Leading law firm Herbert Smith Freehills advises some of Australia’s most successful technology companies on investment deals, including Atlassian, Mr Yum, Carma, Sonder, Culture Amp, Linktree, Who Gives A Crap, :Different, Pearler and Instant Checkout.
Following the dramatic shift in venture capital in 2022 after an exuberant two years during the pandemic, HSF venture capital experts Claire Thompson, Elizabeth Henderson and Adam Ong “cautiously optimistic” about the year ahead after the record volumes and valuations from 2021, and then last year’s anxiety, adding that the Australian market has proven resilient overall with some clear success stories.
Here are the 10 key themes they see playing out over the next 12 months.
1. Go to the opportunity
“With technical valuations down, most of the companies that didn’t need to raise in 2022 chose to wait. Our recent survey of Australian founders found that 76% plan to raise capital in the next 12 months, and we expect most founders to be turning their minds to their next round of awards as early as January 2023,” they said.
2. Play SAFE
“We saw a wave of bridging rounds in 2022 for a variety of reasons, including to extend cash runways and delay landings on valuations. In some cases, investors also wanted to provide security and peace of mind to founders so they can focus on the business with fewer distractions. We expect this trend to continue through 2023, especially as technology valuations slowly recover,” they said.
Companies and investors need to consider the complexities of SAFE (a Simple Agreement for Future Equity) and the economics of convertible bonds, especially when multiple instruments are “stacked” on top of each other. They should also avoid unintended downward rounds by considering a lower bound for any discounts at the final valuation.
3. Due diligence is the new black
“In 2021, speed to termsheet was a critical competitive advantage. Going forward, we expect an increased focus on due diligence and a challenge to the assumptions behind forecasting, ensuring a clear path to neutral or positive cash flow,” said Thompson, Henderson and Ong.
“So how can founders set themselves up for success in this environment? Advance planning, organization and responsiveness are key. Line up your ducks and keep your information up-to-date for potential investors before it’s needed.
“Long term, we believe this will be a positive development and will see a more confident deployment of capital by investors.”
4. Evolving secondary labor market?
“Secondaries have served an important role in encouraging founders and employees by providing a partial liquidity event. However, we have not seen as many secondary bonds in 2022 as in previous years, probably due to the increasing use of SAFEs and convertibles and uncertainty about valuations (a secondary bond really needs to be agreed on price). We believe the rationale and motivation for these secondaries will continue, even though it may not have held the same prominence in 2022 as it did in 2021,” they said.
“And as some companies consider a longer path to an IPO or other exit, secondary stocks may increasingly be viewed by investors as a mechanism for liquidity.
“The recent close of Second Quarter Venture’s $83 million fund focused on secondaries sends a strong signal that secondaries will pass as solid companies.”
5. Left podium?
“With changing costs of capital, we expect some founders and boards of directors to review exit and liquidity strategies and any sales and consolidation opportunities that may arise,” they said.
“Discussions like this should take place with the understanding that different stakeholders may have different drivers and with any exit while a company is still in a growth phase, the founders remain critical to the future.”
6. Market for talent
“Downsizing by Big Tech in 2022 has talent moving and may even see some expats returning home. This presents an opportunity for well-funded homegrown companies that have found it more difficult in the war for talent. It also has the potential to spawn a slew of new start-ups as people consider starting their own business.”
7. Employee incentives
“With a focus on cash burn, start-ups will increasingly look to employee equity to reward and motivate staff. In Australia, the 2022 regulatory changes have sharpened the focus of founders, start-ups and their boards on the disclosure rules for offering equity to employees. The nature of the new reforms may increase adoption of zero strike price options (ZEPOs) over options with a strike price equal to market value,” said Thompson, Henderson and Ong.
“In a market where valuations are hard to determine, ZEPOs provide greater comfort to employees that they will get some value from the options, even at the cost of access to the ESOP startup tax benefits.
“Companies that want to rely on the ESOP startup tax breaks, or that want to offer employee capital structures that only reward increases above the current market price, will likely need to follow the more regulated pathways that require robust offering documentation.”
8. PE funds reach earlier in the business lifecycle
Venture capital has been the standout among the alternative asset classes in APAC for the past five years and is expected to continue to lead APAC for the next five years.. Coupled with being a gateway to technology, it’s no wonder Private Equity funds have looked at opportunities and returns earlier in the business lifecycle. We expect this interest to translate into more announced deals, the first of which are 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 long ago,” they said.
“Founders and family offices of Australian success stories such as Atlassian, Canva, Culture Amp, Safety Culture, Linktree and Mr Yum are strong supporters of the Australian ecosystem, and we believe many founders will continue to support local start-ups, including through initiatives like Sidestage Ventures and the fund.”
10. Green shoots emerge
“Despite 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 a number of notable increases, including Sonder, Vexev, Greener, Gamurs, Reejig, 6Clicks, Great Wrap and Rentbetter, and the announced equity 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 have seen a record amount of fundraising from leading Australian VC funds, including Square Peg, OIF Ventures and Blackbird, and we expect to see more from these players in 2023.”
More about the Herbert Smith Freehills Australia’s VC team of over 25 legal experts work, plus the company’s recent founding research available here.
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