Venture capital trends across the UK and MENA
The past few years have seen unprecedented occurrences such as the global pandemic with significant fiscal decisions and ‘future of work’ phenomena creating uncharted waters. In spite of the pandemic, or perhaps driven in large part by it, venture investing enjoyed a veritable boom period in 2020 and 2021 driven by excess liquidity in capital markets and a breakaway bull run in global tech stocks and valuations.
And while the chicken of quantitative easing was always going to come home to roost, 2022 has been an unexpectedly tumultuous year following the invasion of Ukraine with its resultant European energy crisis along with runaway inflation and rising interest rates introducing new challenges for governments and businesses globally.
Unsurprisingly, market sentiment has shifted from the ‘abundance’ mentality of the tech bull run to a panic bear market that has sent tech stocks (and stocks generally) into freefall. For venture capitalists, there’s now an odd juxtaposition of dry powder at unprecedented levels against severe macroeconomic headwinds causing investors to recalibrate their investment playbooks.
Given our privileged position at the cutting edge of venture and tech markets in Europe, the UK and MENA, we’ve observed some very interesting developments in how venture investors are looking to mitigate perceived risk and how this is impacting deal terms.
Below we’ve laid out some observations which indicate how the market has been moving and some emerging norms for venture deals which are likely to persist for the foreseeable future.
Market sentiment has shifted from the ‘abundance’ mentality of the tech bull run to a panic bear-market that has sent tech stocks … into freefall. For venture capitalists, there is now an odd juxtaposition of dry powder at unprecedented levels against severe macroeconomic headwinds which is causing investors to recalibrate their investment playbooks.”
Rounds structured as convertibles
Founders not wishing to enter into valuation debates in the current economic climate are increasingly structuring capital raises as large convertible rounds in preference to priced equity rounds.
Aside from helping to defer valuation discussions, this also helps start-ups to secure funding faster and we’re seeing 18-36 month terms being used. On the flip side, investors are implementing full diligence exercises and demanding warranties and disclosure upfront. We’re also increasingly seeing stepped discounts and coupons which convert being used and the use of valuation caps is reducing significantly.
Liquipref multiples and ‘pay-to-play’ structures on the rise
The common approach of 1x non-participating liquidation preference is also shifting and we’ve seen a marked increase in investors requesting multiples on liquidation preference to reduce their risk during the current volatility, and requests for participating preferences to support higher valuations and help start-ups to avoid a down round.
Additionally, we’ve seen an increasing number of pay-to-play structures in the market with investors deploying capital today seeking to squeeze out the rights of co-investors who don’t participate in later rounds.
Rounds structured as convertibles
Founders not wishing to enter into valuation debates in the current economic climate are increasingly structuring capital raises as large convertible rounds in preference to priced equity rounds.
Aside from helping to defer valuation discussions, this also helps start-ups to secure funding faster and we’re seeing 18-36 month terms being used. On the flip side, investors are implementing full diligence exercises and demanding warranties and disclosure upfront. We’re also increasingly seeing stepped discounts and coupons which convert being used and the use of valuation caps is reducing significantly.
Liquipref multiples and ‘pay-to-play’ structures on the rise
The common approach of 1x non-participating liquidation preference is also shifting and we’ve seen a marked increase in investors requesting multiples on liquidation preference to reduce their risk during the current volatility, and requests for participating preferences to support higher valuations and help start-ups to avoid a down round.
Additionally, we’ve seen an increasing number of pay-to-play structures in the market with investors deploying capital today seeking to squeeze out the rights of co-investors who don’t participate in later rounds.
Increase in distressed sales
We've seen more sales of both distressed and early-stage start-ups happening. Typically, distressed companies are being forced into a sale due to their inability to raise funding, while early stage start-ups are choosing to be acquired more often than before where they've developed a successful business proposition/technology but are struggling to scale.
More often than not, these transactions are being positioned as ‘exits’ with both founders and investors wanting to avoid the optics of failure.
We've also seen more companies and investors looking at pre-pack administrations, although both founders and investors tend to prefer a sale due to the optics of a sales compared to an administration.
Investors moving towards earlier stages
An increasing number of investors are moving further down the value chain to do earlier stage deals. By participation in earlier, smaller funding rounds, investors perceive themselves as reducing their exposure to risk by writing a larger number of smaller cheques.
This is an interesting phenomenon and it remains to be seen whether this turns out to be an effective risk-mitigation strategy given the statistically higher proportion of companies that fail before they get to the growth stage.
Increase in distressed sales
We've seen more sales of both distressed and early-stage start-ups happening. Typically, distressed companies are being forced into a sale due to their inability to raise funding, while early stage start-ups are choosing to be acquired more often than before where they've developed a successful business proposition/technology but are struggling to scale.
More often than not, these transactions are being positioned as ‘exits’ with both founders and investors wanting to avoid the optics of failure.
We've also seen more companies and investors looking at pre-pack administrations, although both founders and investors tend to prefer a sale due to the optics of a sales compared to an administration.
Investors moving towards earlier stages
An increasing number of investors are moving further down the value chain to do earlier stage deals. By participation in earlier, smaller funding rounds, investors perceive themselves as reducing their exposure to risk by writing a larger number of smaller cheques.
This is an interesting phenomenon and it remains to be seen whether this turns out to be an effective risk-mitigation strategy given the statistically higher proportion of companies that fail before they get to the growth stage.
Challenges in closing deals
As the year has progressed, we've seen a number of deals having issues around closing due to major investors pulling out or looking to reduce the amount they want to invest. This in turn has led to a lot of flat rounds and extended follow-ons, with rounds effectively reopening for new investors at the original price due to a lack of interest.
Along with the challenges to closing, we’ve also seen an increasing focus on, and nervousness around, completion mechanics such as lead or incoming investors wanting certainty of funding in respect of each other (in the case of co-lead or multiple new investors) and sometimes also in respect of participating existing investors.
We’ve also seen simultaneous funding mechanics increasingly sought along with various mechanisms to deal with investors who don't fund, lead investors wanting existing investors to fund before they wire and so forth.
Interest in venture debt on the rise
There has also been an increasing level of interest in the use of venture debt facilities. This is largely due to debt being cheaper than equity as valuations drop in the face of current conditions, and a desire to extend cash runways rather than having to have possibly difficult valuation conversations.
As stated above, as venture capital firms triage their existing portfolios to weather the current economic storm and try to reduce their exposure, venture debt provides a faster and less complicated method of short-term funding than equity can provide.
Challenges in closing deals
As the year has progressed, we've seen a number of deals having issues around closing due to major investors pulling out or looking to reduce the amount they want to invest. This in turn has led to a lot of flat rounds and extended follow-ons, with rounds effectively reopening for new investors at the original price due to a lack of interest.
Along with the challenges to closing, we’ve also seen an increasing focus on, and nervousness around, completion mechanics such as lead or incoming investors wanting certainty of funding in respect of each other (in the case of co-lead or multiple new investors) and sometimes also in respect of participating existing investors.
We’ve also seen simultaneous funding mechanics increasingly sought along with various mechanisms to deal with investors who don't fund, lead investors wanting existing investors to fund before they wire and so forth.
Interest in venture debt on the rise
There has also been an increasing level of interest in the use of venture debt facilities. This is largely due to debt being cheaper than equity as valuations drop in the face of current conditions, and a desire to extend cash runways rather than having to have possibly difficult valuation conversations.
As stated above, as venture capital firms triage their existing portfolios to weather the current economic storm and try to reduce their exposure, venture debt provides a faster and less complicated method of short-term funding than equity can provide.
The market outlook
While the concept of ‘market practice’ has traditionally been more established in the mature venture markets (the US and Europe in particular), the shifts in deal practices observed above are not insignificant even by MENA standards which have been more fluid.
In spite of the abundance of VC dry powder, which would ordinarily be expected to result in a company-friendly investment environment, our prediction is that the more-investor friendly terms we’re seeing in the market will last for at least as long as the macroeconomic situation is precarious and volatile. Possibly longer.
In markets such as the present, we’d expect quality companies to chase quality capital (the reverse being a truism) and to accept terms that are less favourable as a quid pro quo for the value-add that quality asset managers bring to the table beyond mere cash.
For founders looking at term sheets in the current environment or considering ‘off-market’ terms, retaining legal counsel with deep experience across global markets, will be of huge value in navigating the ‘new normal’ of venture terms.
