The Sunday Times 5 Feb 2023
Start-ups that fetched racy valuations in the boom years are facing a rude awakening, says Jamie Nimmo
By Jamie Nimmo
When former British Army officer William Cowell de Gruchy raised $15 million (£12.5 million) for his software start-up in November 2020, he must have dreamt that the fledgling company was well on the way to becoming a “unicorn” — a firm with a $1 billion valuation.
Infogrid had helped the NHS monitor the safety of hospitals during the pandemic just two years after it was founded. Its work earned the company plaudits — and funding from a handful of venture capital firms (VCs) led by Northzone, a backer of Spotify.
More than two years on, the London-based company — whose artificial intelligence software also helps supermarkets and banks manage the cleanliness, air quality and occupancy of their buildings — is trying to raise another round of funding. However, conditions have deteriorated badly.
Instead of chasing the unicorn dream, the pandemic-fuelled fundraising bubble that put a rocket under the values of young companies has burst, leaving loss-making start-ups scrambling to raise money to survive.
In an effort to keep Infogrid’s valuation high, Northzone came up with a plan: instead of trying to raise a big round of funding now and risk a cut to the valuation, it would offer other investors the chance to take part in a smaller “bridge” round through convertible loan notes that turn into shares in the future.
These would be priced in such a way that the investors who took Northzone up on the offer would get a sizeable discount when Infogrid issues shares in its next big $50 million funding round.
That round would value the company at $195 million. But these secretive discounts meant investors backing the bridge round would buy in at a $66 million valuation — much cheaper.
Infogrid’s fundraise is an example of how start-ups are trying to ride out the current turmoil and retain their lofty price tags. Some in the tech industry — in which a number of these firms operate — predict that their valuations will be slashed. Others believe there will be a wave of failures.
As of September, there were 44 unicorns in the UK, not including those that have floated on the stock market or been sold, according to the tech-data provider Beauhurst. Of those, 25 became unicorns in 2021 as the Covid lockdowns and changing working and social patterns drove investors to digital companies.
Is this the year when the unicorns die? Or will they hobble on?
Dharmash Mistry, a veteran venture capitalist, said more established start-ups would struggle to keep raising large sums in the current climate, having grown too large, too fast during the bull run. Investors will baulk at throwing such amounts at propping up valuations, he argued, and the firms will be left to wither unless they are drastically restructured.
“The reality is, there’ll be quite a few failures because many of these companies will not be sustainable as they raised way too much money,” he said.
Karen McCormick, chief investment officer at Beringea, the investment house that has backed jewellery maker Monica Vinader, said a number of highly valued start-ups would lose their unicorn status in 2023. “We’re going to see more realistic valuations, starting from the beginning of this year,” she said.
“Within the next quarter, I think most of the things that are going to be materially revalued will have happened.”
Andrew Williamson, managing partner of Cambridge Innovation Capital and chairman of the British Private Equity & Venture Capital Association, said:
“We’ll continue to see a shaking out of the ecosystem. There’s always capital available for good businesses on competitive valuations. However, a natural part of growing the next generation of businesses is that there will be some failures and down rounds over the next six months.”
A “down round” is a description that makes entrepreneurs and their investors shudder.
Companies listed on the stock market are revalued every time the shares change ownership, but companies in private hands are only valued at each funding round, which can be years apart. Often, that valuation is carefully controlled by the investors putting the funds in, so that it keeps going up.
In the start-up world, founders and investors have become used to raising funds at a valuation higher than the one reached in the previous round. This, they believe, shows confidence in the company’s direction, product and strategy.
A down round is when they raise funds at a lower valuation, which can deal a blow to a start-up’s reputation.
The past decade, which has seen low interest rates and generally low stock market returns, has driven investors towards tech, where valuations can multiply in just a few years. Unless a company was struggling, it used to be almost impossible to have a down round.
Now the economic downturn has hit, they are doing everything to avoid them. Like the one at Infogrid, discounted bridge rounds for select investors are becoming increasingly common. They even have different names. Some call them bridge rounds, others refer to extension rounds, top-up rounds, even “acceleration” rounds.
But not everyone is in favour of such tactics to encourage investors to keep putting money in. Alex Lim, managing partner at the venture capital firm Blossom Capital, which has backed payments company Checkout.com, said rounds engineered to avoid lower valuations were usually done without the knowledge of staff or the general public. He explained: “There are places where it’s valuable and necessary and it could be the best option, but generally we advocate against it — because if you’re going to take pain at some point, it’s better to take it sooner rather than later and rebuild somewhat.”
Mistry said: “I’ve seen this in two cycles before, and it’s happening now — people want to kick the valuation down the road.”
McCormick added: “There are some weird and wonderful instruments being used to try and keep companies from having to undergo down rounds, which I don’t think is a good idea.”
But from a start-up’s point of view, the hazard of a down round is not just the reputational risk but also the possibility of an employee exodus. Many people are attracted to working at start-ups because of the share options on offer. If those drop in value, the allure of hanging around to see what they could be worth is gone.
It’s not all doom and gloom, though. Last week, a report by Beauhurst showed that funding in 2022 was not as bad as many had feared, even with tech companies under pressure since the start of last year. British tech start-ups raised a total of £19.7 billion, which was down just 16 per cent on the year before. There were 2,722 deals announced, only 7 per cent fewer than 2021.
In fact, there were more equity investments for younger companies carrying out so-called “seed” rounds. Simon Menashy, a partner at MMC Ventures, a firm that has invested in recipe-box business Gousto and flower delivery outfit Bloom & Wild, admitted there was “paralysis” for start-ups trying to raise larger sums. But he insisted that there was “still quite a lot of money around and deals being done” at the smaller end.
He added: “I think some of the slowdown at the early stages is [down to] companies choosing not to go out and fundraise. There’s a lot of advice out there saying, ‘Don’t go out now — it’s terrible, there’s no money and VCs aren’t writing cheques.’ And that’s possibly less true than some of the advice being given.”
If venture capitalists are telling their companies not to raise money, it’s because they have their own problems to worry about. They have to raise funds of their own to invest in these start-ups, and the appetite from their own investors — or limited partners (LPs) — is not what it was.
A number of VCs are having difficulty hitting the target amounts for their funds, or it is taking longer than expected to do so. These are understood to include Atomico, the venture capital firm set up by Skype co-founder Niklas Zennstrom, and Lakestar, whose venture partners include Sam Gyimah, the former universities minister. Atomico and Lakestar declined to comment.
One reason why limited partners are holding back from putting more money into venture funds is the fall in public markets. That has not yet translated into the private markets, meaning many LPs now have too much invested in private funds and are unable to put more in.
As well as the failures predicted in the tech start-up world, some believe the current climate could lead to a string of VCs shutting up shop too.
“I think we’ll see venture firms disappear,” said Blossom Capital’s Lim.
“There will be funds that just cannot raise a subsequent fund and they will wind down. And that’s probably the right thing to do. There was definitely too much capital in venture — that is what created the overvaluing of private assets relative to public assets, in my view.”