By Howard Watt on Monday 30 January 2023
Record amounts of dry powder from investors and recently laid-off tech operators turned founders could prompt a return to growth for European VC in 2023, writes Fladgate's Howard Watt.
While 2022 was another banner year for venture capital fundraising in Europe, the year closed on around $76bn in funds raised, some 17.5 per cent lower than 2021.
Much of that was in the first six months of 2022 and the sharp pullback in the second half of the year has continued into 2023.
We’re certainly off the breakneck pace of the last two years. There are still funding rounds happening, but mainly at the Seed stage and Series A and for better-performing companies.
Investors are being much more cautious in reviewing investment opportunities and the bar for an ‘investable’ company has been raised. Fewer companies above the bar, plus no reduction in the number of investors (many of whom are sitting on record amounts of dry powder) is keeping valuations competitive, though it is still down on the heady heights of 2021.
What’s more noteworthy is less the reduction in the volume of instructions and more the types of instructions we are receiving. Good companies which are running out of cash are increasingly looking at ‘rescue rounds’ – existing investors injecting enough new money to extend the company’s runway.
These rounds are usually not only beneficial to those who take part (multiples on liquidation preference are coming out of the woodwork), but are also punitive to those who don’t take part – ‘pay-to-play’ provisions which force a shareholder to forfeit their previous preference rights for not continuing to back the company through a difficult time.
Bridge loan financings – the debt equivalent to rescue equity - are also on the rise.
The objectives of this type of funding are also symptomatic of the current investing environment. Rather than invest with the aim of emerging from the other side of the economic malaise and carry on as before shooting for the moon, these financings are often explicit about entering immediately into a sale process.
With the public market IPO window all but closed, shareholders are looking to opportunistic M&A to realise gains. M&A instructions remain healthy as a result. It naturally follows that taking an earlier exit ramp means venture capital investors are settling for a much more conservative return than they normally want.
So, is this a sign that venture capital investing has had its day and the good times are over? I for one don’t believe that.
First off, the reports of record amounts of dry powder are true – estimates put it at an eye-watering $580bn globally – and investors will be under pressure to deploy that capital given that most funds are structured with a five-year investment period (usually extendable by no more than 12 months).
Investor clients appear keen to hear about new deals, perhaps signalling that they are growing restless on the sidelines and eager to get back in the game.
Secondly, the widespread layoffs occurring in larger, later-stage tech companies and global tech giants like Google, Microsoft and Twitter, is releasing experienced tech operators back into the ecosystem, many of whom will remain tech-focused and entrepreneurial.
You can be certain that these individuals will conceive some of the most important companies of the next decade, just as the last post-crisis cohorts did in 2008/2009 and the period following the Covid-19 pandemic.
Sectors such as climate tech, and data storage and organisation continue to attract funding, and I’ve had to resist the temptation to have ChatGPT write this article, such is the hype and interest in this growing sector of AI.
Tech start-ups that exit to other larger tech companies do not necessarily disappear - they end up creating larger and more resilient entities to survive the storm.
All this to say that although early signs point to a nervy and quiet start to 2023, investor sentiment is not writing off the year entirely.
Once the economic conditions begin to trend upwards, we anticipate a fairly speedy return to the playing field for venture investors.
When they do, plentiful dry powder will be available to be quickly deployed into innovative companies founded by a raft of seasoned tech operators with names like Google and Microsoft on their CVs.
The reports of tech’s demise are premature. Progress and innovation will lead the way in solving the problems highlighted by the recessionary climate and all the ingredients are present for the venture capital ecosystem to turbo charge that progress. When the pitch is match-ready again, all of the players will return ready to play again.
Howard Watt is a corporate partner at Fladgate LLP, with a particular focus on UK and European venture capital.
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