A Look at the First Half of 2020:
Early Venture Activity is Down, but Remains Active
Co-Founder and Investment Board Member at DataTribe, LLC, Mike Janke
In March, DataTribe conducted an analysis of early stage venture capital investments over the preceding decade and offered some insights into how early venture investing may be affected by COVID-19, just as state and local jurisdictions were beginning to implement stay-at-home orders. Deal volume was trending down before the pandemic, and we expected the onset of a global pandemic to add additional pressure. We also expected cyber to be a bright spot in the new environment. Through the first half of 2020, deal volume is down, but there are bright spots emerging.
Early 2019 marks the beginning of a downward trend in early venture1 deal activity. Q1 and Q2 of 2020 extend the prior year’s decline, though we attribute some of the decline to pre-coronavirus catalysts: the impeachment, geopolitical concerns, and natural business cycles after historically high investment levels in 2017 and 2018. Venture deals are a lagging indicator of investor sentiment – discovery and due diligence occur months before closing, so many of the early 2020 investments are likely the output of a process that started in Q3-Q4 2019, when people were still traveling to meet and shake hands. There are other external factors contributing to the decline in activity over the last year: the pending presidential election, geopolitical concerns, shifting monetary policy, unsustainably high investment levels, etc. The pandemic is an additional variable in the current cycle bringing heightened economic uncertainty and entrenched behavioral changes as the pandemic persists.
In reviewing deal activity through June 30th, 2020, the Q2 close marks the largest year-over-year deal volume decline since 2002, with U.S. Early Stage investment across all verticals, Technology2, and Cybersecurity down 19.2%, 45.8%, and 37.7%, respectively. Other verticals relevant to the pandemic, including E-commerce and Digital Health, are also down by historic margins (29.4% and 22.9%, respectively). This is neither unexpected nor irrational. Millions of Americans were losing their jobs and face-to-face meetings, a cornerstone of early venture due diligence, came to a screeching halt. In the early days of the pandemic, investors hit pause on new opportunities to instead focus on shoring up existing portfolio companies while waiting for some stability to return to the business environment.
Today, with the pandemic impacting all aspects of business, waiting for things to return to “normal” is no longer viable. Early venture investors, seed in particular, need to figure out how to find, evaluate, and execute deals in the COVID world, one where co-location and business travel is the exception rather than the rule. We anticipate that early stage venture investors will shift the face-to-face meeting(s) later in the due diligence process. As well, we’ll likely see an increase in the number of pre-deal meetings – as many as necessary to build the trust and rapport required of a long-term business relationship. However, we do not expect a shift to localization – this is a good time to invest and investors are willing to expand their geography for the right opportunity. Furthermore, founder track record and references from trusted sources were always part of the process – they are simply more important today. Regardless of how deals are done, it will take time for investors to figure out – extending the downward pressure on deal activity through the remainder of the year.
New early stage cyber deals are down, but cyber continues to gain as a percentage of the early stage Technology, Media, and Telecom investing landscape. By the end of the second quarter, cybersecurity deals reached a historic high of 14.9% of technology deals (by deal volume). Continued growth of digital technology adoption, perpetual offensive cyber operations by nation states, and a newly distributed workforce all contribute to the growing demand for cybersecurity technology.
At DataTribe, we have seen strong deal flow in the first half of 2020, up 5% YoY, and sales performance among our cybersecurity portfolio companies is on track to exceed their pre-COVID sales targets. This is remarkable, especially when considering the historical context of previous recessions. So, why is cybersecurity performing well right now?
When the whole world was told to stay home, most of their attention and resources shifted from brick and mortar to digital (e-commerce, telemedicine, grocery delivery, etc.), accelerating a transition that otherwise could take years. According to the U.S. Census Bureau, e-commerce as a share of U.S. retail grew an average of 3.0%3 in 2019. Expect a spike in both this figure and the overall volume of e-commerce when the 2nd Quarter report is released later this summer. The speed of the transition is the cause for disruption, and it bodes well for the digital economy, particularly essential digital solutions found in cybersecurity.
One of the main reasons that DataTribe companies are faring so well during the pandemic is the focus on “over-the-horizon” technologies coming out of the Intelligence Community. These are the technologies that define new categories. Because DataTribe plays mainly in that thematic area, it is not investing in “me too” or highly competitive spaces that are either over-invested or simply incremental improvements in existing technology. In a crowded market, investors often “buy growth” via heavy investment in sales and marketing. During an economic down-turn, investor appetite for such strategies contracts. The money that purchased growth via large investment in marketing and sales is no longer available. Startup fundamentals and technical merit, particularly over-the-horizon capabilities, become the differentiators for success.
It is not all bad news in the first half of 2020. Early venture deal volume is down across the board, but interest in cybersecurity is growing. Investors are waiting for some economic stability and adjusting to the new environment. In addition to the ongoing macroeconomic headwinds created by the pandemic, we anticipate additional uncertainty in the second half of 2020 due to the U.S. presidential election. However, venture remains attractive to investors. “Through the first half of the year, US VCs closed 148 funds totaling more than $42.7 billion, which has already surpassed the full-year total for every year of the decade except 2016, 2018, and 2019,” according to the National Venture Capital Association (NVCA)4. We expect cybersecurity to remain robust as the adoption of digital technologies accelerates.
1PitchBook U.S. deal activity in all verticals and cybersecurity for Early Stage Venture Seed & Series A
2Technology, Media, and Telecom (TMT) vertical
3U.S. Census Bureau: Quarterly Retail E-commerce Sales 1st Quarter 2020