Unicorns starting to shift back to fantasy, says new report

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The downturn in venture capital is global, says a new report from KPMG and CB Insights about VC activity in the first quarter of 2016. The Venture Pulse Q1 2016 report shows that there is weariness for hype and new demand for profitability that has the potential to shake up the unicorn census.

The report leads with heavy doubt about the valuations of current unicorns, or startups valued at more than $1 billion. A glaring figure is the low number of new unicorns christened — five — less than half the figure from any quarter in 2015.

That might also be indicative of where the downturn is most acute. Silicon Valley seems to be weighing down the U.S. market, while New York City saw growth both in the number of deals and the amount of funding its companies had for the second straight quarter.

Silicon Valley leads global slowdown in venture capital investment

It’s important to look at the North America section of the report. With $25.5 billion in VC deals globally, $3 billion of it was in the top 10 North American rounds, led by Lyft’s $1 billion in January. There were 1,101 VC-backed deals in Q1 2016, down from 1,403 in Q2 2015. There has been a steady decline over the last five quarters in the share of seed deals, with seed rounds making up 32% of all deals on the continent in Q1 2015 compared to just 24% last quarter.

North American quarterly financing trends to VC-backed companies (source, Venture Pulse Q1'2016)
North American quarterly financing trends to VC-backed companies show a big drop-off in the last six months. Source: Venture Pulse Q1 2016

If the problem is localized in Silicon Valley, evidence can be found in the state-by-state analyses that the report highlights. California saw its investments halved between Q3 2015 and Q4 2015, from nearly $12.25 billion to $6.86 billion. Massachusetts slowed over the same period, but only dropping from $1.9 billion to $1.4 billion. New York rebounded in Q1 2016, going from about $1.5 billion in the last quarter of 2014 to $2.6 billion in the first quarter this year.

California saw a dramatic drop in venture capital investments in the last six months (source, Venture Pulse Q1'2016)
California saw a dramatic drop in venture capital investments in the last six months. Image credit: CB Insights

In the meantime, some regions saw a rise in the number of deals. While Toronto, Canada saw only 48 in Q4 2015, 63 deals came to pass in Q1 2016. With eight deals, Halifax creeped into the top three VC Canadian cities in the country, just behind Vancouver’s nine. Austin, Texas also jumped from 33 deals in the final quarter of 2015 to 57 in the first quarter this year.

Seeds not getting watered

Where is all that would-be seed money going? Why, to Series A of course. The average seed round has grown from $2 million to $3 million over the last five quarters, suggesting VCs are consolidating their portfolios and hedging bets on their proven investments. At the same time, the size of late-stage deals has slumped. After bouncing from an average of $22.4 million in the first quarter of 2015 for late stage rounds, and then up to $34 million in Q3, late stage deals dropped again to an average of $21.5 million in Q1 2016.

Trends seem to apply across all major verticals. Funding remained relatively unchanged by sector, with some noticeable growth in share of deals for internet companies. Mobile, health, software and B2C companies saw their share of the dealbook relatively stable.

Asia feels the pinch, Europe is stable, and some verticals are flat

While Asian investments peaked at $14.3 billion in Q3 2015 and dropped mightily last quarter to $6.5 billion, Europe was remarkably consistent. Over the last five quarters, the mean and average funding by quarter was $3.5 billion across the continent, including in Q1 2015, Q3 2015, and Q1 2016.

CB Insights sees big dips in North America and Asia, but consistency in Europe (source, Venture Pulse Q1'2016)
CB Insights sees big dips in North America and Asia, but consistency in Europe. Image credit: CB Insights

Cybersecurity deals saw major growth in the second half of 2015, jumping from $795 million in Q2 2015 to $1.067 billion and $1.099 billion in the next two quarters respectively. Then it dropped to $764 million, while the number of deals remained in the low sixties across the last five quarters. The bulk of deals were in the U.S., Israel, and then the U.K.

CB Insights notes the number of investments in cybersecurity is steady, but any talk of a bubble might have been tempered by the quick drop in actual funds invested (source, Venture Pulse Q1'2016)
CB Insights notes the number of investments in cybersecurity is steady, but any talk of a bubble might have been tempered by the quick drop in actual funds invested. Source: Venture Pulse Q1 2016

Digital health actually saw growth despite the markets. Q3’15 and Q1’16 both saw over $1.6 billion in venture deals. Where there was noticeable retreat was edtech. The number of deals has dropped dramatically from 72 in the first quarter of 2015 to only 36 in the first quarter of 2016. And after a $1.1 billion fourth quarter last year, numbers crashed down to $287 million in Q1 2016.

9-digit rounds begin to recede and valuations are definitely being reassessed

Rounds of more than $100 million are dwindling, though it might take a couple more quarters to say that definitively. After a peak of 61 such deals in the three major regions in the third quarter of 2015, they dropped to 40 in Q4 2015 and 37 in Q1 2016. All three continents saw a drop.

“Given the tougher environment for raising funds, we anticipate many of the unicorns will tighten their belts by pulling back on spending, driving operational improvements and being more cautious with the money they already have because it will be more expensive for them to raise capital in the near future,” writes KPMG’s Arik Speier in the report, who co-leads their Innovative Startups Network and is their head of technology in Israel.

$100-million+ financings are down (source, Venture Pulse Q1'2016)
$100-million+ financings are down (source, Venture Pulse Q1’2016)

There is some skepticism creeping through the numbers about the true valuations of startups. After seeing 25 new members of the unicorn club in both Q2 and Q3 of 2015, there were only 13 in Q4 and just five — that’s right, five — in Q1 2016. Thirty of those Q2 and Q3 unicorns were North American.

“Over the past few quarters, one VC market trend has become increasingly clear: the days of unhindered investor confidence are gone,” writes the report’s authors. “With much of the global IPO market stalled in Q1 2016 and many IPOs from the second half of 2015 having failed to realize their private sector valuations, VC investors are becoming much more skeptical and demanding of their investees.”

The bulk of this problem might be cultural says the report, without elaborating.

“Unicorns and late-stage companies . . . have been able to raise previous funding rounds without the same level of scrutiny,” the report goes on. New pressure will force startups to look at layoffs and pull back on discretionary spending, which “may require major culture changes which may foster anxiety.”

Click here to find the full Venture Pulse Q1 2016 report.

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