Seed Stage Slump: Why Israel Will Pick Up the Slack
Fred Wilson, the much-revered NYC-based venture capitalist has written much on the “early stage slump” as fewer and fewer investors are writing checks for Seed stage companies. (Note: this post is from 2017 but his perspective on 2018 data remains consistent.)
Fred posits that, following a 2012-2016 early-stage bubble, angels became more selective after some bad burns, and that early-stage VCs who had had some level of success were quick to move ‘up-market’ (Series A, B and onward) in order to be able to deploy more capital – and earn higher fees – with the same amount of work.
Mark Suster added to the conversation this week with some great data on trends in Seed investing and a more generous interpretation that what we’re seeing is both: (1) a natural maturation of the industry; and (2) a result of VCs’ recognition that they need larger ownership stakes to optimize returns (read: it’s strategy, not greed).
Whatever the reasons, a shortage of investors writing checks at Seed and Pre-Seed means, quite simply, that we’re going to see far fewer startups making it out of the gates. This trend is seen acutely in the plummeting number of early-stage deals in the US. Pitchbook data shows the number of US early-stage deals closed falling in absolute numbers over the past years, with only 4,843 deals <$5M in 2018 compared to a high of 6,689 in 2015. Yet total deal value remains the same, meaning fewer and fewer early-stage deals are getting done.
And in the Holy Land?
It turns out we have a bit of a slump ourselves, although not nearly as severe as what’s happened in the US. True, the number of early-stage deals in Israel has fallen dramatically since our own 2015 high. Only 352 of Israel’s deals were under <$5M in 2018, down from 456 in 2015, representing 57% and 66% of total deals closed, respectively. But this decline (23%) proved less acute than that seen in the US (28%) over the same period.
(Source: Data from Israel Venture Capital Network. www.ivc-online.com)
And despite a clear up-market shift by investors, average deal size in Israel has stayed a good amount more sane than it has in the US. Mega-rounds and the “Softbank effect” drove US average deal size to $14.6M in 2018, an increase of 67.4% (!!!) year-on-year, while Israel’s average deal size leveled off at $10.4M. In many cases in Israel, entrepreneurs are expected to do more with less.
Israel: Still Sowing Seeds
As the “first check” problem becomes more acute and we see a declining number of early-stage companies coming out of the US, we believe Israel (and to some extent other newer tech hubs around the world) will pick up the slack, generating a growing share of today’s early-stage and tomorrow’s growth companies.
A few of the reasons why we expect Israel to become an increasingly significant source of great early-stage deal flow:
Huge isn’t our thing. The overwhelming majority of our CEOs are extremely technical founders – alums of intelligence programs, PhD researchers, etc. – who love to geek out on their product. These entrepreneurs are less frequently interested in managing massive headcount, building out sales teams in far-away markets, and fundraising nearly full-time. For many, an acquisition by a strategic partner who can scale distribution is a great way to get back to doing what they love – starting the next company. (Not occupying a corner office on a fancy corporate campus.)
We’ve got more impact. Over a third of Israel’s more than 6,000 startups are in high-impact sectors like agriculture (500+), medical devices (500+), digital health (500+), water (250+), food (250+), energy (250+), and education (250+). Impact companies dedicated to solving a major environmental or social challenge are finding growing sources of non-dilutive capital – grants, awards and prizes often totaling several millions of USD – that help them change the world while also providing runway to future financing, profitability and/or exit.
The Israeli Innovation Authority. This government program subsidizes R&D for hundreds of Israeli companies each year under a range of sectors. Most every company that we see at Seed stage has already – on a very limited budget – used what is effectively that elusive ‘first check’ from the IIA to perform some validation of their technology and frequently with a significant pilot partner. (What’s more, Naomi Krieger Carmy and Patricia Lahy Engel and team run the IIA’s awesome and forward-thinking Division for Societal Challenges specifically for companies with significant global impact. We love them. Sending gratitude.)
It’s hard to go back down. This is the lesson of disruption for incumbents. As Fred Wilson writes, many VCs in the US may begin to sense that they’re missing the value at Seed stage. But going back down once you’ve moved up-market is tough. It’s not just ditching the nicer office and higher salaries. Deal-sourcing is scrappier and more demanding. Entrepreneurs require a more intimate and thoughtful kind of support. LPs are often of a different ilk, size and risk profile, and building investor trust and relationships can take time. Holding multiple strategies across investment stages can complicate team dynamics, incentives and required skill sets.
As Mark Suster points out, with the number of A rounds staying more or less the same, the growing imperative for many Seed startups over the next several years will be to leverage their early funding toward profitability or acquisition. (Not just more and more fundraising.) We believe that many Israeli startups are well-positioned to do just that.
In the past two weeks alone, we’ve had a great time getting to know other early-stage investors from UK, US, China, Norway, the Netherlands and beyond who are increasingly looking to Israel as a source of deal flow. If you’re in this camp and interested in co-investment, send us a hello. We’d be thrilled to show you around the neighborhood.
