Some thoughts on the Baltic Startup Funding Report 🇪🇪 🇱🇻 🇱🇹🦄🦄🦄
We are happy to see that next to Atomico’s State of European Tech report and Vendep Capital’s report on Finnish Saas Companies, there is now an up to date report that covers the Baltics — the Baltic Startup Funding Report by Change Ventures. We enjoyed reading the report, and when going through it, came up with some additional ideas we would like to share. In this article, we aim to bring out both the common ground between our experience and the report’s data, as well as some novel aspects we find the report has not yet covered.
As a brief recap, some of the main conclusions of the report were that the number of funding rounds in H1 2020 stagnated, together with a decrease in the round sizes for both pre-seed and seed stages. Looking at our portfolio, we agree that during the few months after the crisis broke out in March, the deal activity became remarkably lower. Nevertheless, the funding levels had a quite rapid recovery, as the deal flow reached a pre-crisis state by September and has moved even further than this by now, at the end of 2020.
Estonian seed round valuations
Another finding of the report was the significant increase in median seed stage valuations, which in Estonia jumped from €7m in H2 2019 to €10.7m in H1 2020. Firstly, the increase well illustrates the overall trend of consistent growth of seed stage valuations in Estonia during the last years. One of the main reasons for that is the spillover effect from unicorn startups producing an increasing amount of high quality Estonian founders, which allows to attract foreign investors already in early phases. Additionally, such founders can often bootstrap the companies for a longer period, resulting in higher-value seed rounds. Also, we believe that the general wage increase in the IT sector arising from talent scarcity plays a role in this trend — higher salary costs lead to bigger burn rate and a potentially higher valuation (more on this logic later, as we discuss the valuation differences for hardware startups).
Despite the above-mentioned context, the €10m+ median for H1 2020 is exceptional, rivalling even the median seed valuations in the US. We guess that this high median figure can be attributed to the number of high-profile high-value seed rounds reported during H1, such as Pactum, Whatifi, Planet42, Dashbird, and Viveo, among others. Complementing this well-known group of attention-grabbers, we have seen from our deal pipeline this year that there is also a sufficient number of very attractive seed round prospects within a more modest valuation range of €5–7m.
Equity vs convertible
Moving on to round structure, the report highlights that 75% of the Baltic seed rounds are formed as equity deals. When we look at our portfolio (mostly Estonia-based), we see that the proportion of convertibles is more or less equal to equity rounds. We speculate that since a convertible note is a slightly more complex investment instrument, the use of it may be more common in Estonia, where the local startup ecosystem is more advanced. Another aspect specific to Estonia is the bureaucracy regarding equity deals’ notary requirements, making the investment process especially burdensome for foreign investors. As Estonian funding rounds might have relatively more foreign investors, we believe this could have led to a larger proportion of the deals in which convertible form was chosen instead. Fortunately, the notary requirements are now relieved, and it remains to be seen whether the move could decrease the popularity of convertibles in the future.
New trend — SAFE
Another aspect we find interesting regarding convertible deals in pre-seed rounds is the rising trend of using SAFE notes, or Simple Agreements for Future Equity. SAFE is an investment instrument developed by Y Combinator in 2013, which differs from convertible note by having no maturity date, nor an interest rate, in order to make the round closing process less time-consuming. There are also variations of SAFE which have no valuation cap (read more in the SAFE Guide), but the standard practice is to include one. Thus, as the investors and founders will basically have to agree on only the valuation cap, the negotiation time and legal fees are greatly reduced. It is important to note, however, that although convertible notes in the Baltics are mainly formed using a pre-money valuation cap, SAFEs employ a post-money cap. The benefit of the latter is that both the founders and investors can more easily calculate their ownership, as opposed to a pre-money cap, with which the dilution can arise on the account of an option pool increase or later investors in the round.
Hardware vs software
One topic the report didn’t address is the business verticals. Perhaps one of the biggest differences in this regard can be drawn between software and hardware enterprises. We would say that it is natural for hardware startups to have, by default, higher valuations. Due to a long R&D process, it takes a longer period for a hardware enterprise to reach its first business objectives — e.g. to close the first sale or to become breakeven. More capital-intensive R&D also increases cash burn, leading to a need for raising bigger rounds. Yet, the dilution of founders’ equity in each such round follows the same logic as for any software enterprise, and therefore the hardware founders would face a quite remarkably higher dilution. In order to prevent such dilution, a greater valuation is justified. To put it briefly — producing meaningful results in a hardware startup is more costly than for a software startup, and it is reflected by the differences in the valuations. In future, we plan to write an additional blogpost on the specifics behind deeptech and science-based startups investments, where the capital-intensiveness is taken one step further.
Moreover, we have noticed that the proportion of hardware deals we have faced this year exceeds the hardware deal flow we have seen in previous years. One of the reasons for it could be that there are now a number of successful examples of hardware startups in Estonia which have managed to establish significant traction — Starship Technologies, Click & Grow, Cleveron and Comodule — to name some of the most prominent ones. Several strong hardware companies in different funding phases have also emerged from the Latvian startup ecosystem — AirBoard and Sonarworks — to name a few.
Another aspect we would add is the view from the angel investors’ side. The graph below shows the distribution of angel ticket sizes in both pre-seed and seed rounds we have taken part of during the previous 2 years, where the average angel investor ticket seems to remain in the range of €15–25k. There also exist several high-profile founders, who now have the capability to invest in sums of €200k and more. Another way for Estonian angel investors to contribute to the startup ecosystem is via EstBAN — an umbrella organisation that aggregates the funds of numerous angel investors (starting from €5k per individual) to form syndicate investments with a minimum ticket size of €20k.
Although most of our comments regarding the report mostly touch upon the Estonian startup scene, we also aimed to capture the general differences in the deal activity compared to Latvia. Based on the publicly collected datasets on funding rounds (for Estonia and for Latvia), we mapped all the pre-seed and seed round sizes during the past 2 years on a timeline:
Besides the fact that Estonian funding activity is generally more active, the chart above reflects that the decline in the number of funding rounds in H1 2020 seemed to be more explicit among Latvian startups. Nevertheless, we see that it is only a matter of time once the ticket sizes and valuations become close to the figures in Estonia. We see great potential in the deal flow that we have faced among Latvian startups, and therefore aim to increase our investment activity in both Latvia and Lithuania in the coming years.