In our latest blog post, we talked about rising interest rates and how they impact startups. While we have no doubt that the startup scene will continue to thrive, we do doubt that it will continue at the rate at which it has been going until now. The reason isn’t that of a lack of great ideas, but because the investment industry has changed – rising interest rates being just one of the factors contributing to the shift in the way investors view startups of all sizes.
In 2016, the lack of luster in investment activity was the talk of the town, and while 2017 is showing slightly better numbers, the overall funding is still below what many anticipated. Even though the amount of investment money rose in the first quarter of 2017, with $16.5 billion invested in over 1800 companies, the allocation is far from fair, with a handful of startups taking a large portion of the budget.
The increased appeal towards near-IPO companies and the change in the way early-stage investments are perceived (as well as the return investors expect to see) is going to alter the startup world in the coming months.
Let’s Talk Valuation
One of the things that impact investment is, of course, valuation. Since startups, particularly those in the early stages, cannot rely on the Discounted Cash Flow method, nor can assumptions about growth rate and profit margin be considered accurate, VC’s looking to invest in a startup often look towards comparable companies, those in similar stages and sectors, in order to assess the potential exit value of the startup.
The current market situation is welcoming towards startups, especially considering that there were few alternative options for potentially high ROI due to the low-interest rates of the past few years. These past events overly inflated valuations, as can be seen from the perceived value of social media powerhouses and mobile apps whose revenues often have little connection to their valuation.
As a result of the high valuation, investors developed exceptionally high expectations of the exit value and the potential profit that can be made from the investments they make – a situation that will change as the market shifts towards a more optimistic one in terms of investment opportunities outside the startup world. The increased opportunities outside the startup world will reduce the demand for startups to invest in, causing the valuation of the startups to inevitably go down as a result. While this may seem like good news, it’s a catch-22 situation for long-time investors who have existing portfolios that they don’t want to see reduced in value, yet simultaneously want to take advantage of the lack of demand and get more equity for less investment. This will particularly impact angel and early stage investors who invest based on the team and the product rather than the financial model of the startup.
Changes in the Different Investment Stages
As angel investors are already well versed in the risk of funding a startup that is little more than an idea, the reduced valuation and the increased interest rates (and external opportunities that come with it) will impact the way early stage investments are made more than anything else.
In the past year, angel investments have slowed and investors are taking a “relatively cautious approach”, as they wait to see the impact of current market changes on startup valuations. According to the 2016 Angel Resource Network Report, pre-money valuations have been rapidly declining since 2015, with angels and early stage investors slowing down the rate and value of investments. The report furthermore indicates that 2016 was the first time angel groups participated in more follow-on investment deals over first-time investment deals, showcasing the shift that angels are taking in terms of aversion to risk and optimism in the ROI startups can yield.
Between 2010 to 2015, there was an 84% increase in pre-money valuation for seed stage startups. On the other hand, 2017 is showing drastically different numbers already in the valuation of pre-seed startups and is currently experiencing the most drastic reduction in activity in angel and early stage since the startup buzz took off. The 2016 report by the National Venture Capital Association and PWC confirmed that early stage investments are declining, with 2016 experiencing a 9% reduction in dollars invested and an 18% decline in overall deals.
Contrary to high valuations of early-stage startups, late-stage and tech growth investments are continuing to rise, with investors seeing prospective IPO’s as a sure way to get a high return on their investments – something the early stage startups could never offer.
The Look of Future Investments
Angel investors and early stage investors who have yet to be a part of an exit might find themselves pushed out of the investment pool, as the more appealing opportunities will come with high price tags. The late stage investors with deep pockets will likely continue to benefit from the changes in the investment world, as they will be able to postpone investment until IPO or exit is all but certain.
Later-stage startups will win from this change as they are on the upward climb and all they have to do is ‘sell the dream’ of an exit or IPO in order to appeal to late stage investors with capital and rich dreams.
Startups, on the other hand, will have to come up with new ways to maximize valuation and showcase ROI potential in order to continue getting support from angels and early stage investors. By waiting until they have a viable product in order to prooV their idea to investors and by participating in successful PoC’s with big names (like those found on the prooV platform), startups will be able to boost their valuation and retain more equity than other similar companies in their space.