As we approach the end of the year, I wanted to reflect on where we stand in terms of an asset class we know well at the firm, that of late-stage Venture Capital (VC) backed companies, some of which fall into the “Unicorn” category based on their latest valuation, and with a focus on Europe. As a reminder, the term Unicorn refers to a privately held startup company valued over one billion dollars, and has been held as one of the main KPIs indicating the success of a start-up in recent years, though many questions have emerged on its relevance or on how to refine the category.
2022 has been a year of unprecedented change, with a brutal awakening for Tech companies which started at the beginning of the year with the fall in valuations of unprofitable publicly-listed companies, across all verticals, and which has continued all year-round in a context of adverse macro-economic conditions — of which predominantly the rise in interest rates — and geopolitical uncertainty. It has taken almost a year for the translation of these events into late-stage financing and the effects are being seen with increasing clarity.
Let’s take a quick step back. Following the pandemic, we have seen a boom in European Tech favored by the trend of digitization, placing Tech front and center in many business models, and many companies have emerged as powerful enablers of these trends across the fields of software, healthcare, e-commerce and education, just to name a few. This boom has been accelerated by the political will to promote the “start-up nation(s),” both in France where we are headquartered and more generally across Europe, and by the arrival of a broader category of investors — on top of historical VC investors — that of non-traditional investors (NTIs) that were allowed to pour in massive amounts of financing in the Tech scene. These NTIs include mutual funds, hedge funds, family offices and private equity firms that have viewed the upper-end of late-stage financing as a separate asset class from venture, presenting a lower risk profile and allowing for excellent returns. Accustomed to writing much larger checks, NTIs are widely acknowledged to have sent valuations and the number of unicorns soaring in recent years.
The FTX implosion we saw recently — the implications of which go well beyond crypto — is perhaps the culminating event at this point, putting an end to what was not a sustainable context in our view: growth at all costs, plenty of money, the famous “fear of missing out” (FOMO), and favorable market conditions. All this has changed in 2022, and it is perhaps good news.
So let’s look at where we stand in European Tech, both in terms of deal count and valuations, and consider different pathways going forward.
Where do we stand in terms of deal count?
Europe has already registered its second biggest year after 2021 for newly minted Unicorns.
In the first three quarters of this year, 40 European companies achieved a €1 billion-plus valuation, according to PitchBook’s Q3 2022 European VC Valuations Report. The picture is nonetheless contrasted; while the first two quarters of 2022 saw similar levels of Unicorn creation to last year, the numbers dropped off in Q3, with only 4 new unicorns created.
While billion-dollar valuations have become more rare, Unicorn growth remained robust until the start of the summer.
Where do we stand in terms of deal valuation?
Per Pitchbook, Venture Capital (VC) pre-money valuations remained robust through Q3 2022. The drop off in public market capitalizations has not filtered in the VC ecosystem.
However, this overall picture hides disparities between financing stages: while seed and early-stage have largely held-up (€8.0m median Early-stage valuation in Q3 22 vs €6.0m in ‘21), the reality is more contrasted at late-stage. Here, even if Q3 median valuations are stronger than in ’21, we are seeing a decreasing trend quarter-over-quarter (€19,7m in Q1 ’22 vs €11,9m in Q3 ‘22). Rounds are continuing for Unicorns, but there are no more records or 10B + valuations at the top of the ecosystem.
With plenty of cash on their balance sheet, the rise of structured equity in VC deals enabling companies effectively to trade investor protections and control for higher valuations, many Unicorns are avoiding down rounds and are extending runway by cutting costs. Apart from a very limited number of highly mediatized downrounds in Q3 ’22, Unicorns have not come back to the market at lower valuations.
European Unicorns are in a limbo: strongly valued, and no financing for their next round either through crossover investors — in the course of reassessing their strategy on Tech scale-ups — or through IPO, with a doomed context set to continue for a large part (if not all) of 2023.
Which pathways lie ahead for entrepreneurs and investors?
It is clear that the context has changed for Europe’s Tech entrepreneurs.
If large amounts of funding and the arrival of non-traditional investors helped fuel the growth of the late-stage scene, allowing the scaling of many businesses and the development of a whole asset class, the reset in public valuations and the uncertainty around the financing of large rounds, especially from non-traditional investors like hedge funds, mutual funds (an important part of them being US-based), has generated a new paradigm in which efficient growth is the priority. I prefer to use that term rather than that of profitability as the implications are quite different: If the ultimate goal of these businesses, rather in the short-medium term than in the long term, is to be profitable and to effectively deliver operating cash-flow in a steady state, some of these companies can afford to stay unprofitable if their high growth is efficient and if that is key in the company’s survival.
Please remember that it takes on average three years for a NASDAQ listed company to reach profitability, and if a company demonstrates that it can grow at scale in a stellar way with Tier 1 growth metrics (such as endurance growth rate or an NRR of 120% +), then it is not an imperative here to be profitable, but rather to continue to scale so as to gain market leadership.
For all the others, of course it is time to focus on profitability: in today’s environment, it is unthinkable to demonstrate high-burn and deceptive profitability metrics (starting with S&M spend), if growth is below a 30% average to set a number. For those companies, focusing on capital efficiency rather than on growth at all costs will help continue the growth trajectory.
As such, several pathways for entrepreneurs emerge in our view, with different valuation considerations each time that we list hereafter.
The first scenario is for those companies that are best-in-class in terms of metrics. Let’s take the case of enterprise software delivered through SaaS mode, both horizontal and vertical. We are referring here to companies showing consistent and important ARR growth (north of 30%), with the right level of gross margins (80%), with high net retention (north of 120%) demonstrating product-led growth potential and last with efficient customer acquisition tactics on the company’s target customers (measured notably through LTV/CAC ratios superior to 3). For these companies, the financing is still here, and they will need it to extend runway, and it will come from top VC players or non-traditional investors at late stage. Some of these companies will continue to prioritize growth over profitability (cf. supra), but in all cases the path to profitability must be clear and well demonstrated to the investment community. In the end, a handful of those companies will complete an IPO and will have stayed on their initial track, though with more demonstration and proof points on the way there. Last, many of these companies will find that the current environment allows them to enhance their existing advantages through many consolidation opportunities.
The second scenario is for those companies that have successfully scaled their businesses and gone on to be key players in their verticals, but that are not able to display these best-in-class metrics, either at the growth or profitability level. This is the core of these unprofitable VC-backed companies that have gone through a Series B/C financing round that makes them appear “too big to fail,” even if in fact none of these companies are too big to fail. In our view they face the challenge of being able to pivot their business models to continue to deliver growth (perhaps at a slower pace, but north of 15%) while transforming into profitable businesses generating even minimal levels of EBITDA. Some of these companies might end up becoming attractive targets for private equity investors as long as they are able to avoid highly-mediatized failures which could cause GPs to refrain from investing in them in order not to cause anxiety among LPs. The challenge they face in that case is that of being able to build an equity story, with clear checkpoints along the way so as to build confidence, and to strengthen their financial systems and processes so as to meet due diligence requirements when in front of private equity investors.
Last, there is a scenario in which companies are conscious that they are not in the first scenario and not willing or able to take the second track, and which prefer to enter into discussions with other strategic players in the vertical/industry to be acquired in a defensive move. This scenario has many positive outcomes, but must be well anticipated by Management teams and entrepreneurs to preserve optimal valuation conditions.
In all three cases, the question of the valuation of these companies will be at the center of the discussions. If in the first scenario, it is likely that valuations will be below those expected by founders and management teams as the decorrelation from public markets is not durable at term, valuations will tend to be (much) lower in the second and third scenarios. Indeed private equity investors and strategic acquirers have different investment lenses than pure VC players, and their risk/reward balance influences the valuation. This might sound harsh to entrepreneurs, but the rationale is there.