The year 2021 was record-breaking for Venture Capital (VC). U.S VC funding into startups increased 98% to $330B in 2021 - from $167B in 2020. This is the largest one-year funding increase since at least 2006. The following article will provide AIN's critique of this record-breaking year and our predictions for 2022.
The record-breaking increase in venture funding occurred for several reasons. We believe the three most important reasons are i) low-interest rates, ii) a persistent COVID environment continuing the 2020 theme of increasing digital adoption, and iii) a large amount of "dry powder" in the venture ecosystem that needed to get deployed (we attribute this dry powder to the compounding effect of many years of low-interest rates).
We also note that a technological paradigm shift is occurring, rooted in rapidly decreasing computing power costs, increasing connectivity at faster speeds, and material science advancements.
Both deal count and deal value experienced record-breaking years. Similar to 2020, mega-deals (companies that raised greater than $100M in funding) drove the increase in deal value. However, unlike in 2020, there was also an increase in deal count across all levels of venture -- from the pre-seed/seed stage, where AIN invests, to the growth stage, where VCs typically write checks greater than $25M.
The following chart illustrates how much mega deals influence the broader VC market, particularly when it comes to accumulated deal value. In addition, mega deals account for 58% of all capital deployed.
AIN Opinion: The increase in deal value combined with mega-deal activity illustrates the influence of low-interest rates over time. There is an inverse correlation between interest rates and VC investment activity, as investors seek yield in a low-interest-rate environment. Further, historically low-interest rates for several years mean that VC funds have raised record funding and need to deploy this capital. AIN believes that 2021 was effectively a "supercycle" year. The combination of low interest rates and a great deal of dry powder resulted in the largest amount of VC funding ever.
At AIN's stage of pre-seed/seed investing, deal value and deal count both experienced record increases in 2021. The pre-seed and seed market did not
increase at the pace of the broader VC
market. However, growth was strong, with deal value increasing 53.1% and deal count increasing 12.8%. The fact that deal value increased so significantly illuminates that deal sizes at the earliest stages are increasing significantly; as the saying goes, "Seed is the new Series A."
AIN Opinion: The relatively small increase in deal counts illuminates that factors driving the overall rise in venture funding are not filtering down into the earliest stages. We have already addressed how low-interest rates are a catalyst to this asset class. Later, we will dig into how these low-interest rates drive new entrants. These include Corporate VCs and asset managers from other asset classes seeking yield that only venture capital can uniquely provide. These new market entrants have not yet displayed an appetite for the earliest financing rounds (pre-seed/seed). Separately, the driving force behind the increase in deals is mainly due to the increase in dry powder for the funds currently in the early-stage investment space. To be clear, traditional seed-stage funds have raised more capital; this is not a situation where new entrants who have never invested in VC are now investing at this stage.
Additionally, previous seed-stage players that now invest more in Series A, B, C, and growth rounds, are unwilling to cede ground at the seed stage, and they have raised funds that are relatively large for the seed stage. An example is Greylock raising a $500M seed-stage fund. The combination of a large amount of dry powder plus the desire to have significant ownership upon the initial check into a company is causing the increase in deal size. The median pre-money valuation for seed-stage deals is now $9.5M. Some of the most competitive deals have a pre-money of almost $20M. These valuations represent a greater than 35% increase over 2020. When exiting from a VC investment, the most critical factor is percentage ownership upon exit. Therefore, VCs work to establish the largest percentage of ownership possible. This factor creates a self-reinforcing cycle where increased fund sizes and the desire for maximum ownership drive up deal prices.
Impact of New Entrants on VC Asset Class
This phenomenon began years ago but has increased significantly in recent years. Corporate Venture Capital (CVC) and large asset managers are increasingly investing in the venture asset class. For CVCs, the phenomenon of "M&A being the new R&D" has been around for quite some time, and their venture investment arms are essentially an extension of this concept.
Large asset managers, such as SoftBank and Tiger Global, have also entered the VC market at a torrid pace in recent years. Combined, we call these CVCs and large asset managers "non-traditional V.C. investors," and in the chart below, you can see the degree to which their investment activity has impacted the VC market. These non-traditional investors accounted for 77% of all capital invested and 38% of all deals in 2021. The delta between capital invested and deals participated in reinforces our earlier point that these non-traditional investors are mainly investing in larger-to-mega deals.
AIN Opinion: Low-interest rates heavily influence non-traditional investment activity. With regard to CVCs, a low-interest-rate environment fuels increased earnings and enables more money for reinvestment. Additionally, CVCs want to ward off disruption by upstart companies with innovative technologies by taking a stake in them when the companies are relatively early in their development. CVC VC investment activity is essentially a survival tool. The large asset managers' search for yield in a low-interest-rate environment causes them to move into the venture asset class. Additionally, large asset managers realize that a technological paradigm shift is occurring, creating entirely new markets. These asset managers are trying to invest in a crop of new industry leaders that will lead us through the halfway mark of the 21st century.
VC Exit Activity was robust in 2021
Money raised both for companies and funds is all well and good, but the essential thing in any asset class is the return on investment. Again, 2021 broke all records, including exit activity. Total exit activity was almost $800B, representing a 168% increase over 2020. Bottom line - the VC asset class is earning a return on its investment.
Exits have been in the form of M&A, IPOs, and Special Purpose Acquisition Corporations (SPAC) - which is another method to go public. Exit value was not driven by a small set of deals; exit count was also up dramatically.
AIN Opinion: Exit value and exit count heavily depend on market conditions, which were outstanding in 2021. Even if market conditions deteriorate in 2022, the money taken off the table in 2021 will likely be reinvested into venture capital. This activity has the aforementioned secondary effects of increasing money in the asset class and therefore deal sizes. In addition, there is a tried and true tradition where entrepreneurs who make money in these exits insert their capital into very early-stage companies. Therefore, we expect to see deal counts at the earliest stages increase in the coming years as these entrepreneurs reinvest their capital.
Record-Breaking VC Fundraising Activity
In 2021, VCs raised a record amount of funding, with VC funds raising north of $100B for the first time - a 48% increase over 2020. Low-interest rates combined with the VC asset class outperforming all other private and public market equivalents drive the ability to raise capital. To be clear, the VC asset class, particularly at the early stages, is the world's number one performing asset class.
AIN Opinion: At AIN, we believe that we are experiencing a technological paradigm shift, with new technologies transforming existing markets and creating new ones. The increase in investment exits and the performance of the VC asset class over time relative to other asset classes reinforce the effects of this technological shift. We believe that this technological shift has only just begun. At AIN, we are deep technology investors. While a great deal of recent advancements has occurred in software, we believe that software advancements will increasingly bleed over into the world of hardware. There has been a revolution in the "world of bits and bytes," and the revolution is only beginning in the "world of atoms." These worlds work together to increase computing power that enables rapid prototyping to a degree that the world has never experienced. The record amount of funding that has been raised (including the money AIN has raised) means that there is plenty of capital to continue to drive these changes far into the future (greater than 15 years).
Geographical Distribution of Investment Activity
Deal Activity throughout the United States continues to spread, although the traditional VC ecosystems continue to dominate. The top four metro areas, the Bay Area, New York City, Los Angeles, and Boston, continue to dominate the VC landscape. These four areas accounted for 55% of deal volume and 74% of deal value. Despite apocalyptic press reports, the Bay Area continues its significant lead over other regions in the U.S., experiencing significant deal count and deal value growth. The year 2021 was the first time the Bay Area experienced more than 3,000 deals, and the region blew past that previous barrier by 15% to reach 3,445 deals. One new, notable standout on both levels was Miami. This metro area saw a tremendous increase in both deal count and deal value. However, we must highlight that the law of small numbers is at play here, with Miami accounting for less than 2.0% of all deals completed in the U.S. and 1.2% of all deal value. L.A., NYC, and Philadelphia all had standout years when it comes to deal count. In the case of L.A. and NYC, their performance is remarkable given the size of those markets.
We must note that 2021 was only the second year one non-top four ecosystems surpassed 400 deals. The 400 deal count mark has been difficult for non-traditional ecosystems to overcome. The first to do so was Seattle. In 2021, Seattle, Philadelphia, and Washington DC all crossed that amount, and Austin, Denver, and Chicago came extremely close. Deal counts over 400 within these non-traditional ecosystems will indicate the health of the VC ecosystems outside the coasts.
AIN Opinion: The often spoken about case of the demise of California, particularly the Bay Area, is wildly overblown. A strong VC ecosystem consists of: a mix of top-tier universities, talented people, a spirit of freedom, innovation, and the ability to fail and yet try again, plus military technologies and government non-dilutive funding. While the pandemic has proven that the Bay Area, NYC, and Boston have restrictive governments relative to other areas of the U.S., we believe that the success of these areas is rooted in their top-tier universities (particularly in STEM fields), a robust network of talent that have experienced success at previous startups, and strong federal government support in the form of non-dilutive funding. These critical factors are not ending anytime soon. We have seen the local ecosystems in these areas double down on their strengths. Therefore, we believe that these ecosystems will continue to thrive for years to come.
In 2021, we conducted a study of patterns in dual-use technology and discovered that California accounts for half of all dual-use technology companies that have successfully raised more than $5M in the last 20 years. We expect that trend to continue. Further, sources of national security innovation funding such as the Defense Innovation Unit and In-Q-Tel continue to maintain strong outposts in California. That said, it is clear that Silicon Valley-style innovation is clearly spreading throughout the U.S., and this is a net positive. We look forward to sourcing deals in locales throughout the U.S.
AIN Vision for 2022
We are excited about what 2022 will bring. A confluence of factors makes 2022 an excellent year for a fund at our stage. The same cannot be said for funds at other stages. One of the fundamental changes in 2022 will be increased interest rates combined with tighter monetary policy. These changes are already being felt with the volatility in the public markets in January 2022. We believe that secondary effects will include the VC market being less attractive to market participants than other asset classes. This is especially true for new entrants and larger entrants (those who invest in mega-deals above $100M). The volatility in the public markets will mean that exits will not be as lucrative as in 2021, and the threshold to go public will be more stringent. This shift will filter down into the early stages of VC. Later-stage investors will be more sensitive about the valuations they place on companies if they do not believe these companies will exit via the public markets at a high valuation. Additionally, higher interest rates will hurt earnings. Public market volatility will negatively affect the market cap of M&A acquirers, meaning these potential acquirers may have less cash to pay for acquisition targets.
As you can see, 2022 will be tough on late-stage investors, which will eventually filter down into the early stage. This is good for AIN because valuations will eventually drop for the early-stage companies we invest in - which is great as a new fund. However, this will be limited because there has been a great deal of money raised in recent years. While AIN will benefit from decreased valuations, we will not receive the full benefit because so many funds have been raised, and need to invest that money. The sheer amount of cash will increase valuations.
Nonetheless, the equilibrium will result in deal valuations less than where they are today. The favorable factors that underpin early-stage technology investing are all still in place, but there is a more favorable macroeconomic environment for investors seeking returns. Technology will continue its march toward positively changing how we live, communicate, play, work, and even fight as a nation. Investors will continue to back companies at the bleeding edge of this shift. We are excited to find the best-in-breed that will lead this change.
In the coming year, we will publish more data-informed research on our investment focus areas (Space, Sustainability, Health, Disaster, Civic, and Defense Tech, as well as Veterans). Please feel free to reach out with any questions or comments about our analysis and predictions.