Tuesday 27 September 2016

Angels wanted as Irish startups face venture capital seed fund crunch

Published 13/08/2015 | 02:30

Brian Caulfield, head of Irish Venture Capital Association.
Brian Caulfield, head of Irish Venture Capital Association.
Brian Caulfield, head of Irish Venture Capital Association

If you're an Irish tech startup looking for funding of under €5m, look out: there's a crunch coming. Or so says one of Ireland's most visible venture capitalists, Brian Caulfield. As the newly appointed head of the Irish Venture Capital Association, he spoke to our technology editor about unicorns, the state of third level education and a growing funding gap that could see startups seek financial backing overseas

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Adrian Weckler (AW): What is the climate like for Irish tech companies raising money in the immediate future?

Brian Caulfield (BC): In the short term in Ireland it's going to be pretty tough for startups and companies to raise either seed funding or Series A funding of between €2m and €5m.

AW: Why is that?

BC: There are a couple of reasons. The biggest issue is that almost all of the seed funds and the series A funds here are in fundraising mode at the moment. So they're finished the investment period of their existing funds. While some of the larger funds here are close to announcing that they've closed funds for around €100m, it's going to remain a very tough fundraising environment here for a while.

AW: So are we looking at a fundraising crunch in Ireland?

BC: Yes. I would say we're already in that crunch and that the seed crunch is coming.

AW: So where will Irish startups go for funding?

BC: Well you're definitely seeing companies raising money under the UK's EIS [Enterprise Investment Scheme]. I'm aware of quite a few examples of that. In some cases, the companies are staying here but making themselves qualify for EIS by doing parts of their business in the UK. In other cases they're actually moving to the UK. Because right now, it's incredibly easy to raise those kinds of funds in the UK.

AW: What other reason are behind this fundraising crunch?

BC: It's ironic that, on the one hand, the government is tremendously supportive of the venture capital sector through Enterprise Ireland and ISIF [Ireland Strategic Investment Fund].

But then aspects of legislation, including the regulation of pension funds, make it tremendously difficult for pension funds to invest in venture capital. So that makes it very difficult for Irish VC funds to raise the matching capital that they need to put a big fund in place.

And we need those big funds. If you're raising €20m, you can go to the US and US investors will talk to you. US investors will certainly make a €20m investment in an Irish company because they're deploying enough capital to make it worth their while.

But if you want to raise €5m or €10m, they're really not interested. These guys are not going to fly the Atlantic four times a year for a €5m investment in an Irish company. So we need a domestic sector that's capable of making investments, especially those in €2m to €5m range.

AW: Other than pension funds not investing here, why don't Irish startups get the same amount of venture capital access here as in the US?

BC: There's definitely a significant gap when companies want to raise anything in the €2m to €10m range. That's not just an Irish problem, it's a European problem. When you look at the statistics, the US does about 1,500 funding rounds of under €5m and it does about the same number of funding rounds for over €5m. Europe does about 750 funding rounds of under €5m, but only a couple of hundred rounds of over €5m. So there's definitely a gap for decent-sized Series A or Series B chunky rounds. That does have a constraining impact on the growth of the companies which are relatively early stage.

AW: Why are there twice as many deals in the US as in Europe?

BC: A couple of reasons. Returns in Europe have historically lagged returns in the US. But it's also a basic issue about the maturity of the industry itself. If you look at our [Draper Esprit] sister venture capital firm in Silicon Valley, DFJ, its most recent fund is Fund 11. There are many other tier one VC firms that are on funds 15 or 16. But if you look at Europe, there's almost nobody who's beyond funds three or four. So the industry is just a lot younger in Europe.

AW: Does a more fractured single market in Europe play any part in lower venture capital activity?

BC: Well you do have the issue of over 25 EU countries that have different company law and regulatory environments. That definitely does make it harder. But the other big issue is the very different kind of investors in venture capital funds between here and there. In the US, you have a lot of large pension funds and institutions that are investors. And there are a lot of large endowment funds. University endowments are a very big player in the VC industry there. You don't have those in Europe.

AW: Speaking of universities, does a more unashamedly elite approach to third-level education in the US help the development of successful companies or the VC sector?

BC: I'm not sure that it's the biggest issue in terms of the difference between the US and Europe. People forget that while there are a significant number of elite universities in the US that boast incredible resources, every state there also has a dozen or more local state colleges that are in many cases inferior to our institutes of technology. So I don't believe for a second that there's a major educational gap in quality between Europe and the US.

Sure, we should be educating more engineers and more computer scientists. And yes, education is one of the few things that gives you real leverage in terms of your ability to grow an economy or develop a society. But I don't think it's the main difference, no.

AW: Is the funding system for third-level education here an issue?

BC: The universities would have a strongly-held view that we need to move back towards a fee-based model or a partially fee-based mode, because the universities have been absolutely strangled in terms of resources over the past eight years or so.

AW: Are endowments and alumni a route into that?

BC: Well, I can tell you that TCD is definitely looking to ramp up alumni engagement and trying to develop that model for sure. They're also doing a lot of things in engaging alumni in specific projects. Launchbox is a specific example of that.

That was effectively funded originally by a half dozen Trinity alumni to get the concept of a student incubator off the ground. The issue unfortunately is that there isn't really tradition of making a donation to your alma mater here.

Whereas in the States, it's kind of seen as a religious obligation. You go to Stanford and the campus is absolutely staggering, just incredible. But you have to remember that you have guys like Phil Knight of Nike making donations of $110m.

We do have an interesting example in Europe in the IE Business School in Madrid which is often rated as top business college in Europe and it is privately owned. So the concept does exist here but it is relatively unusual.

AW: The tech world is currently obsessed with unicorns, startups with a valuation of over $1bn. How far away are we from an Irish-based unicorn?

BC: The whole unicorn thing has become a little overplayed as a meme. And in Silicon Valley it's probably even become a little destructive. Some companies that don't really deserve unicorn valuations are pushing hard to get those valuations and ending up taking money with strange structures and so on.

They're becoming too valuation focused. That said, I don't really see that as becoming too great a risk here and I think that in terms of our ability to attract international capital and to scale up, bigger exits are the kind of thing we need to be shooting for.

If you look at the Irish market traditionally, we've had a reasonable number of exits but the vast majority are below €100m. And even the exits that might reach into the €500m territory, like Cartrawler or Hostelworld, are very few and far between

But I think that one or two big exits would have a dramatic impact for Ireland. They could serve as the poster children for the startup community and the wider tech community in Ireland.

AW: Do you see any unicorn candidates in Ireland?

BC: I think we're probably in the best situation we've been in for many years in having a crop of companies that have the potential to achieve those kind of valuations. I think Movidius is absolutely one of those companies. Then look at Fenergo, which recently took [a €75m] investment from [US-based] Insight Venture Partners valuing it at north of €100m. Insight will have gone into that deal looking for a 5x return.

So for them to achieve 5x in rough terms, that means Fenergo has to get into the kind €500m or €600m territory. Insight will undoubtedly be thinking that there's upside potential beyond that, so it could be a potential unicorn candidate.

AW: Do you think there's a bubble in tech right now?

BC: I do not believe that there is a broad-based bubble in valuations, even in the US. There are some very good tech companies with significant revenues and strong growth rates being valued at between five and six times revenue, which is a very appropriate valuation.

Insofar as there are bubble valuations being paid, it's in a very narrow part of the market, internet consumer services that are disrupting large established industry. It's Uber, it's Airbnb, it's Spotify. And I do think there are some bubble valuations being paid in that area. But it's not a broad-based tech bubble that's remotely close to what we saw in 1999, when all you had to do was to stick internet in your name. You're not seeing anything like that now. Most of the valuations being paid are pretty rational.

AW: What does the VC industry have to do in Ireland to see more engagement with tech firms and startups?

BC: We need to get the industry, through the IVCA, much more engaged in the startup community here, broadly. It's something that John Flynn [former IVCA chairman and managing director of ACT Venture Capital] stated. That means engaging with the Startup Commissioner here and with Startup Ireland. It also means being much more engaged with the startup community generally.

AW: What does that mean, in practice?

BC: Well we do have a few existing platforms we can use more. Like inviting people like Niamh Bushnell or the Startup Ireland guys to come to an IVCA council meeting and tell the council what they're about and how we can work together. Or making sure that when we run events like the annual dinner that the members of the association make a point of inviting that broad community to participate. In general, the venture capital community hasn't done a great job of educating startups about venture capital as an industry.

AW: Is there really that much of an information gap? Surely startups with a bit of ambition find out pretty quickly?

BC: You'd be surprised. Maybe it's just the issue of latent information that one assumes is generally known. But I would regularly meet startup founders who have absolutely no clue about how the venture capital industry operates. To the extent that they don't even understand the distinction between equity and debt.

AW: Other than finding more cash to invest, what's the biggest challenge facing the VC industry in Ireland right now?

BC: There's been a massive democratisation of entrepreneurship over the past 10 years or so. It's driven by incredible reductions in the cost of entry. Cloud computing and APIs mean that instead of it costing you €5m to build a product, you can now do it for €50k.

That's fantastic because it means that lots of people - young people, minorities, women - who previously couldn't get access to large amounts of capital are now able to become entrepreneurs. But that brings with it a challenge for the venture capital industry.

How do we fund very large numbers of very small companies with small amounts of capital in a cost-efficient way? The VC model isn't really set up to work like that.

And the economic model doesn't work if you're investing 50k at a time. So I think we need to work really hard to develop a vibrant angel capital network to support that kind of new model. Also, we really need to replicate EIS schemes and make it attractive on a risk-adjusted basis to invest in risky young companies.

In numbers

An Irish tech funding crunch: "In the short term in Ireland it's going to be pretty tough for startups and companies to raise either seed funding or Series A funding of between €2m and €5m."

Where startups will turn: "Companies are raising money under the UK's EIS [Enterprise Investment Scheme]. In some cases, they're actually moving to the UK."

On a tech bubble: "I do not believe that there is a broad-based bubble in tech valuations, even in the US, except in a very narrow part of the market, internet consumer services that are disrupting large established industry. "

On educating startups about VC finance: "I would regularly meet startup founders who have absolutely no clue about how the venture capital industry operates. To the extent that they don't even understand the distinction between equity and debt."

On the emergence of an Irish unicorn: "I think we're probably in the best situation we've been in for many years in having a crop of companies that have the potential to achieve those kind of valuations."

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