Leading law firm Herbert Smith Freehills advises some of Australia’s most successful tech companies on investment deals, including Atlassian, Mr Yum, Carma, Sonder, Culture Amp, Linktree, Who Gives A Crap, :Different, Pearler and Instant Checkout.
After the dramatic shift in venture capital in 2022 following an exuberant two years during the pandemic, HSF venture capital experts Claire Thompson, Elizabeth Henderson and Adam Ong are “cautiously optimistic” about the year ahead after the record deal volumes and valuations of 2021, and then last year’s apprehensiveness, adding that in general the Australian market has proven resilient with some marked success stories.
Here are the 10 key themes they see playing out over the next 12 months.
1. Raise to the occasion
“With tech valuations down, most companies that didn’t have to raise in 2022 opted to wait. Our recent survey of Australian founders revealed that 76% plan to raise capital in the next 12 months, and we expect to see most founders turning their minds to their next priced round from as early as January 2023,” they said.
2. Playing it SAFE
“We saw a wave of bridging rounds in 2022 for various reasons, including to lengthen cash runways and defer landings on valuations. In some cases, investors also wanted to provide certainty and peace of mind to founders so that they can focus on the business with fewer distractions. We expect this trend to continue through 2023, particularly if tech valuations are slow to recover,” they said.
Companies and investors should be mindful of the complexities of SAFE (a Simple Agreement for Future Equity) and convertible note economics, especially when multiple instruments are ‘stacked’ on each other. They should also avoid unintended down rounds by considering a floor on any discount at the last valuation.
3. Due diligence is the new black
“In 2021 speed to term sheet was a critical competitive advantage. Going forward we expect an enhanced focus on due diligence and a challenging of the assumptions behind forecasting, ensuring a clear path to neutral or positive cash flow,” Thompson, Henderson and Ong said.
“So how can founders set themselves up for success in this environment? Prior planning, organisation and responsiveness are key. Getting your ducks in a row and keeping your information for prospective investors up to date before you need to.
“In the long run we think this will be a positive development and will see a more confident deployment of capital by investors.”
4. Evolving market for secondaries?
“Secondaries have performed an important function in incentivising founders and employees by providing a partial equity liquidity event. However, we did not see as many secondaries in 2022 as previous years, probably due to the uptick in use of SAFEs and convertible notes and the uncertainty on valuations (a secondary really requires agreement on price). We believe the rationale and motivation for these secondaries will continue, notwithstanding it may not have taken the same pride of place in 2022 as in 2021,” they said.
“Also, with some companies contemplating a longer pathway to IPO or other exit, secondaries may increasingly be looked at by investors as a mechanism for liquidity.
“The recent close of Second Quarter Venture’s $83m fund focussed on secondaries provides a strong signal that secondaries will continue for solid companies.”
5. Exit stage left?
“With a changing cost of capital, we expect to see some founders and boards review exit and liquidity strategies and any opportunities for sales and consolidations that may emerge,” they said.
“These kinds of discussions should take place recognising that different stakeholders may have different drivers and in any exit while a company is still in a growth phase, the founders remain critical to the go-forward business.”
6. Market for talent
“Downsizing by Big Tech in 2022 has talent on the move and may even see some expats returning home. This will present an opportunity for well-funded home-grown businesses who’ve found it harder in the competition for talent. It also has the potential to spawn a raft of new start-ups as people consider starting a business of their own.”
7. Employee incentives
“With a focus on cash burn, start-ups will increasingly look to employee equity to reward and motivate staff. In Australia, regulatory changes in 2022 have sharpened the focus of founders, start-ups and their boards on the disclosure rules for offering employee equity. The nature of the new reforms may increase the adoption of zero exercise priced options (ZEPOs), rather than options with an exercise price equal to the market value,” Thompson, Henderson and Ong said.
“In a market where valuations are difficult to determine, ZEPOs provide more comfort to employees that they will derive some value from the options, even if this may come at the expense of accessing the startup ESOP tax concessions.
“Companies wanting to rely on the startup ESOP tax concessions, or that want to offer employee equity structures that only reward increases above the current market price, will likely need to take the more regulated pathways which require robust offer documentation.”
8. PE Funds reaching earlier into the business life cycle
“Venture capital has been the stand-out performer of the alternative asset classes in APAC over the past five years and is forecast to continue to lead the pack in APAC for the next five. Coupled with being a gateway into tech, it’s no wonder Private Equity funds have been looking earlier into the business life cycle for opportunities and return. We expect to see this interest translate into more announced deals, with the first already coming out of the blocks.”
9. Circle of life
“As the first generation of Australian unicorns consolidate their growth and global reach, we expect them to contribute back to the ecosystem that gave them their first opportunities way back when,” they said.
“Founders and family offices of Australian success stories like Atlassian, Canva, Culture Amp, Safety Culture, Linktree and Mr Yum are strongly supportive of the Australian ecosystem, and we believe many founders will continue to back local start-ups, including through initiatives like Sidestage Ventures and The Fund.”
10. Green shoots emerge
“Amidst the negative press, don’t miss the bright lights — there is reason for founders to be optimistic in 2023,” they said.
“The last three quarters of 2022 saw some stand-out raises including Sonder, Vexev, Greener, Gamurs, Reejig, 6Clicks, Great Wrap and Rentbetter, and announced equity capital raised for April to October 2022 is not substantially below the same period in 2020.
“And there is no shortage of dry powder — this year we’ve seen record fundraises by leading Australian VC Funds including Square Peg, OIF Ventures and Blackbird, and we expect to see more from these players in 2023.”
More on the Herbert Smith Freehills Australian VC team of more than 25 legal experts works, plus the firm’s recent founder survey, is available here.
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