Despite the global market turmoil in H1 2022, investor demand for technology startups has shown no signs of abating. In H1 2022, US$133 billion of venture capital funding was raised globally. Considering that the total amount raised in 2021 was US$209 billion,
a record high since 2000, 2022 looks primed to be another record-breaking year.
We have also seen robust venture investing activity in Cyprus as well. The
number of venture deals as of August YTD in 2022 has already reached 2021 numbers, with six deals comprising three seed deals, one series B deal, one add-on deal, and one unspecified round completed.
In Europe, the Alternative Investment Fund Managers Directive EU/2011/61 (AIFMD) provides the framework for the management and marketing of AIFs (alternative investment funds), which includes venture capital funds. To raise and manage venture capital funds,
AIFMs must be authorised under the AIFMD. The regulations are meant to improve the transparency of the industry and allow fund managers to market funds more easily across the EU with a single internal market passport.
The challenges of investing in startups for AIFM
Despite the attractions of startup investing, AIFM and AIFs under management face several challenges and risks. We categorise them broadly as investment risks, security risks, and business risks.
Firstly, under investment risks, AIFs can face total capital loss when early-stage startups fail completely. Even in the “free-money” era of the past decade, we have seen many startups come and go. In the US, the
Small Business Administration reported that only 80% of startups survived after one year. The difficulty is compounded for AIFMs as financial statements and other traditional financial metrics
of an early-stage company are typically not meaningful.
Secondly, the range of returns that an AIF can achieve is also highly variable. Experienced venture capitalists will know of the power law, which states that the success of a fund is typically determined by one or two home-run investments (e.g. 100x returns).
Such winners are needed in a portfolio to compensate for the complete loss of many other failed startup investments.
Thirdly, AIFs invested in startup companies have to take on very high liquidity risk. We have seen companies stay private anywhere from seven to ten years before turning public. Even if you can source a secondary buyer to sell your private shares, specific
clauses and restrictions may prevent you from selling or transferring your shares.
The next category of risks comprises risks associated with the security (e.g., preferred equity, common equity, or convertible notes). Generally, all investors face dilution risk and valuation risk (i.e. share price determined by the issuer and not the market).
Some AIFMs may be able to negate these risks if they are large enough to exert influence over the portfolio company and secure preferential terms.
The final category of risks is business risks (e.g., revenue, costs, etc). Early-stage companies are particularly vulnerable once they enter the ‘valley of death’, where operations have started but no revenues are being generated. The longer a startup stays
in the valley, the more likely that the startup will face a cash crunch. Besides operational risk, startups tend to be opaque, and the lack of disclosure means fraud risks are higher than with publicly listed companies. AIFM should take them into account and
closely monitor them.
How AIFMs can succeed in startup investing
There are a few ingredients to successful startup investing. Firstly, AIFMs must be able to build a proprietary deal sourcing channel. Hundreds and thousands of new companies are started each day globally, and these companies have many funding sources to
choose from. Amongst the most successful AIFMs who have been able to access the best startups, we have seen them work tirelessly to build close relationships with other parties such as angel investors, accelerators, incubators, and business networks while
bringing value to the whole ecosystem.
The due diligence stage comes next and from our experience, there are a number of items that an AIFM must assess critically: i) the company’s development plan, ii) technology stack, iii) uniqueness of solution, iv) market analysis, and v) the team’s chemistry,
experience, and capability. Depending on the stage of the startup, the potential return must also be high enough to compensate for the other potential failed investments in an AIF.
The future of startup investing
Despite global interest rate hikes that portend the end of the easy money era, we believe that venture capital funds and AIFMs that invest in early-stage technology companies will have critical roles to play. In a world of higher interest rates and cost
inflation, there is a dire need for technological advancements to drive productivity growth. Today, we are at the cusp with the advent of 5G, artificial intelligence, machine learning, and the Internet of Things. However, the startup investing playbook that
has worked for the past decade has changed, and AIFMs will have to adapt to the times.