The startup scene took a big hit from the global financial crisis five year ago, but big investments and increased exit activity have 2014 looking stronger than recent years.
It's difficult to judge the health of a particular startup scene, and it's especially difficult on a national level where specific market and cultural traits are disregarded. However, the overall health of a startup scene is generally measured by the amount of money going into it, through institutional investments, and the amount of money coming out of it, through exits such as mergers and acquisitions (M&A) and initial public offerings (IPOs).
When it comes to the money going into startups, the US is in a pretty good spot. According to the MoneyTree Report from PricewaterhouseCoopers (PwC) and the National Venture Capital Association (NVCA), VCs invested $9.5 billion through 951 deals in the first quarter of 2014. This shows a rise in the numbers of dollars invested, but a drop in the overall number of deals compared to the previous quarter.
According to John Taylor, head of research for NVCA, we shouldn't over-read the numbers for Q1 as we are seeing more money put into middle and late-stage companies that have developed a minimum viable product and have proved a market opportunity. This could just be follow-ups to last year's early stage investments.
"What is happening, and the numbers clearly show this when you look at stages, is that the spotlight shifted," Taylor said. "So, in 2012, 2013 we had a record proportion of the deals being seen in early stage, and now those companies are starting to mature. So, you have more of these companies that have left the early stage category and are now in the expansion stage category. They're through proof of concept and they just take more capital."
The first quarter of 2014 also saw another milestone in terms of money invested into software companies. In Q1 2014, investments in software companies reached $4 billion for the first time since Q4 2000. According to the MoneyTree Report, "Venture capital investments into software companies accounted for 42% of total dollars and 44% percent of total deals in the first quarter. Five of the top 10 largest deals for the quarter were software companies."
The money going in is good, but what about the money going out? According to a report also done by the NVCA, M&A deals have been trending downward for the past few years. In 2010, there were 544 M&A deals with 499 deals in 2011, 489 deals in 2012, and 390 deals in 2013. IPOs, however, were trending downward from 2010 through 2012, but saw a spike in 2013 with 81 IPOs reported.
A recently released report outlining data from a survey done by Morrison Foerster shows that 2014 might be the year that this cycle is broken. The report found that 72% of the M&A experts queried said they planned to increase their M&A activity through 2014. It also found that 72% of participants believed the pace set by the first quarter of 2014 would continue through the end of the year. According to the report, the M&A experts queried included, "tech M&A insiders, including C-suite and business development executives, in-house counsel, investment bankers, venture capitalists, and financial advisers within the tech sector."
"First and foremost I think it says there's more confidence in the boardrooms and at the executive levels," said Rob Townsend, co-head of the Morrison Foerster global M&A group. "Because that's the precursor to paying some of these valuations and moving forward on acquisitions. It takes a fair degree of confidence in both the projections and prospects of the target, and the parent company's ability to integrate that in a way that delivers value to their shareholders."
While the Morrison Foerster data seems to conflict with the data obtained by the NVCA, we don't yet have enough data to prove that the two are contradictory. The NVCA data shows that, in Q1 2014 alone, there have already been 105 M&A deals. If the M&A market continues along that trajectory through 2014, we will end up with 420 deals at the end of the year — easily above the 390 we saw in 2013. And, a continuance of the momentum set in the first quarter was something that 72% of the survey participants said they expected to see.
What's also interesting to note is the correlation between the rise in venture capital investments with the rise in exit activity. Townsend calls them "oceanic currents" and said that the two often play off of and influence each other.
"When you see exits of the kind that some of these companies are getting in either trade sales, M&A deals, or IPOs, that just whets the appetite further for people to invest in that asset class. And, it also improves the returns that the funds can show the prospective investors that they have achieved , and that then validates that strategy," Townsend said.
According to Townsend, there has been whispers of the timing being right for an uptick in M&A activity for the last few years, but everything remained flat until 2014. As I noted in a previous article, 2013 was a poor year for tech deals, but it set the scene nicely for 2014 to bring exit activity roaring back to life.
"There's a huge external factor here that's running the show. That is, the increase in public market valuations. Meaning, specifically, that the stock market is up," Taylor said.
Of course, the Facebook/WhatsApp deal has the potential to skew the numbers, but increasingly high valuations will likely lead to acquiring parties targeting younger companies that might not be as ready to IPO to eliminate competition with the public market. Townsend notes that buyers are probably not willing to compete with current market valuations and are more apt to target companies without a jaw-dropping price tag.
Another aspect of these numbers is, as mentioned in the same previous article, mature companies investing in growth opportunities, while at the same time selling off asset classes that are not critical to that company's future. Both the acquisition, and the selling of a part of that company can count toward the traditional M&A volume and value numbers, but Taylor said that the NVCA doesn't count the selling of a corporate asset as a venture-backed acquisition.
During the financial crisis in 2007 and 2008, we saw a lot of corporations pull back their in-house research and development (R&D). Now, these companies are looking to acquire startups as outsourced product development. According to Taylor, this is also fueling growth in corporate venture capital investing.
"What we are seeing in parallel with all of this is an increase in corporate venture capital activity," Taylor said. "Whether it be a smoke stack traditional industry of whether it be one of these tech groups such as Google or Intel. We see their corporate venture groups really ramping up in terms of how early they're getting into these companies."
While this can be a pathway to acquisition, it isn't always the case that a corporate-led venture investment will lead to the target company being acquired. Still, it gives the corporate entity a window into new technologies and innovations and a way to vet the founding team before bringing them on.
We are seeing some of the highest valuations for startups of all time, but we'll see whether or not that will last. Founders can keep demanding billions for their startups, but if acquiring parties keep seeking out cheaper options it might force the market to respond with progressively lower valuations.
The technology world may not bear another $19 billion dollars for a startup any time soon, but other trends make 2014 look like the strongest startup environment in recent memory.