Is fostering venture capital industry vital for developing startup ecosystems? How will the industry be affected by Covid19?
In my last post, I visited the challenges and opportunities of the developing startup ecosystems and emphasized “the broken investment value chain” as a major issue. In the post, I had analyzed CEE(Central Eastern Europe) countries and Turkey.
Although ecosystems like Poland and Turkey have substantial ICT potential in nurturing startups, I had pointed out the lack of corresponding venture capital investment. Now, I want to discuss on venture capital industry as a driver potential in developing ecosystems for innovation and economic growth. Then, I will elaborate on the Covid19 impact.
Venture capital has not invented risk capital, transformed it into a full-fledged industry in supporting innovation.
If a business needs an initial investment and carries a risk, it requires risk capital. Is the risk capital process invented by venture capital? No. Naval trading in antiquity, colonization expeditions in the 15th and 16th centuries, US whaling in the 18th century had a high risk due to storms, mutinies, and pirates. It needed to be financed either by a rich merchant or a king who accepts the risk for the sake of a significant return.
The first industrial revolution (the 18th and beginning of the 19th century) emerged with inventions of the steam engine and textile production. In this period, existing businessmen or financial institutions supported or recruited engineering skilled inventors.
Second industrial revolution(19th century)proliferated electricity, steel production, and oil usage and risk capital notion had improved. For example, Thomas Edison, pioneer of the incandescent light bulb, conducted early-stage experiments with capital from some of the leading financiers and investment bankers of the time including J.P. Morgan. That was a seed capital with our recent terms.
After World War II, mainly in the US, the third industrial revolution created electronics, telecommunications, computers, software, and the internet. Initially, corporate R&D took the lead, innovation houses like IBM, Bell Laboratories, Xerox Parc, and DuPont labs developed new scientific developments and new products. The first task was to conduct scientific research, the second was market development. The source of the risk capital was the company’s senior management decision to allocate existing businesses’ cash flow to new areas. Henry Chesbrough, in his book “Open Innovation”, claimed that after the 1970s, the corporate R&D approach calling the “Closed Innovation” period was over, and the “Open Innovation” era has started. Corporate companies need to collaborate across the innovation process with universities, suppliers, customers, startups, and even competitors.
While corporate innovation was still alive, the second chapter of the third industrial revolution is mostly written by venture capitalist backed companies like Fairchild, Intel, Apple, Sun Microsystems, Genentech, Facebook, Google, and countless others. Venture capitalists were not investing research, they were looking for promising ideas with high market potential. I am suggesting Tom Nicholas’ book or documentary named “Something Ventured” on birth of venture capital.
With modern venture capital, risk capital has become a structured organization, process, a “hits” business where exceptional payoffs from a few investments in a large portfolio of startup companies compensate for the vast majority that yields mediocre returns or simply fail, this is called “long tail” payoffs.
Nevertheless, we should ask; what is the exact impact of the venture capital industry?
Venture capital spurs innovation and market development success.
In one research, Kortum and Lerner(2000) find that venture capital is three to four times more powerful(receiving more patents)than corporate R&D as a spur to innovation. In another one, Kaplan and Lerner(2009) find that roughly 50% of the entrepreneurial US IPOs (Initial Public Offering) in recent years are venture-backed although only 0.2% of all firms receive venture funding. In the 2015 study, Will Gornall finds significant venture capital impact for startups that were founded after 1974.
Venture capital investments support employment growth.
While investors are interested in the return of their investment, society’s main concern is employment growth. According to multiple studies(Belke2003),(Achleitner2005), venture capital can significantly raise employment growth and job creation. We should keep in mind that this employment covers a generally high level of tech talent proportion which makes it more valuable than low tech employment. Below the graph is from the EU.
Fostering venture capital is vital for risk capital drought developing startup ecosystems.
Venture capital can not exist without entrepreneurs but a startup ecosystem can only flourish with risk capital support. There is a coexistence. Multiple points, historical evolution, strong impact on innovation, employment, and market development suggest that fostering venture capital in a strong entrepreneur base ecosystem is vital. Toward the question on “how to foster”, I will have a deep dive in my next post.
Now, I want to discuss Covid19’s potential impact on the venture capital industry relating to developing startup ecosystems. But before that, let’s look at some recent facts and discussions on the venture capital industry
The average return from VC for investors is better than public instruments.
From the investors’ return point of view, according to Cambridge Associates’ report, venture capital investors have better returns comparing to public market instruments(S&P 500 stock market index). With this positive data, Cambridge Associates wrote an appealing report to invite fund managers to the venture capital industry.
Venture capital has big winners and big losers.
Although the industry’s average return looks promising, there is a great variation in return between the top and low performers. The below graph depicts that top performer venture capital funds(first %25 performing funds) outperform the lowest-performing (last %25 performing funds) significantly.
Venture capital is a cyclical business.
There are a supply and demand relationship between venture capital(supply) and entrepreneurship requests for investment(demand). The supply of venture capital is determined by the willingness of investors to provide funds to startups. The willingness of investors to commit money to venture capital funds is dependent upon the expected rate of return against other investment instruments. Higher expected return leads to a greater desire of investors to supply to venture capital funds. However in the venture market, this equilibrium generally happens with a lag, the number of funds provided may not shift rapidly. In the 2001 study, Lerner states;
Venture capital funds’ adjustment process is often quite slow and uneven, which can lead to substantial and persistent imbalances. When the quantity provided does react, the shift may “overshoot” the ideal amount and lead to yet further problems.
I associate this pattern with the bullwhip effect from the supply chain. Due to slow market feedback diffusion into the supply chain, usually either huge sales opportunity is missed or excess inventory happens.
Dotcom boom was an example of the bust period as there was a rush for startups with incredible return expectations.
Questions on the current VC market toward a dot-com boom intensified.
Venture capital investment increased fivefold since 2012, however number of deals did not accompany this one.
It seems that the growing gap between the supply of venture capital investment and the number of startup investment boosted startup valuations, in other words, the price of the product. We can see the valuation increase of the startup valuations in the last 7 years on the below graph.
In 2019, we observed some disappointing IPO entrances from Uber and Lyft. In recent years, companies going public in the US, have still not yet settled on stable business models; consequently, the percentage of companies going public with negative earnings has now reached peak dot-com bubble territory as below.
Mega venture capital funds were the reason for imbalance.
In December 2018, $100.0 Billion SoftBank Vision Fund, in August 2016, $15.0 Billion Chinese Reform Holdings Corporation Fund were announced with the other 13 VC funds more than $1 billion size. Then we have observed some VC concerns over giant fundraising. According to recent research, overvaluation of VC backed companies reached %37 as the median average. After humiliating Softbank experience on WeWork, it seems that the era of the mega-funds will not last long.
In his concise analysis, Mark Suster explained questions on a boom and remarked that the imbalance was driven by mega-funds coming from public markets to private markets, he had a positive future expectation on skilled and traditional VC business regarding new technology possibilities. But that was before the Covid19 pandemic.
Developing startup ecosystems in CEE has sizable support by funds from outside.
After some global trend analysis, let’s go to our point. As the VC per capita investment is low in developing startup ecosystems, a sizable amount of investment is provided out of the region. The below graph shows that more than %60 of the investment is received from outside of Europe.
The main reason for the above picture was that some of the global venture capitalists believed in developing startup ecosystems in terms of tech talent and sizable digital adopted population. One of them is Dave McClure has set the investment strategy of 500Startups in investing in Brazil, Turkey, India, Asia and Gulf countries. In venture capitalist Tim Draper’s recent pre-Covid19 statement;
Now is the perfect time to look into investing in Poland. The region has always had great technology but now they are starting to connect it to the marketplace. Poland is a generation ahead of other countries in the region in understanding the market system.
Local investors can not provide late-stage investments
In developing startup ecosystems, local venture capital funds focus on early stages with low ticket size. The below graph from Poland shows the concentration of venture capital funds focuses on below $1M ticket size. If your startup reaches a valuation of $60M and you need $10M investment round, you need to find “tourist money” that is not committed to your country and looking for opportunities around the world. In Turkey, Getir, a mobile grocery delivery platform received 38M USD investment from Michael Moritz at the end of 2019. As a very promising business model, they had to wait 3.5 years for the investment after losing a nearly closed deal in July 2016 due to a coup attempt. Local investors did not have the ticket size. I define this phenomenon as “Broken Investment Value Chain” in my earlier post.
Covid-19 will have a very negative immediate and long term effect on venture capital investing globally.
Startup-Genome reports that in China- the initial location of coronavirus- venture capital deals dropped 50–57 percentage points in the first two months of 2020 compared with the rest of the world. Although EuropeanStartups.co observes that venture capital activity in March and April was not significantly lower than in previous months and the same period last year. These deals are likely to have been working on for the past 4–5 months.
As a cyclical business, venture capitalists generally do not react quickly to significant market developments. The reaction will mean overreaction. European Union Commission reports;
What all of this suggests is that the most likely scenario is that there will a steeper decline in VC investing over the remainder of the year and beyond.
According to the report, there are three reasons for this expectation.
1- Huge Demand Shock: Burn rate of startups accelerated as sales revenues fall much faster than they can reduce the costs.
2- Limited Fundraising: The ability of VCs to raise new funds is expected to be much harder.
3- Exit Wall: Opportunities for investors to exit, both to harvest successful investments and also for distress sales, will diminish.
In my opinion, cyclical type of industry and mentioned imbalances of mega-funds will accentuate this overreaction, in other words a much colder period for venture capital.
Covid19 Impact on VC Investments in Developing Startup Ecosystems
We have a global downfall due to Covid19, the venture capital will have its share. For developing startup ecosystems in Europe like Poland, Turkey and Romania, we should ask the question “Will their VC investment picture differ negatively or positively?”
Demand Shock: Developing startup ecosystems may differentiate negative due to less startup focus on fiscal stimulus packages
The below table suggests that the IMF’s GDP projection in 2020, Poland, Romania and Turkey has slightly less expected damage than France, Germany and the UK in 2020. However, the fiscal response to GDP ratio is much lower in Romania in Turkey except Poland. Also, in the package, startup focus is higher in Germany and France. That means even though economies are expected to contract less in 2020, fiscal support will help much less in Turkey and Romania. Hence I expect a negative differentiation rather than a positive one for those 3 developing startup ecosystems post Covid19.
Demand shock is driving VCs to focus on existing portfolios rather than new startup investments. In 2020 and 2021, it will be difficult for startups to find new investors.
Please look at the tech startup rescue packages in Europe from the link.
Fundraising: It will be difficult to find early-stage money but worse for late-stage rounds in CEE
Local venture capital funds will have difficulty in new fundraising in 2020 and 2021 relating to the difficulty to demonstrate startup growth and exit opportunities to limited partners candidates. On late-stage investments, developing startup ecosystems need “tourist money” who do not commit to the region. I think that this tourist money will have a bigger contraction than local money. In the light of contracted global fundraising, the markets in the US, the UK and Germany or China will have a priority for global VCs comparing to developing ecosystems.
Exit Wall: Valuations will fall and exit will not be attractive
Investors will have to write-down many of their investments on account of their poorer prospects for future growth and profitability, reducing the likelihood that they will be able to exit from many of their investments. Falling prices and fewer opportunities to sell may require VCs to delay exits, requiring them to fund such companies for longer, appealing to buyers when market conditions improve. In CEE, acquisition by large companies is the most common way in which exits occur. There is likely to be a slowdown in the M&A market as large companies are less likely to make acquisitions as they focus on their liquidity and maintaining operations. For those exits that do occur, valuations will fall, returning less cash to investors and entrepreneurs. This reduces their capacity to make new investments. Fewer exits and downward pressure on the valuation of those exits that do occur will hurt fund performance.
Last Note on Covid19 Impact over developing ecosystems
Developing startup ecosystems is not privileged in escaping the demand shock. On the Covid19 perspective, the real problem is the dependency of those ecosystems’ to late-stage money. 2020 and 2021 will be more difficult for the venture capital industry and startups in developing ecosystems than developed ones.
