Despite global market turmoil in the first half of 2022, investor demand for tech startups shows no signs of abating. In the first half of 2022, USD 133 billion in 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 set to be another record year.
We are also witnessing strong venture capital activity in Cyprus. The number of venture deals as of August since the start of 2022 has already reached 2,021 numbers, with six deals including three seed deals, one Series B deal, one additional deal and one completed open-ended round.
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 include venture capital funds. In order to raise and manage venture capital funds, AIFMs must be authorized under the AIFMD. The regulations aim to improve industry transparency and allow fund managers to offer funds more easily across the EU with a single internal market passport.
The challenges of investing in startups for AIFM
Despite the attractiveness of investing in startups, AIF managers and managed AIFs face several challenges and risks. We categorize them as investment risks, security risks and business risks.
First, in investment risks, AIFMs can face a complete loss of capital when early-stage start-ups fail completely. Even in the era of “free money” the past decade has seen many startups come and go. In the US, the Small Business Administration reported that only 80% of startups survive after one year. The difficulty is compounded for AIFMs because the financial statements and other traditional financial indicators of an early-stage company are usually meaningless.
Second, the range of returns that an AIFM can achieve is also highly variable. Seasoned venture capitalists will know about the Law of Extent, which states that a fund’s success is usually determined by one or two of its own investments (eg 100x return). Such winners are needed in a portfolio to offset the total loss of many other failed startup investments.
Third, AIFMs invested in startups have to take a very high liquidity risk. We’ve seen companies stay private for seven to ten years before going public. Even if you can find a secondary buyer to sell your private shares, specific covenants and restrictions may prevent you from selling or transferring your shares.
The next category of risks includes risks related to the security (eg preferred capital, common capital or convertible bonds). In general, all investors face dispersion risk and valuation risk (ie a share price determined by the issuer, not the market). Some AIFMs may be able to offset these risks if they are large enough to exercise leverage over the portfolio company and secure preferential terms.
The last category of risks are business risks (eg revenue, expenses, etc.). Early-stage companies are particularly vulnerable once they enter the “valley of death,” where operations have begun but no revenue is generated. The longer a startup stays in the valley, the more likely it is to face a cash crunch. In addition to operational risk, startups tend to be opaque, and the lack of disclosure means that fraud risks are higher than with publicly listed companies. AIFMs should take them into account and monitor them closely.
How LUAIFs can succeed in investing in start-up companies
There are several ingredients to a successful startup investment. First, AIFMs must be able to build a supply channel with their own deals. Every day, hundreds and thousands of new companies are created worldwide, and these companies have many sources of funding to choose from. Among the most successful FAI executives who have managed to gain access to 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 of the entire ecosystem.
Next comes the due diligence stage and from our experience there are a number of elements that the LUAIF should critically evaluate: i) company development plan, ii) technology stack, iii) uniqueness of the solution, iv) market analysis and v) chemistry, experience and team capabilities. Depending on the start-up stage, the potential return should also be high enough to compensate for other potential failed investments in the AIF.
The future of startup investing
Despite global interest rate hikes heralding the end of the era of easy money, we believe venture capital funds and AIFMs that invest in early-stage technology companies will play a critical role. In a world of higher interest rates and cost inflation, there is a dire need for technological advances to drive productivity growth. Today we are on the cutting edge with the advent of 5G, artificial intelligence, machine learning and the Internet of Things. However, the start-up investment playbook that has worked for the past decade has changed, and AIFMs will need to adapt to the times.