The rate at which the venture capital industry invests in startups has experienced a significant slow down since November 2015. The average deal size in Q4 2015 fell to $15.6 million, from $19.3 million in the previous quarter; the total number of VC deals fell by 13%.

This phenomenon may impact Silicon Valley more significantly than other areas.  Does this mean that entrepreneurs should more aggressively look elsewhere for investment?  Or should they have been diversifying their investment strategy all along?

Why was there a Slowdown?

The value of many startups, especially later stage ones, climbed over 2014 and 2015 to levels that may have been out of sync with fundamentals. Venture capital funds in the US alone raised over $59 billion over the two-year period, to levels not seen since 2006-2007. In addition, there was a glut of funds that closed in the 2010-2011 period that needed to put their money to work.

“… [Because venture funds struggled to close in 2008-2009, and so many closed in 2010 & 2011], there was a glut of venture money in the funds that closed in 2010-2011. As many funds have a four – five year investment horizon to place initial investments, this resulted in greater activity. As a result, the resulting urgency would have prompted more competition in the 2015 period, simply because of supply and demand” -Owen Matthews, Managing Director Wesley Clover

The influx of available capital heated up competition for investment opportunities and valuations increased accordingly. However, this changed towards the end of 2015.

“You come to the end of 2015 and suddenly we’re into a different cycle.  There’s less pressure to get that money out and into companies, due diligence gets a little bit more thorough, deals aren’t getting done as easily, and the valuations begin to come down.” -Owen Matthews

As many companies moved towards IPO in 2015, it became clear that the public markets were not valuing companies at the levels the companies and their investors had expected. Beyond that, the stock performance of many of the firms that had recently gone public was lower than expected. Many high-profile examples of lower-than-expected IPOs include Dropbox, Square, and Snapchat. Recent drops in the share price of established high profile tech stocks such as LinkedIn and Tableau has exacerbated  the issue, and all these factors compounded to affect valuations for private company financings.

The net result has been less competition for each potential investment and, thus as would be expected, valuations have fallen. In addition, investors have demanded stricter terms of investment and greater transparency, slowing down the process and resulting in fewer deals per quarter.

“…as there is less competition to get the deal done, VC firms are taking the time to ensure the deal makes sense for them. The drop in urgency translates to: ‘okay, we are really interested, but let’s take the time to perform deeper due diligence before we put a value on it and give you a term sheet’.” -Owen Matthews

The Devil is in the Details…

When you look at the details there are additional trends worth noting.

  1. The slowdown did not impact all geographic markets equally. From Q3 to Q4 2015, total VC investment in both the US and Asia fell by more than 31%. Europe, on the other hand, fared pretty well with total VC investment only falling by 14% while some markets, such as the UK, actually experienced an increase in investment. Funding in Canada saw a pullback from Q3, but Q4 was still the second-best quarter of 2015.
  2. According to a new report in the Globe and Mail and new figures from the Canadian Venture Capital & Private Equity Association, “funding for entrepreneurs comprised 536 deals for a total of $2.25-billion in 2015. That’s the best result for Canadian startups since before the 2008 financial crisis, and according to CVCA president Mike Woollatt the trend is likely to continue in 2016, since Canadian venture investors raised another $2-billion last year, and are now on the hunt for new deals.”
  3. The slowdown did not impact companies at all stages of development equally. The deal size pullback was felt strongest in late-stage financing where the median deal size fell by 10%. In contrast, the median size of early stage financing (seed and series A) actually increased from Q3 to Q4, although the number of  these deals fell, likely due to a greater emphasis on due diligence.
  4. The slowdown did not impact all sectors equally. Companies in the FinTech sector experienced a total VC investment drop of almost 70% from Q3 to Q4. Conversely, better established sectors like EdTech increased dramatically on the back of major deals for HotChalk, TutorGroup and Udacity.
  5. There is still a lot of money out there to be spent. Venture capital overhang (the amount of uncommitted capital held by VC funds) is still substantial and increased from $71 billion in 2014 to $80 billion in 2015.  This is promising for the entrepreneur, as it means funds remain readily available for good deals, unlike 2008-2009 when general uncertainty resulted in a much broader and deeper impact across all VC activities.

With change in activity that occurred towards the end of 2015 being noted, 2016 is proving to be a very interesting time for entrepreneurs and investors alike.

One additional thought to consider; investment activity outside the Valley, while smaller on a average deal basis, lower costs mean the investment dollars often go further.

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