Stories
In US technology circles, 2022 is starting to look a lot like 2000. The year the dot com bubble burst, billions of dollars in value was wiped out and tens of thousands of tech workers were laid off. Similarly to the late 1990s, the last decade has seen record amounts of cheap capital flow into tech start-ups and a general mania for tech stocks on the public markets, which peaked in November last year. Since then, sentiment has soured towards public tech stocks, cheap capital is no longer flowing, and high-profile firms like Netflix, Robinhood and Snap have laid off staff, leading commentators to dub it the “tech wreck” with much speculation about when the bottom will be reached.
The latest boom in tech investing wasn’t just fueled by the usual source of investment for early-stage companies – venture capital. A whole host of investors – private equity, hedge funds, private equity and crossover funds (funds that invest in both the public and private markets) – have been competing with VCs to back a finite crop of startups. As a result, capital was cheap and plentiful.
One real-world example illustrates just how easy it became for new US start-ups to raise capital. In 2021, it was considered barely remarkable that two founders with an idea and a 12-slide presentation could raise a $6 million seed round, and institutional investors were competing to get more money into the company. With numerous examples like this, it was no surprise more start-up founders flooded into the space, valuations went through the roof and even the most enthusiastic cheerleaders of the sector had to admit that things had gotten a little “frothy”.
There’s still some debate as to whether the tech wreck will turn into a full-blown crash a la dot com, or will just impact companies that were overly growth-focused at the expense of business fundamentals. Regardless of how that plays out over the rest of the year, there are legitimate questions to be asked about what the impact is likely to be on funding for Irish innovation.
Deals and data
While Ireland’s startup scene largely avoided the excesses that cheap capital brought to start-ups in the US (and to some extent Europe), that’s not to say there hasn’t been a massive injection of venture capital into Irish firms in recent years. According to figures from the Irish Venture Capital Association (IVCA), the representative body for local VCs, investment into Irish companies reached a record €1.3 billion in 2021, up 44 per cent from €925 million the previous year. The high point for Irish venture investing mirrored the peak for public US tech stocks. Q4 of last year saw an eye-watering €458 million raised by Irish firms – a tripling from the same quarter in 2020.
Despite those record-breaking quarters of investment, research from Scale Ireland, the representative body for Irish tech startups, finds that raising capital is a challenge for the vast majority of its members. A late-2021 survey of 230 start-up founders and CEOs found that 79 per cent found it difficult (57.6 per cent) or extremely difficult (21.4 per cent) to raise capital. Fundraising was cited by 47 per cent as by far the biggest challenge facing Irish start-ups, with staff recruitment and retention (25.2 per cent) the only other issue that came close.
“The survey had very strong findings, particularly that finance and staffing are the key issues for startups and scaleups,” said Martina Fitzgerald, CEO of Scale Ireland. “It’s also notable that startups don’t avail of a lot of the state supports that are available such as the R&D credit. We hear that our members see them as a time sink and they usually have to get external advisors to help them apply for those supports.”
The most recent figures show that VCs here are pulling back, but nowhere near the extent of US firms. The most recent data from the IVCA shows funding in Q2 of this year was up 2 per cent annually to €398.4 million, suggesting a slowdown in growth but overall venture capital remains close to historic highs. “It remains to be seen whether the significant slowdown in growth in the second quarter to under 2 per cent heralds a more difficult second half to the year,” said Leo Hamill, chair of the IVCA and managing partner of Investec Ventures by day.
In comments previously reported by The Currency, Will Prendergast, partner with Frontline Ventures, suggested that the slowdown in European venture investing has already happened.
“We are going to see a material slowdown in all stages of investment in Europe over the next six months. It has already happened. It is just not hitting the numbers yet,” said Prendergast.
He suggests that current data is being boosted by deals that were negotiated before the war in Ukraine and inflation spiralled out of control and that there will be a sharp drop in the numbers in the second half of the year.
That chimes with the view of Brian Caulfield, a long-time VC and supporter of the startup ecosystem, who thinks if things get very bad, capital could dry up quickly. “I think the VC perspective is widely misunderstood,” explains Caulfield. “The big VC organisations, the fund of funds, rely on returns from the funds they are already in to fund their new commitments. If there are no exits from their investments, that chokes off any new commitments they are going to make.”
For its part, the IVCA has raised particular concerns about the amount of overseas capital that goes into Irish start-ups and how that money can easily retreat in tough times. The IVCA’s data shows that funding from overseas investors was just €152 million in the second quarter of 2022, a drop of 50 per cent from 12 months prior. As a result, it is lobbying the Government to include some kind of measure in the Budget to encourage Irish pension funds to invest in venture capital funds. It’s estimated that pension funds contribute about 65 per cent of VC in the US, 18 per cent in Europe and 12 per cent in the UK. The IVCA estimates that figure is less than 1 per cent in Ireland.
“In 2021, 56 per cent of the funding for scaling businesses here came from overseas, but that’s the first money that’s going to dry up in a recession,” says Sarah Jane Larkin, director general of the IVCA. “As a nation, we’re capable of creating world-class companies in areas like AI, blockchain and deeptech, but Irish VCs are not able to write the cheque sizes to back those companies as they scale.”
She cites recent large rounds raised by LetsGetChecked, Flipdish and WayFlyer, where there was “very little Irish money going in”.
Banking on the state
The lack of investment by pension funds is not the only unique feature of the Irish funding landscape. We also stand out in a European context given the high level of State involvement in the sector. For many years Enterprise Ireland was cited as being one of the largest VC players in the European market, thanks to the equity stake it took in start-ups in exchange for the financial and other support it provided, like mentoring and access to overseas markets. During the good times, that led to a phenomenon known as the “start-up dole” where it was relatively easy to get funding from a combination of friends, family and state agencies, which enabled even the flimsiest startup ideas to limp along for a couple of years while paying the founder a basic salary.
In the current macro environment, any such concerns have been largely set aside by those in the startup ecosystem. Brian Caulfield, who in addition to his VC work is now chair of Scale Ireland, says that the available State and EU supports for Irish innovation make him “reasonably positive” about the continued availability of funding for early-stage companies.
“There are signs of some early-stage deals being pulled, mostly by angel investors,” says Caulfield, “but overall I think things will be OK in Ireland”.
In common with others in the space, Caulfield thinks the Government’s €90 million Irish Innovation Seed Fund (IISF) programme, which was initially intended as a Covid support and will invest in other venture capital funds, will provide a boost for early-stage funding. Although opinions vary on the benefit of the State being such a large start-up investor, almost everyone interviewed for this article cited its “counter-cyclical” nature – pumping new funds into the ecosystem at a time when international markets are closing – as a huge positive.
Before it is even launched, it seems the scheme is a victim of its own success. It’s understood that as many as 30 existing and new VC funds have applied for funding from the IISF, significantly more than initially expected, leading to delays in the funds being disbursed.
One of those who hopes to be a beneficiary of the IISF is Eamon Leonard, a 15-year veteran of the Irish start-up ecosystem, who has co-founded three companies during that time. He’s one of three partners in Broadstone, a new VC fund that will back founders with small cheques while they explore if their idea has potential.
Leonard believes that funding at this “pre-seed” stage is essential to ensure a continued pipeline of start-ups. While the most common fate of start-ups is to fail, Silicon Valley and other successful tech hubs have shown that funding so many early-stage ideas creates significant jobs and wealth from tech and innovation.
Leonard is also in little doubt that there are enough technology projects and ideas in the Irish ecosystem to be funded. In the manner you would expect of an engineer, he pulled data from meetup.com, a popular website for organising networking events, to support his thesis. He found in Dublin alone, there are about 100 events on average each month with 130,000 people registered to attend them. Even allowing that many of those will be duplicates, Leonard guesstimates that there could be as many as 70,000 people who go to a meetup once or twice a year, which suggests a “very active, but hidden” grassroots community of engineers and other tech workers, who are using their spare team to share knowledge and network with others.
A lack of angels
Traditionally such pre-seed investments are made by individuals – either friends and family or angel investors. In the US and other tech hubs, angels are usually drawn from the ranks of successful tech workers who write cheques for as little as $1,000 to get ideas off the ground.
While there are a number of founders and senior technology executives (e.g. Des Traynor of Intercom, Bobby Healy of Manna and ex-Workday exec Philip Reynolds) who have become regular angel investors, overall those in the tech ecosystem believe this is an under-developed source of funding. Data from EBAN backs that view up. The European representative body for early-stage investors found that when looking at angel investment as a percentage of GDP, Ireland was resolutely mid-table compared to our European peers, even lagging behind countries such as Malta, Turkey and Austria, which don’t have a well-developed tech ecosystem.
One particularly vocal critic of the state of angel investing is Patrick Walsh, CEO of start-up incubator Dogpatch Labs, who says angel investing is “one of the most underperforming parts of the ecosystem”.
Halo Business Angel Network (HBAN) is the organization tasked with developing angel investing on the island of Ireland, for which it receives financial support from Enterprise Ireland, Invest Northern Ireland and InterTradeIreland. It says angels investing through its syndicates put an average of €44,000 each into a deal, although many “participate at the €25,000 range”.
Walsh says that, even at the €25,000 level, this means they are seed investments rather than angel ones and so don’t support really early-stage ventures or attract typical angels.
“If you assume that you need 10 private investments to diversify your portfolio, we are talking about individuals who have €250,000 to invest. That’s why the profile of angels in Ireland versus San Francisco is very different,” says Walsh. He argues that bringing in people with relevant domain knowledge who can write smaller cheques quicker is what the ecosystem needs – and has proved successful in other countries.
Walsh certainly has skin in the game as he is pitching for the tender to operate HBAN, which is worth €6 million over three years. A spokesperson for the current HBAN operator said the organisation was not in a position to talk to the press at the moment, citing the ongoing tender process.
While the debate about whether there is enough capital available to support early-stage start-ups is a perennial one, there’s no doubt that start-ups that raised later stages of funding in the last couple of years are now facing a very different environment than they planned for.
A flight to substance
Before November last year, investors were looking for startups to grab market share and grow the business regardless of profit. Now the message is all about moving swiftly to cut costs, conserving cash and figuring out a pathway to profitability. Legendary Silicon Valley investor Sequoia was not the first to advise its portfolio companies to be ready for a downturn, but given its stature as an early backer of tech giants from Apple to WhatsApp and Stripe to Qualtrics, its opinions have huge influence.
In May this year, it published a 52-page slide deck entitled “Adapting to Endure”, which urged companies to make cuts quickly, focus on profitability, and concluded by offering them frameworks and management techniques which would allow them to capitalise on the opportunities presented by the crisis.
Given they were more reserved during the era of cheap capital, Irish investors are not sounding the alarm bells to the same extent as their US peers.
“Even though they didn’t invest in me, I would say the VCs in Ireland are smarter, in that they are more long-term and strategic in their thinking, compared to US VCs,” says Mark Little, the co-founder of Kinzen, which provides tools to identify fake news and disinformation.
Denise Sidhu has been a partner with Kernel Capital, the Cork-based tech investor, for over 20 years and believes that there is always a “flight to substance” in a bear market.
“From the VC perspective, if a company has deep IP, tier-one customers, sustainable market share and a good management team, of course we are going to continue to invest,” explains Sidhu. “When there is change, there is also a good opportunity. Our job as VCs is to see what the global geopolitical situation means from that perspective.”
Siddhu believes that markets deal with crises far more regularly than most people think. She reels off some of the geopolitical events that have impacted business during her time at Kernel and the opportunities they threw up, from 9/11 creating demand for security software and solutions, to Covid, changing the way people work and the tools they need to support that.
“Technology always continues to innovate,” says Sidhu. “For companies with substance behind them, there could be less competition in the market, less staff movement, and operating expenses should drop.”
A multi-million euro Series A or B round could be expected to fund a company for 12-24 months until they reached certain growth milestones and raised again, but that’s no longer the case. Startups instead are having to look to stretch their funding for at least another two years.
“Everyone is looking at burn rate now,” says Colm Long, chief revenue officer with Tines, a software start-up that allows non-technical staff to automate repetitive processes and raised $26 million from international investors in April 2021. “Everything changed pretty dramatically this summer – it was almost literally over the course of a week. Investors went from ‘growth, growth, growth’ to now wanting you to focus on profitability.”
Tines was valued at $300 million at the time of its latest fundraising and while Long is very confident that revenues will support that valuation, he says it would be very different if they had accepted a higher valuation: “If we were trying to justify a $1 billion valuation, a lot of decisions would be taken out of our hands.”
&Open, a corporate gifting platform that counts AirBnB, Spotify, and Reebok amongst its clients, raised $26 million led by Molten at the start of the summer, but certainly isn’t taking anything for granted.
“The default scenario is that you close a round and you get busy spending,” says Jonathan Legge, &Open’s co-founder and CEO. “We immediately thought about how we could maximise the value we get from the investment.”
Although the company grew headcount from 33 staff a year ago to 94 today, Legge says every new hire now has to be justified according to the impact on revenue. “When you raise, staff assume there are more people coming to help, but that’s just not the case now,” says Legge. “I’ve had to say to my staff, these are our problems and we need to own them.”
“Series B, C and later private companies are going to be hit hardest – particularly the companies that focussed on growth at all costs and raised lots of capital at very high valuations,” says Caulfield. “They are going to have to either cut their burn rate significantly to buy time to grow into their previous valuation, or consider doing a down round.”
A down round, raising more capital at a valuation lower than at previous fund-raisings, is problematic as investors are forced to write down the value of their holdings. It also makes it harder to retain employees, a significant portion of whose compensation comes in the form of stock options, which will be below water after a down round. Although this can be solved by creating a new option pool for employees, it’s an additional legal and financial overhead to have to deal with.
“Series A and B stage companies don’t have the option to restructure,” says Bobby Healy, co-founder of Manna, the drone delivery start-up. “If they are not generating revenue they are at risk of running out of cash. But they don’t have a balance sheet to support debt as they have no revenue to talk of. I think there are going to be a lot of failures and down rounds in Ireland as a result.”
As you might expect from an entrepreneur who by his own admission is taking a “big crazy bet” on bringing drone delivery to the masses, Healy is a half-glass-full kind of person. He thinks the downturn will have a positive impact on seed-stage companies that are still building out their products and hiring their teams.
“Up to now, it was very difficult for seed companies to hire, because they were competing with the ridiculous offers from US companies based here,” says Healy. “It’s going to get easier to build a team now as big companies freeze hiring.”
Advantages
One significant advantage seed-stage companies have is that they can raise capital using convertible loan notes rather than selling equity. This means they don’t have to value the company before raising finance – something that was always slightly ridiculous as you are effectively putting a valuation on a founding team and their idea, before they had either a product or revenues.
Legendary Silicon Valley incubator Y Combinator introduced its SAFE (Simple Agreement for Future Equity) in late 2013 as an easier way for startups to raise their first money: The company did not have to be valued as they were effectively providing notes that would grant access to a later priced round. SAFE notes are now a common way to invest in startups globally, with incubators like Dogpatch Labs using them as their default way to back startups.
The jury is still out as to just how bad the tech wreck is likely to become and how much of the impact is going to be felt on these shores. But investors and founders are broadly in agreement that both investment and the companies it supports are much better set up for success than they’ve ever been.
“There’s going to be a tough two years ahead but as an investor, if you consistently bet on technology and innovation, you will make money,” concludes Caulfield.
John Collins is an independent consultant and advisor for technology companies. He has over 20 years’ experience as a writer and editor primarily covering business and technology. He was previously director of content in Intercom.
Further reading
Constantin Gurgdiev: The tech giants are bleeding. The knock-on effect on start-ups could be worse
