A single pitfall the early stage VCs should not fall into in 2021

(Editor's note: this a guest post from Konstantin Siniushin, co-founder and managing partner at the Untitled Ventures, a deeptech-focused European early-stage VC fund.)

For nearly a year now, we are living in a new world defined by the coronavirus pandemic. Lockdowns, border closures and remote working turned services like Zoom and Deliveroo into mainstream tech even for those who never used them before. Some VCs have fallen for the hype, too – and thus made the single biggest mistake. Let’s talk about how to avoid it.

In 2020, the European tech sector saw a record volume of VC funding of $43.1 billion, and 18 companies have achieved unicorn status. It hardly comes as a surprise: new challenges require unprecedented solutions that only the tech industry can offer. Essentially, tech helped the economy to stay afloat: high-street shopping got replaced by e-commerce, office spaces migrated into cloud and productivity tools, restaurants still are able to provide a Friday night treat via delivery services, while smart fintech solutions allow paying for all these and still managing the budget.

Adding the edtech platforms to replace the closed schools, telemedicine to support the overwhelmed health systems, and videoconferencing systems to stay in touch with friends and family during lockdown paints quite a picture. The Covid-19 pandemic put many tech startups into the spotlight as solutions for the most urgent needs.

And not only for the users: some VCs flocked towards the startups that carried the whole industries on their shoulders.

Where is the pitfall?

Unlike the later-stage funds, the ability to look beyond the current hype is vital for success of an early-stage VC. The key mistake here would be to take the areas with the current high level of interest (and funding) for a trend. Such sectors which can can hardly be classified as strategic trends, can roughly be split into:

1. Existing technologies, which enhance but do not change the industry. Certain consumer solutions — videoconferencing, edtech, even e-commerce — have all benefited from the pandemic. However, this is a compelled growth: consumer tech might see high returns in the short term, but those startups won’t be booming, they will still have numerous usability issues, and they won’t provide a long-term yield. For instance, the UK’s online supermarket Ocado saw a 52 percent surge in sales in 2020. What are the chances that the growth rate would stay the same after the lockdowns? Would the habits and effects of COVID-19 pandemic stick and define the new normal? And which of those would naturally subside?
2. Existing sectors and startups which grow regardless of pandemic. European fintech companies raised more in 2020 than any other industry, with Klarna being a prime example by raising $850 million across two rounds (and now facing stricter regulation in the UK). However, fintech is growing continuously for the past five years, with over $20 billion invested into European companies in the sector in the past two years alone. So while the innovative finance solutions are efficiently creating a backbone of the digital economy, this segment is already overheated for early stage VCs.
3. Ongoing deeptech developments with longer-than-two-years cycles. While deeptech in general is where the ambitious VCs should be looking, segments like biotech might cause some bumps on the road for the early stage investors right now. Vaccine development rush and a call for the digital health passports certainly got more eyes on the industry, particularly with BioNtech, the company supporting Pfizer in developing the first mRNA vaccine in use. Some noticeable biotech rounds included Immunocore ($130 million), Freeline Therapeutics ($120 million) and Compass Pathways ($80 million) — importantly, all those during Series B and C. However, when looking at the ‘trendy’ biotech segments, the early stage investors should be ready for the scenario when the follow up rounds or any sizeable outcome will take longer than a standard two-year cycle.

Naturally, each of those three categories still can present a good early-stage opportunity in 2021. For quite a few projects, however, now it’s technically the best time not to invest, but to exit with a high return. A good example here would be Apax Partners selling idealista in September 2020 to EQT for €1.3 billion.  Spanish online real estate classifieds platform, it is a prime example from the first category of consumer solutions. Five years earlier, Apax bought idealista at a reported €150 million valuation.

Where is the trend?

One thing that 2020 has led the industry to was a shift in strategic venture investment focus from capital-intensive and experimental initiatives towards the startups with predictable growth models, designed for the post-Covid world. For the early stage VCs, the key to success would be finding the sweet spot on the verge of technology innovation and proven economics.

Sectors ticking off both boxes include, but are not limited to:

• Deeptech, with a focus on AI and SaaS

Combined valuation of European deeptech startups is closing to €700 billion, while deeptech accounted for about 25 percent of all European venture capital in 2020. One of the strongest success stories comes from Romania, where UiPath, a startup creating software robots to automate repetitive business tasks, have raised a hefty $225 million round. Notably, Accel has earlier predicted it would take Europe at least 3 years to produce a SaaS decacorn, while UiPath there nine months after that.

Deeptech startups naturally take a bit longer to grow compared to the tech startups in general, but less compared to the biotech ones (2 vs 1.5 vs 2.5 years respectively). However, the exit opportunities are better in the long run, the economy is more predictable — in case on UiPath, the RPA sector is growing 60 percent a year irrespective of pandemic), and the B2B focus adds confidence.

• Generative adversarial networks

While some investors eyed at-home entertainment platforms helping people cope with isolation in 2020, others focused on related adtech, based on machine learning. A wide array of AI solutions help businesses to find potential customers, hyperpersonalise the messages, improve ad spend and placement, etc. Potentially the most exciting solutions are being created within the generative adversarial networks (GANs) paradigm.

In a way, GAN-developing startups caught their momentum in 2020: less time and opportunity to create expensive photo- and videoshoots made advertisers and investors both turn their eyes on AI models. But the GAN application goes much further with automated video translation into natural language, personalised customer video chats and synthetic image databases to train AI, and more.

• Drones

From being a tech gimmick, drones have quickly turned into a segment with clear business offering and simplicity of implementation. Compared to some biotech developments, drone technologies are easier to get approved and licensed, and offer a variety of B2B applications: from grocery delivery, like Ireland’s Manna Aero, to construction and aerial photography, mapping, photogrammetry, laser scanning (LiDAR), last-mile delivery, precision agriculture, critical infrastructure monitoring and more, like Fixar.Pro in Latvia.

Just a few days ago, Germany’s Wingcopter also announced a $22 million Series A. Definitely getting a boost from the interest towards contactless delivery, drone technologies are, nevertheless, here to stay beyond the COVID-19.

Overall, we see the early VC focus shifting to B2B solutions providing familiar industries with new opportunities to improve efficiencies — new energy (Octopus), semiconductor technologies (Graphcore) and space solutions, naming a few. Finding the right projects with a fast growth rate, go-to-market strategy and understandable exit strategy, while looking beyond the current hype, is the way for the early stage VCs to thrive in 2021.

Image credit: Danil Aksenov on Unsplash