Recently there have been a lot of hefty discussions about the bursting of the startup bubble, with VCs limiting drastically their investments and activities. It all started with a Report by the National Venture Capital Association showing that in Q3 2015 US VC firms raised $4.4bn, a whopping 59% decrease to the previous quarter and a 33% slowdown from Q3 2014. What happened following to that, was a significant decrease of investment activities in Q4 2015 on a global scale. Now that we have some numbers to work on, let’s take a look whether it is fair to say that the bubble has burst.
The numbers take us at least a year back in time
Let us dive in right into the numbers. In their Venture Pulse Q4 2015, KPMG and CB Insights provide a lot of significant data, so let’s look at this apparently disastrous quarter.
- The number of deals made globally went from 2,008 in Q3 ’15 to 1,742 in Q4 ’15, the lowest since Q1 ‘13
- Global VC investments shrunk from $38.7 billion to $27.2 billion over the same time
- The number of unicorns was cut in half to 12 in the last quarter of last year. In Europe no startup has reached the 1 billion valuation at all
- In the US, funding to VC-backed startups stopped at $ 14.1 billion, the lowest since Q3 ‘14
- Mega rounds (over $100 million) in the US dropped from 39 to 18, in Europe from 6 to 4 and in Asia from 27 to 16
- VC Investments in Asia fell short 32% compared to the previous quarter, down to $9.7 billion
Also PricewaterhouseCoopers and the National Venture Capital Association in their Q4 2015 MoneyTree Report find that startups received $11.3 billion funding from VC firms, down 32% from the previous quarter.
Well, this looks pretty bad. Over one quarter the contraction of VC activities has taken the numbers back to the levels we saw one year ago or even further.
The look behind the curtain
But it is all really that bad? And what is behind this development?
2015 Record Year! One would not expect that after reading the points above, right? Globally, 2015 hit an all time high with $128.5 billion funding going to VC-backed companies. Seems to be contradicting, but the negative aspects tend to stick in people’s minds. Just a couple of weeks ago, we were greeted by an investor who started the discussion with: “As you know, the bubble has burst…”. As these news influence how investors and institutions perceive the whole startup ecosystem, with impact on valuations and future development of companies, a series of questions beg to be answered. Was Q4 just an outlier? Have these numbers real substance behind them, and if so, what justifies what seems to be a paradigm shift in how investors look at companies?
Probably, the only way to lift the veil and really understand the logics that determined the Q4 contraction is to look at each macro-ecosystem separately.
Starting with the US, we can identify a number of significant indicators.
Funding volume and number of deals both decreased from $20.8 billion to $14.1 billion and from 1,177 to 981 respectively from Q3 to Q4 last year.
Mega rounds (Investment rounds greater than $100 million) dropped from 39 to 18
The average seed deal size increased from $2.6 million to $3.2 million, while the average late stage deal size decreased by more than 10% from $34 million to an even $30 million
Still, the seed-stage investments fall the second quarter in a row to account for 24% of all deals
What we see from these changes, is a trend that seems to favor earlier and smaller deals over huge late stage and growth rounds.
A relatively industry-unrelated motivation for the overall slowdown in the US can be attributed to the rumors of expectations of interest rates rising in the near future. Particularly institutional investors might be following this line of reasoning, looking at acceptables returns at significantly lower risk levels. Corporate investors, which make up for about one quarter of investments, will be less sensitive to this factor.
Recently investors have been hit by massive write-offs as IPOs failed to reach the level of private valuations. Investors looking for growth companies who joined in in huge deals have been evaluating investments more carefully as a result.
The focus on early stage investments and the increase of the deal size shows a rethinking of investors in their portfolio composition. More attentive evaluation might lead to a cherry picking of higher quality companies with solid valuations.
For many aspects, the situation in Asia is quite similar to the US.
Despite a record year in terms of VC funding (2015 saw more funding than the last 4 years combined), in Q4 there was a massive 32% drop from the previous quarter, from $14.2 billion to $9.7 billion.
Mega rounds dropped from 27 to 16
The size of late stage rounds has significantly increased to an average of $154 million
As a result of these development, the mid-stage deals (Series B — C) have reached a 5 quarter high, adding up to 29% of all deals.
Macroeconomic factors are determining the overall decrease of VC activities. Concerns about a slowdown in China’s economy, the falling exchange rate and the weakening of the retail sector lead investors to greater caution.
China is employing greater regulatory scrutiny on certain business models, practices and industries. Fintech is particularly subject to this development, making investors more wary.
A possible source of stability in the Asian market may come from Corporate VCs. They make up 35% of all deals, compared to about 25% in the US and Europe
As a further development, it can be expected that the VC activities will be further strongly linked to macroeconomic factors, especially concerning China. There might be a shift from investments to a consolidation phase. Significant M&A activity has already been recorded in Q4 ‘15.
Let’s look at how Europe developed over this timeframe. Did it follow the same path as the US and Asia?
2015 was a record year for Europe as well, with $13.4 billion in VC-backed funding, up from $8.4 billion in 2014
The trend in Q4 ’15 has been negative as well for funding and number of deals, but the drop has not been as steep. Funding went down to $3 billion (from $3.5 billion in Q3 ’15) and the number of deals barely moved from 347 in Q3 to 338 in Q4
The early stage deal size went back to $2 million (where it was in Q2), after lowering to $1.6 million in Q3
Well, it turns out that Europe is the least affected by the decline. But why?
On a macro level, the opposite is true as for the US. Interest rates are expected to remain at extremely low levels, giving continuity in the investments coming from institutional investors
Diving into the startup world, European VC investors have always had a more conservative approach. In many instances, investments would flow only after a new business model had proven itself
This behaviour, in turn, has always determined relatively low valuations. Even with the current increase in deal size, the valuations are not comparable to the US and Asia. Overall, there is less concern about inflated valuations.
The road ahead
Probably the most relevant quote from the report by Brian Hughes, Co-Leader KPMG, looking at things to come is: “Up until the third quarter 2015, we saw as much capital going into companies that were generating negative cash flows as those that were generating positive ones. […] In 2016, the fundamentals are really going to matter again.”
Netting out the macroeconomic effects, the fall of new unicorns, the decrease of funding and deals seem to point at a significant shift in the way VCs look at new investments. More than a bubble bursting, the developments are the result of self-regulating measures, hopefully giving the whole startup ecosystem more stability and foundation on concrete value assessment.
If this will really assess itself as the new VC mindset, we can all look forward to many more deals to come, but in more solid business models at sustainable valuations.
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