Making Heads and Tails of Recent Venture Dynamics in Israel
As we approach the end of summer and the conclusion of the first three quarters of the year, it has become clear that over the past 12–18 months we have witnessed unparalleled changes in the dynamics of the venture capital industry. Startup funding in some of the world’s leading ecosystems is set to surpass previous years by close to 100%, and the number of liquidity events — primarily public market IPOs and SPACs — is exploding.
While in the short-term these dynamics have been driven by macroeconomic trends such as the persistently low interest rate environment and by unprecedented technological adoption across all industries as a result of the spread of COVID-19, many market participants (including ourselves) believe that the main, long-term, driver behind these dynamics is rooted in the inherent compounding effect of innovation.
This compounding phenomenon is the process whereby prior layers of innovation provide the infrastructure needed to build subsequent layers, which then become easier and faster to build (read more about this by Tim Urban and Packy McCormick). The impact of compounded growth rates, enabled by today’s exponential speed of innovation, tends to generally be underestimated by investors, since their perspective is shaped by historical and current growth forecasts and not by compounded growth rates. Look no further than the development of the cloud to understand the compounding effects of innovation — how much has the cloud contributed to today’s innovation velocity? Without the growth of cloud services, how could startups scale their infrastructure effectively? Imagine the infrastructure built by Twilio for seamless mobile network integration or fintech innovations like Plaid and Stripe which have built layers on top of which other fintech companies can build new applications, saving massive development and execution costs for startups.
A growing number of investors currently believe that the exponential growth of innovation will result in exponential growth of financial returns for investing in startups. As a result, some market participants have started to deploy investment strategies that were not previously feasible in venture capital. Perhaps the most notable player in this regard has been Tiger Global, the New York based hedge fund who has become notorious for its lightspeed investment pace (average of 1.3 deals a day during Q1/21) and deployment of large amounts of capital in short time spans ($6.9bil deployed in just three months). The Tiger approach has been described by many as the “hedge fund approach to venture”, but, in a nutshell, it’s essentially a strategy which centers around investing in a large number of technology companies, expecting that a certain number of them will lead to extremely outsized returns, which, in aggregate (perhaps in combination with leverage), will allow Tiger to deliver a performance which may otherwise not be achievable in the public markets. We see many venture capital and private equity firms following Tiger’s example, all switching from a value-based, limited investment strategy to a velocity-based strategy that involves large-scale investments.
These trends have had a fundamental impact on the dynamics of the Israeli venture capital ecosystem, from early stage to late stage. In this blog post, I will highlight a few data points, particularly around the current market dynamics in early stage investing, where Sweetwood Ventures, as a fund of VC funds is most focused on, and how some funds in the market are adapting their strategy to these changes.
Investing in startups is more expensive than ever before, but the end game is exponentially larger
One of the key trends which we have seen over the past few years is the stark increase in round sizes and valuations across the board, some of which has been driven by the frantic investment activity by some of the players mentioned above. While it’s natural to assume that these move in tandem, this has clearly not been the case, as valuation growth outpaced investment round growth. As a result, investors are now required to deploy additional capital in order to maintain similar holdings to which they were targeting several years back.
If you observe this from a dollar based view, you can see that while in 2015 $100k would have bought you 2% of a seed stage startup, today the same amount only allows you to acquire 1.02% of it. This increase in valuations has been quite similar in A and B rounds, as ownership rates per $100k investments have dropped for both by almost 50%. In other words, while in 2015 $1mil would have bought investors 20% of a startup, today you would need almost $2mil to obtain the same holdings.
While it’s clear that investors today are paying a premium on an absolute basis to invest in venture capital, the main question is if the opportunity set of investing in venture has grown in tandem? While assessing this is extremely difficult, we believe that the compounding effect of innovation is the main driver behind two compelling reasons to claim that the opportunity set for early stage investing is growing at faster pace than ever before.
The first, is that the pace of establishing a startup and getting to product-market fit and substantial revenues is faster today than ever before. This is very much driven by the fact that today the technological means allow you to innovate much faster. The examples mentioned at the preamble make a compelling case for this — imagine the costs and resources required to build a startup before the age of the cloud. Or think about the ability to build today a fintech startup with click-of-a-button integration to banks, thanks to infrastructure created by companies such as Plaid. These are changes which save years of development and millions (if not much more) in costs.
The second, is the new belief that the market opportunity for technology has greatly expanded as a result of the rapid digital adoption we have seen. In June, Tiger Global mentioned this to investors, by noting that it had “consistently underestimated” the market for private tech companies. Six months earlier, data suggested a $3tn market opportunity. It was now closer to $5tn, the firm said. While technology tends to be a game of outliers, it’s clear that the growth of the market opportunity will allow more participants seize on the opportunity.
As things relate to the local Israeli venture capital market, it is clear that both trends outlined above are also very much present locally. As in the past 18 months we have observed both a significant increase in the valuations of large scale Israeli technology companies, along with a faster pace of innovation and scale of early stage startups.
Increased velocity is pressuring portfolio construction
As noted above, the increase in round pricing has been somewhat on par between seed and A round, but one of the questions which we are asking ourselves is if A round investors are now assuming more risk than ever before, as the time between financing rounds is at an all-time low. As seen in the chart below, median time between raising a seed and an A-round has dropped in five years from about 700 days to a mere 550 days. With companies having 25% less time to hit their round-A KPIs, we have clearly seen a drop in the KPIs which are now typical for a round A (this is many times despite the fact that the development velocity of startups has increased rapidly, as noted above). While revenues were a clear must a few years ago, it is clear that they are not a must today. Granted, the same compounding effects on the pace of startup development should also be taken into account to mitigate the drop in time, but has this been enough to neutralize the difference? Or are A-round investors investing at a higher risk-adjusted basis than ever before?
The increase in velocity and maturity rate from seed to A (due to increased capital in the market) noted above, has resulted in enhanced pressure on portfolio construction for seed stage funds. While in the past the modus operandi of seed stage funds revolved around the ability to build a pyramid shaped portfolio — i.e. following-on only on the best companies in the portfolio from seed to B/C — to maximize their returns, it would appear that with the increase in velocity and follow-on rates, this task is harder than ever before. As seed investors now need to follow-on before meaningful progress has been achieved (see KPI note above and as they wish to avoid signalling issues) and as the rate of follow-on keeps increasing, the second layer of the elusive venture pyramid starts to look more like a brick tower.
This trend, again, can be also viewed as being mitigated by some of the observations above regarding the lower risk in technological investments, but remains in our view a key concern for early stage managers.
Early stage investing is adjusting
Driven by these two trends highlighted above, we have seen many of our partners adjust quite impressively to these trends and believe that there are some tactical adjustments that seed stage funds can make (and are making) in order to better positions themselves to these dynamics, I’ve highlighted some of these below:
(1) Increase in Investment Size — early stage funds have consistently increased the size of their investments to achieve target ownership and in turn also their funds sizes, all the while shortening deployment periods. We expect this trend to continue in full force in the coming years and the median size of Israeli venture capital funds to grow to new highs.
(2) Pre-empting Rounds — in order to ensure that funds can maintain their allocations throughout the life cycle of companies, many managers are now looking to pre-empt external rounds by leading internal rounds, capturing the majority of the equity investment in the round.
(3) Reserve Adjustment — allocating more capital to initial investments vs. follow-on, in order to maximize the impact of capital deployed at the earliest stage. This allows smaller funds to mitigate the risk on portfolio construction.
While these trends (and many more not discussed) are clearly changing the venture capital landscape, many have affirmed our views on the value of early stage investing and we continue to believe that early stage investing in Israel remains the most attractive investment stage on a risk adjusted basis. With that in mind, we are extremely excited to continue supporting our partners investing in those stages and see what is more to come in the coming decades!
