Sunday 19 January 2020

'Down rounds' the new threat to Ireland's tech firms as fewer investors now believe in unicorns

A meltdown in valuations among the industry's biggest startups has created a new wave of doubt among institutional investors about whether they should be backing tech firms

Evan Spiegel
Evan Spiegel
Drew Houston, Founder, Dropbox, in Conversation with Laurie Segall, CNN, on the centre stage. Photo: Naoise Culhane
Adrian Weckler

Adrian Weckler

What's happening to the tech industry's unicorn dreams? Are funding 'down rounds' washing away the prospects of startups with billion-dollar valuations? And are we about to see the rise of 'cockroaches' in place of unicorns?

At the World Economic Forum at Davos earlier this year, Salesforce chief executive Marc Benioff bluntly laid it on the line.

"There are going to be a lot of dead unicorns," he said.

Companies valued at "lofty valuations" of over $1bn and which skipped the chance to go public when financial conditions were more euphoric were in a "very difficult position", he said. "Those startups will have to raise money at the new reality."

There's a term for this. It's called a 'down round'. This is where money is raised by a startup but in the process of doing so, the valuation of the startup is reassessed downwards.

In a climate of increased scepticism over eye-watering valuations that are unrelated to actual revenue or profit, Silicon Valley is starting to pile up with these down rounds.

Dropbox, which has an office in Dublin, and Snapchat are among a growing list of tech companies now considered to be less valuable than they seemed a year ago.

There's even a list documenting the down rounds. The research and analytics firm CB Insights has what it calls a 'Downround Tracker', a site that reveals the major tech companies that have seen their valuations fall over the last year as a cold wind of scepticism washed over the tech industry. There are currently 59 companies on the list, including some unicorns and established tech names.

For example, the unicorn-rated wearables company Jawbone saw its value slashed from $3.3bn to $1.5bn in its most recent January funding round. Similarly, the mobile location app Foursquare dropped from $600m to $250m in a January funding round.

The US mobile payments firm Square saw its worth plummet from an attributed $6bn to $2.9bn when it tested itself on the public markets.

Something similar happened to online enterprise storage service Box, which dropped from $2.4bn to $1.67bn when it floated.

US venture capital firms and asset fund managers are warning that the write-downs are set to continue. The American VC firm First Round Capital, which has invested in big startups such as Uber, recently warned that the contraction was not a "temporary blip" and that it would continue to write down some of its tech investments "with many potentially being written off entirely".

Why is all of this happening? Does it prove the existence of a tech bubble? Or does it mean that cyclical factors such as rock bottom interest rates have run their course in pushing tech valuations to dizzyingly high levels?

And does this have any impact on Irish tech firms' prospects or the funding environment here?

"We've entered into an overheating period," says John Flynn, managing director of ACT Venture Capital, which has invested in Irish tech companies such as Cubic Telecom, Storyful and Cape Clear.

"If companies go public and their price halves, it sends jitters into the market. And that's the period we're in at the moment. There's a fear factor emanating from Silicon Valley and that's a concern."

Currently, there are 153 'unicorns' at a combined valuation of $535bn, according to CB Insights. A majority of these companies, by number and value, are in the US. The problem for these unicorns is that at least 100 of these will need to raise more money in the next nine months. If there is a squeeze on valuations, this could spell trouble for some of them.

"Some marginal companies may now not get funded, that's for sure," says Brian Caulfield, a partner at Draper Esprit, which invests in early stage companies.

"That said, good companies will continue to get investment."

Other VC executives say that Irish tech companies are not immune from a tightening in valuations for flagship companies.

"We're all striving to build big companies here," said John Flynn. "But it needs an ecosystem. "What happens is that big companies like Microsoft need to acquire smaller companies. Ireland is good at growing companies to €40m. And the biggest bell curve of returns on companies happens between the €30m to €150m mark. If the market takes a dive, and there are no IPOs, eventually it reduces the number of buyers for companies that Ireland is producing. It's a supply chain issue." Separately, Ireland might be affected by a valuation crunch in that big private tech firms (like Dropbox) are one of the biggest growth areas for inward investment here. Some of these companies are profitable while others aren't. A fall off in funding for the unprofitable ones could hit Irish economic interests.

However, there is some evidence to show that cash and valuations for European companies aren't being affected in the same way as funding to US firms.

The European tech funding scene is much more nascent that the American one. Last year, US venture capital firms ploughed a whopping €52bn into start-ups and later stage firms, according to a MoneyTree report from PricewaterhouseCoopers and the US National Venture Capital Association. That is far more than European VC firms' investment haul. A study by estimated that European companies landed about €4.4bn across 770 funding deals in the first three months of 2016, leading to an average round of €4.6m.

One of the characteristics of the US-based tech valuation squeeze is a softening of non-specialist public and crossover funds into the tech sector. This may not be happening to the same extent in Europe or in Ireland. "I don't think we're seeing a fall off in public investments in Europe," says Caulfield. "If you look at the European Investment Fund [which has over €20bn invested in over 300 VC funds], it has a very large amount of capital in the VC sector in Europe.

"In Ireland, Enterprise Ireland has both a seed program and a lot of people who got allocations for later stage funds. The problem is more the lack of private capital. If Enterprise Ireland, for example, gives you an allocation of €20m, you have to find a matching €20m from private sources. And there's very little private capital in Europe for that."

Overall, European funding figures are up on the same period for 2015 although that is mainly because of one gargantuan deal - Spotify's €900m debt round. If that deal is excluded, funding growth in Europe is flat over last year.

In general, American tech funding rounds are usually much bigger than European deals, mainly because the venture capital industry is more established there and companies have a chance to scale more quickly.

"There are many tier one VC firms in the US that are on funds 15 or 16," says Caulfield. "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. The other issue is the 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."

There is only one 'unicorn' with strong Irish DNA and it's Stripe, the online payments firm set up and run by Patrick and John Collison. At the time of the company's last funding round in July 2015, it was valued at $5bn. It is also likely to seek further capital reserves in the next year.

Leaving aside the question over whether valuations actually matter all that much, could its next funding event be a 'down round', bringing that $5bn figure closer to earth?

It seems unlikely, for a number of reasons. First, the company has been expanding its commercial territories steadily over the last 12 months. (It famously got a shout-out from US President Obama last month as part of a trade delegation to Cuba.) There are other signs that Stripe may not be among the more vulnerable section of the unicorn herd. The funds that back Stripe are among Silicon Valley's biggest and richest. This means that they tend to take medium-to-long term positions in companies. One of them is Sequoia Capital, the chairman of which is Michael Moritz. Moritz was an early investor in Google, PayPal, Yahoo and YouTube.

He is also one of the quoted critics of unicorn valuations. Last October, he wrote a scathing piece in the 'Financial Times' about "deluded" founders and ingenue investors who are "new to technology" and who are creating a bubble in the tech industry. But Moritz also sits on the board of Stripe. It would be quite a surprise if Moritz chose to be involved with one of the companies he might otherwise class as being overvalued or even "deluded". So it would not seem that Stripe is in the front line of companies considered to be overvalued.

Other Irish interests appear to be similarly unaffected. Intercom, the fast-growing online customer service company, has just closed another funding round that appears to increase its valuation.

Dublin-based Hostelworld, which floated in London last year, just released solid profitable earnings that tops a year when its market capitalisation rose by over 20pc (to more than €300m). Nevertheless, there was always going to be some sort of correction in the market, VC practitioners say.

"We've been living in a world of extremely low interest rates which means investors chasing yields have had very few places to go," says Brian Caulfield. "This has led to money coming into the venture world that might not otherwise have come in. We still have those rates, but when people see those valuations accelerating the way they are, a point comes when people start to ask hard questions."

Caulfield says that the issue affects later stage companies more than it will those at an early stage. This appears to be borne out by the figures.

According to the's analysis of European funding deals, 534 of the 770 rounds were under €10m, a big jump on the 379 funding deals under €10m closed in the three months previous to that.

"The reality is that good companies are going to continue to get funded," says Caulfield.

"They may not achieve quote the lofty valuations as previously and more capital efficient but that's not a bad thing. I do not believe that we're anywhere close to a scenario that pertained in early 2000. Even the unicorns that have suffered material down rounds are mostly companies with real business models and real revenues. It's a very different situation."

But is all of this affecting small stage investments, which makes up the bulk of funding for Irish tech companies?

"It does trickle down to some extent," says Caulfield. "When you're investing in very early stage companies, you're not expecting to sell the company any time soon. But seed and early stage investors may start to worry about where the next round is coming from."

There may be a silver lining to the current contraction in tech valuations.

"Ironically, the fact that the market is cooling off means that it's probably a superb time to get into tech as an asset class because valuations are going to be much more sensible and you'll start to see returns improve as a result," says Caulfield. "Unfortunately what happens in VC is that while you will make the most by investing five years before a stock market peak, the time when it's easiest to raise capital is at that peak."

Are cockroaches the new unicorns? One is white, majestic and has rainbows coming out of its tail. The other is a gritty cling-on that can survive the worst of conditions.

And in an era of 'down rounds', 'unicorpses' and dire predictions for hyped-up billion-dollar tech firms, it seems that 'cockroaches' are emerging as viable underbidders to 'unicorns' in the tech world.

"Companies that want to outlast the coming funding crisis will need to move fast, cut costs, and plan for a future without much money in it," says Caterina Fake, the co-founder of photo sharing website Flickr.

"They will have to lay off staff, move their pricey downtown office to the unsexy exurbs, pivot into revenue-generating business models, kill projects going nowhere, live with less… After the plague and the conflagration that follows, the smoke will clear and you will look around to see who is still standing, and you will see the cockroaches."

The comparison may struggle to catch on at pitching events, however.

"I'm not sure if saying you want to be the new cockroach will be the most successful strategy for startups," said ACT's managing director, John Flynn.

Indo Business

Also in Business