Do VC’s Back Startups?

Executive Summary

  • VC’s focus the vast majority of their capital on established, emerging-growth companies that are already far beyond their formation and seed phases.
  • This tendency is being exacerbated as ever larger amounts of VC capital are going to pre-IPO and later investments.
  • Conversely, the majority of US start-ups that do receive organized funding in their initial phases, receive that funding from accredited angel investors — In each of the last 3 years angels exceeded $22 billion in funding (2014 $24.1 billion, 2013 $24.8 billion, 2012 $22.9 billion).
  • Over the last 3 years, an average of 35% of the angel capital has gone into the Seed or earlier stage of investment or $25.1 billion over the three years compared to just 3% of VC capital.
  • Recently incubators and accelerators have emerged to play an important role especially in the very first formation phases of a start-up’s life cycle however, they provide only modest funding.
  • While equity crowdfunding may offer an additional future source of start-up funding, to date it has focused on real estate and peer to peer lending with technology start-ups representing a minority of the modest equity capital committed in the US.
  • Those writing regional economic plans in the US at the national, state or local levels need to be clear that their plans will not succeed without the creation of a large and vibrant angel community in their region.
  • Innovation cluster strategies must, consequently, include ways to accomplish competitive advantage in attracting angels to invest in the innovation cluster.
  • Conversely, less is needed with regard to VC focus — the VC’s invest after companies have been made VC investable by angel investors by which time the company can raise funding outside the geography of the cluster.
  • US lawmakers and regulators should put more emphasis on finding ways to incentivize and motivate citizens with the potential to be angel investors to become so.
  • More can be done in terms of encouraging today’s angels to invest more — for example, the small business capital gain exemption could be extended and a parallel small business capital loss program could be put in place.

Context

  • Build a world leading innovation capacity through encouraging research and development in government owned and private research facilities, and by encouraging private sector R&D through grants, investments and incentives
  • Make available scientific breakthroughs to entrepreneurs through translational science initiatives, centers for technology licensing and commercialization and provide grants and non-dilutive funding for start-ups
  • Attract investment capital and stimulate the local VC community to act as sources of capital for startups seeking to commercialize on the scientific breakthroughs created by the innovation capacity of the cluster
  • Support the creation of a deep supporting ecosystem made up of professionals such as lawyers, IP attorneys, accountants, consultants and bankers with cluster relevant expertise as well as industry associations and non governmental organizations to support the entrepreneurs and the start-ups in the formative phases
  • Encourage larger companies to assist by asking them to support the innovation cluster as well as act as go to market partners and potential acquirers of VC backed companies

But Do VC’s Back Start-ups?

  • For the full year 2015 US VC’s invested $72 billion but only into 3,916 companies.
  • While US VC’s invested an enormous $17 billion in the 4th quarter, this capital was only distributed amongst 902 companies.
  • Of this $17 billion, the majority went to pre-IPO companies and not start-ups. For example, Uber alone raised a $2.1 billion round (with significant Chinese backing), and the median valuation of the later stage companies US VC’s backed was a staggering $957 million — a far cry from the valuation of any start-up.
  • While US VC’s also made investments in rounds closer to the start-up phase (the Series A and Series B rounds), these investments were made at median valuations of $12 million and $117 million for the A and B rounds respectively. Again, high valuation levels that indicate that these are no longer true start-ups but, rather, emerging growth companies.
  • This last quarter VC’s backed fewer companies than in any of the last 13 quarters but the dollars put to work were the fifth highest in that same period.
  • 74 megadeals of more than $100 million each represented a very large portion of the US VC investment capital deployed in the 4th quarter.
  • 10 deals alone took approximately $2.2 billion in funding, or 19% of the total of $11 billion that MoneyTree says was invested by VCs in the 4th quarter.
  • VC capital invested in Seed-stage companies totaled only $375 million across 52 deals in the same quarter (or an annualized rate of around $1.5 billion).
  • Just 3 percent of all venture investment dollars now go to Seed-stage companies and almost none in formation capital (the first money used to form a start-up).
  • The average Seed-stage deal in the 4th quarter had a valuation of $7.2 million, up from $4.1 million in the third quarter — also implying that VC Seed-stage deals are either closer to a typical Series A round, or that VC’s have become very generous in their valuations of start-ups.
  • While VC’s backed 1,400 companies in the 4th quarter that had not received VC backing before, almost all of those companies had raised capital from other sources in order to reach a VC round.

VC’s back very few start-ups

What Changed?

  • The number of VC funds in the US is today only 1,206 down from 1,803 in 2004 while the number of firms managing those funds is down to 803 in 2015.
  • The number of active VC professionals today has decreased 36% to 5,680 from 8,964 in 2004.
  • Interestingly, while the number of professionals has declined, the money managed has increased. The average firm now manages $195 million and the largest fund raised was a whopping $6.3 billion.
  • In 2014 alone, the VCs raised an additional $29.9 billion which they need to invest.
  • VC’s prefer to put larger amounts of money into each deal that they back — their average check size is going up very quickly and now stands at $18.8 million.
  • In addition, while the larger VC firms are backing more companies, they are doing so in later stages — instead of investing in start-ups at the formation and Seedstages, they are investing in those companies later in their life-cycles.
  • Many VC’s are putting the bulk of their money to work in well-established later-stage growth firms or as pre-IPO capital — essentially what used to be known as expansion capital investing.
  • Furthermore, many VC’s are also participating in “non venture related investments” including investing in debt, buyouts, recapitalizations, secondary purchases, IPOs, investments in public companies such as PIPES (private investments in public entities), investments for which the proceeds are primarily intended for acquisition such as roll-ups, change of ownership, and other forms of private equity that are not even captured in the statistics of the NVCA.

If Not VC’s, Then Who Does Back Start-ups?

  • 73,400 businesses (in contrast with the 3,916 backed by VCs in 2015) were backed by angel investors with $24.1 billion in funding.
  • In each of the last 3 years angels exceeded $22 billion in funding (2014 $24.1 billion, 2013 $24.8 billion, 2012 $22.9 billion).
  • Over the last 3 years, an average of 35% of the angel capital has gone into the Seed or earlier stage of investment or $25.1 billion over the three years.
  • 316,600 angels were active in backing these businesses.
  • Most of these businesses were technology start-ups: 27% were in software, 16% in healthcare services, medical devices and equipment and 10% in IT services.
  • In addition, other sectors backed by angels such as retail (9%) and financial services (8%) also include many technology enabled businesses.
  • The mean angel round was $725,000 in the 3rd quarter 2015 — a fraction of the VC mean investment of $18.8 million in the 4th quarter of the same year
  • The median valuation at the time of investment was just $4 million compared to the hundreds of millions reported by Dow Jones VentureSource for the US VC’s

The angels of the US are seeding most US technology start-ups.

The Rise of Incubators and Accelerators

  • They may have a physical space or they may be virtual in nature.
  • Some focus on providing office space only while others focus on the acceleration activities.
  • Some charge a monthly or weekly fee for space — perhaps $600 for a desk with access to shared facilities but do not take equity. This is the “real estate incubator model as used at WeWork and RocketSpace.
  • Others take equity (Often in the 5 to 10% range) and may provide a small cash grant (Typically between $25,000 and $50,000). This is the “equity based accelerator model” as practiced by Y-combinator, TechStars and 500 start-ups for example.
  • Some may have follow-on funds that can invest in the Seed or even Series A rounds of those companies that they see getting the most traction — though most start-ups in incubators and accelerators do not move into these phases.
  • Additionally, some provide “access to innovation” services for corporate sponsors who want to “scout” the innovation ecosystem and perhaps discover companies for subsequent partnerships.
  • Accelerators have experienced rapid growth in recent years in the US, increasing more than tenfold from just 16 programs in 2008 to 170 programs in 2014.
  • The 172 accelerators tracked by the study supported 5,259 companies over ten years, or an average of 525 companies a year (compared to 73,500 backed by angels).
  • The accelerators themselves provided $2.6 billion over ten years to the companies or an average of $260 million per year (compared to $24.1 billion provided by the angels in 2014).
  • While the annual capital made available has been growing as some accelerators such as Y-Combinator and 500 start-ups raise follow on funds, it is still believed to be less than $500 million a year in aggregate (excluding the capital provided by angels and VC’s to companies graduating from the programs).

What About Equity Crowdfunding?

  • An increase in the number of shareholders a company may have before being required to register its common stock with the SEC and become a publicly reporting company
  • Provide an exemption from the need to register public offerings with the SEC that would allow the use of internet funding portals including “equity crowdfunding platforms” (with certain limits on how much an investor can invest through these portals)
  • Create a new definition of “emerging growth companies” as those with less than $1 billion in revenues
  • Relieve these companies from some regulatory and disclosure requirements when they go public
  • Lift the ban on “general solicitation” and advertising of specific kinds of private placements
  • There had been 6.063 distinct offerings of which 1,596 were successful in raising commitments of $870 million for an average of $545,122 per successful issuer
  • California alone accounted for 472 of the successful offerings raising $270 million
  • The top three sectors benefiting were Real Estate Development, Real Estate Investment, and Oil and Gas Production and Pipelines — technology start-ups are not the leading recipients of equity crowdfunding at this time
  • The two real estate sectors accounted for $208.3 million of the $870 million (23.9%) in total commitments made through equity crowdfunding platforms tracked by Crowdnetic

The angels, for now, continue to be the principal backers of US technology start-ups

Implications for US Innovation and Entrepreneurialism Policy

  • VC’s focus the vast majority of their capital on established, emerging-growth companies that are already far beyond their formation and seed phases.
  • This tendency is being exacerbated as ever larger amounts of VC capital are going to pre-IPO and later investments.
  • Conversely, the majority of US start-ups that do receive organized funding in their initial phases, receive that funding from accredited angel investors.
  • In each of the last 3 years angels exceeded $22 billion in funding (2014 $24.1 billion, 2013 $24.8 billion, 2012 $22.9 billion).
  • Over the last 3 years, an average of 35% of the angel capital has gone into the Seed or earlier stage of investment or $25.1 billion over the three years compared to just 3% of VC capital.
  • Recently incubators and accelerators have emerged to play an important role especially in the very first formation phases of a start-up’s life cycle however, they provide only modest funding.
  • While equity crowdfunding may offer an additional future source of start-up funding, to date it has focused on real estate and peer to peer lending with technology start-ups representing a minority of the modest equity capital committed in the US.
  • Those writing regional economic plans in the US at the national, state or local levels need to be clear that their plans will not succeed without the creation of a large and vibrant angel community in their region.
  • Innovation cluster strategies must, consequently, include ways to accomplish competitive advantage in attracting angels to invest in the innovation cluster.
  • Conversely, less is needed with regard to VC focus — the VC’s invest after companies have been made VC investable by angel investors by which time the company can raise funding outside the geography of the cluster.
  • US lawmakers and regulators should put more emphasis on finding ways to incentivize and motivate citizens with the potential to be angel investors to become so.
  • More can be done in terms of encouraging today’s angels to invest more — for example, the small business capital gain exemption could be extended and a parallel small business capital loss program could be put in place.

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Matthew Le Merle

Matthew Le Merle is co-founder and Managing Partner of Fifth Era which manages Blockchain Coinvestors, and of Keiretsu Capital