than a year payback.”
Even for growth-stage funds, these kind of basic business metrics are crucial. John Rosenberg is a general partner at U.S. late-stage investors Technology Crossover Ventures and heads up their European operations out of London. He says though late-stage investing means most of the business model risk has been taken out of the equation, he still looks for one key metric: “The business is profitable at the unit level. That does not mean the company is profitable, you incur a lot of upfront costs — particular marketing — which take a long while to pay back. When they are profitable at the unit level, that is when you can control your own destiny.”
And while it may be on the “Well he would say that, wouldn’t he?” list, BGF’s Calver cautioned entrepreneurs against going for too high a valuation in early-stage funding. “If you get too high a valuation too early, it may inhibit your ability to get funding later, and that restricts you.
“This is not a sprint. It is a long haul. It took us the best part of nine years to get LoveFilm to where we did and our exit to Amazon. You have to think about capital requirements over the longer term as a founder.”
For entrepreneurs who do get it right, all of the VCs Informilo spoke to suggested, the short-term forecast is a bit choppy, but the long-term picture is bright indeed. With more money coming into the market, more funds, and a sea-change in entrepreneurship, there has never been a better time to set up a company.
“If you want to start a business this is now as good a time as there has ever been in the history of business in Europe to raise the capital,” says Highland Capital’s Garrett.
Just Go Out And Do It
One cloud that the chill winds have blown in was a freezing up of the public markets in the U.S. Tech IPOs have dried up, and publicly-quoted stocks have been through turbulent times. Without IPOs were investors worried about exits? Not even slightly. If the public markets were troubled, there is no shortage of M&A activity, mainly driven by acquisitive U.S. tech giants.
“I do think that just given the number of U.S. companies, and the amount of cash they have on their balance sheets — oftentimes more tax efficient to use within Europe — they would use their balance sheets and you will see the predominance coming from them,” says TCV’s Rosenberg.
But it isn’t just the tech giants. Other players are starting to move in, lured by the huge tickets tech giants are writing. “Big private equity has got into the technology game recently, again for big, strong, cash-generative technology businesses,” he says.
All in all, there is a remarkably upbeat tone from these leading London VCs, all of whom were confident that, short-term blips (such as the Brexit vote on June 23rd) and adverse winds from the Valley aside, London has never looked as strong.
According to Octopus’s Macpherson this is the best of days: “You see the opportunity to build a really, really big business — there are the funds from the European investors to continue to back those businesses to create truly global businesses and brands. Just go out and do it.