Today we announced the closing of Flare Capital’s third fund with a total of $350 million of committed capital. Typically, when our portfolio companies raise their Series C rounds, they have established product / market fit which feels quite relevant to us now. The narrative around the transformation of the business of healthcare being a source for new company creation is profoundly compelling, even more so in light of the pandemic.
This fund is quite a bit larger than our prior fund and was well-above the initial target. We are quite pleased by the reception from both our existing and new investors, which reflects a high level of interest in this extraordinary market opportunity. Industry dynamics today demand innovative business models and novel technologies that will leverage advanced analytics and mobility to enable value-based healthcare. The overarching pressures for better outcomes at lower costs will create important and valuable new companies.
An important dimension to our story, and that we believe is an asset for our entrepreneurs, is the composition of our investor base. A significant amount of the capital is provided by strategic investors representing leading provider systems, national and regional payors, healthcare retailers, device companies, lab operators, and pharma companies. Our portfolio companies have sold several hundred million dollars of products and services to these investors. The majority of the capital comes from sophisticated endowments, family offices, sovereign wealth funds, and other financial institutions, many of which have been active co-investors in our portfolio companies. The diversity of our limited partners underscores the broad appeal of the sector and the potential to build significant new companies.
When we started the firm in 2014, over $4.5 billion was invested in healthcare technology companies; in 2019, when we raised our prior fund, $8.1 billion was invested. Arguably, in part due to the pandemic exposing such significant issues, nearly $29.1 billion was invested in the sector in 2021. Notwithstanding that the 1Q22 amount of $6.0 billion suggests a more moderate investment pace for 2022, this year will also see an extraordinary level of activity, likely to be ~60% greater than 2020, which was the second strongest year for digital health investing. A decade ago, healthcare technology was less than 5% of all venture capital activity; now it is trending to be ~10% of all venture investments.
And the adoption of healthcare technology solutions is accelerating. Many companies launched over the last five to ten years can now point to measurable impact on outcomes and costs. Companies more often than not are able to claim real attribution for the successes of their products and services; that is, they are able to calculate an ROI with actual data. Robust and scalable business models exist and are now better understood (product development timelines, successful “go-to-market” strategies, revenue models, etc). The sector is reaching an important threshold level of maturity.
While this is an important milestone for Flare Capital, we will continue to be heads down assisting our entrepreneur partners to build important and valuable healthcare technology companies. Even in light of recent public stock volatility and troubling geopolitical issues, the next few years promise to be terrific vintage years for healthcare technology investors. We are excited to play a small role in this sector’s future successes.
It is quite easy to see that general economic conditions are deteriorating; it is considerably harder to know what to do given the many confounding signals. The employment data are nothing short of extraordinary. Over 431k jobs were added last month alone, driving the unemployment rate to 3.6% – essentially returning to pre-pandemic levels with last week registering the lowest weekly unemployment claims in the last 54 years. Wages increased 5.6% year-over-year through March, which while tracking below the scourge of inflation, was certainly a robust pace. Annual corporate profit growth in 2021 increased 35% according to Barron’s. An early April survey of 72 leading economists by Bloomberg concluded that the U.S. economy will expand 3.3% in 2022, 2.2% in 2023 and 2.0% in 2024, respectively.
And yet nearly every asset class was down significantly in 1Q22, other than Commodities which increased on average over 25% in the quarter according to Bloomberg data, with the S&P Energy Index up 37.7%. The S&P 500 and NASDAQ indices were down 4.6% and 9.1%, respectively, while U.S. government bonds lost 5.6%, again in the face of rising inflation. Most acutely, the SVB Leerink Digital Health index was down 76% since its February 2021 high. The S&P Biotech index lost nearly 48% over a similar time frame, erasing the gains achieved since the start of the pandemic. Most ominously, with the Federal Reserve signaling that it will raise rates more aggressively, the yield curve inverted last week with short-term rates greater than long-term rates; such an inversion has predicted five of the last six recessions. Of the economists surveyed by Bloomberg (above), the consensus was a 27.5% chance of a recession in the next 12 months.
Data: FactSet; Chart: Baidi Wang/Axios
In the face of an aggressive tightening monetary policy (to say nothing of a heart-wrenching war in Ukraine), interesting signals of investor sentiment are already revealing themselves in 1Q22 venture funding data. Pitchbook and the National Venture Capital Association just released a flash review of 1Q22 which showed overall U.S. venture investment activity was $70.7 billion, which is the lowest quarterly level since 4Q20. As a point of comparison, investment activity for all of 2021 was $330 billion. Notably, prior to 2013 there had never been a full year that even came close to $70 billion so the pace is still relatively strong but a marked deceleration from recent activity (4Q21 was $88.2 billion). Notwithstanding that slowdown, there were still more than 100 “mega rounds” (greater than $100 million) and little evidence that the corporate venture investment pace pulled back, which one might have expected in the face of market volatility.
Global venture investment activity also has slowed dramatically, dropping 19% from 4Q21 levels to $143.9 billion (8,835 deals), according to CB Insights data. Somewhat confounding, the number of unicorns globally reached another high with 1,070, supported by over 350 “mega rounds” which accounted for 51% of the quarterly investment activity. While there may be signs of nervousness at the earliest stages of investing, it does appear that VCs are fortifying the emerging winners with significant rounds of financing.
The canary in the coal mine this past quarter was the activity in the broader equity capital markets. Overall issuance in 1Q22 was $32.5 billion which was the lowest quarterly level since 1Q09. This past quarter declined nearly 90% year-over-year, led by a stark decline in IPO activity which registered a mere $2.1 billion (a decline of 95% year-over-year). Only 18 companies managed to go public in 1Q22. Furthermore, the Renaissance IPO Index traded down 23.9% in 1Q22.
Special Purpose Acquisition Company (“SPAC”) activity was particularly dismal. Of the approximately 725 active SPACs, only 12 announced an acquisition in 1Q22 with another 17 having completed a pending acquisition. After an extraordinary 2021 when 613 SPACs were created, greater SEC scrutiny and poor post de-SPAC trading (once the acquisition has closed) have greatly reduced the attractiveness of this financing alternative. CB Insights reports that the median SPAC deal size was cut in half in 1Q22. The SVB Leerink Digital Health SPAC index (only 14 companies) is off 48.9% since “de-SPACing” through 1Q22. Many of the cross-over investors (hedge funds, mutual funds, etc.) dance between late-stage private rounds and public companies now trading at dramatically reduced valuations.
Notwithstanding the profound trends powering the healthcare technology sector such as the need to reduce costs, improve clinical outcomes, and engage/activate the patient/member/consumer, this sector was not insulated from the 1Q22 volatility. The SVB Leerink Digital Health Index shed nearly $88 billion of market value as forward 12-month revenue multiples reset from February 2021 highs of 15.6x to 5.0x.
Quite clearly, the investment pace in 2021 of $29.1 billion across 736 healthcare technology companies was a high-water mark, likely not to be eclipsed. According to a recent Rock Health report, the level of investment in this sector in 1Q22 was $6.0 billion across 183 companies, suggesting an annual pace equivalent to the number of companies but likely a ~20% reduction in the dollars invested when compared to 2021. Average round size in 1Q22 was $32.8 million which also was a marked decline from the $39.5 million for all of 2021. In 4Q21, $7.3 billion was invested so the quarterly pace is moderating. Also worth watching is the monthly investment activity: January, February, and March saw $3.0 billion, $1.4 billion, and $1.6 billion invested, respectively, perhaps suggesting an even more modest pace for the remainder of 2022.
None of this should suggest the sector is “unhealthy.” Quite the contrary: 1Q22 investment pace matched the activity for all of 2017 and rivaled the annual pace for both 2018 and 2019. The pandemic, as tragic as it has been for so many, is a massive accelerant for technology adoption across every corner of the healthcare system. Arguably, the public healthcare technology stocks have been uniquely exposed to investor uncertainty surrounding surges of the Covid variants and the concomitant uncertain impact on medical costs, particularly for many of the value-based care companies. Overall, the SVB Leerink Digital Health Index is trading at 4.2x and 20.2x 2022 revenues and EBITDA, respectively, with an aggregate market capitalization of $206.2 billion at the end of 1Q22. The pure-play digital health cohort within that basket of companies trades at 6.8x and 26.4x 2022 revenues and EBITDA, respectively. Still very healthy.
Today’s entrepreneurs are launching and scaling companies that will be talked about for years, likely decades. Notably, the list below (not complete) provides a sampling of the healthcare technology unicorns, many of which were started within the past half dozen years. The ability to generate compelling venture returns is, in part, due to the ability to build big companies. Given the massive size of the healthcare markets, it certainly suggests that there will be many more companies added to this roster.
Due to the essential nature of healthcare, the sector has proven itself somewhat recession-proof. Obviously, early-stage companies are exposed to the risk appetite of institutional investors and given the relative capital intensity of these business models, entrepreneurs need to be especially cautious navigating this volatility.
Investor sentiment has clearly shifted from growth at all costs to proving that profitable unit economics, much less overall profitability, are readily achievable. One might expect to see later-stage rounds creep up in size as “emerging winners” take on a more defensive posture to ensure cash runways that can carry these companies through 2023. There may well be fewer and smaller early-stage rounds as investors react to the sheer number of companies that have been launched over the last few years (competitive landscape and lack of differentiation concerns) and the deterioration of the public market valuation metrics. According to Rock Health, Series D and later rounds were $130 million in size on average. In comparison, Series A, B, and C rounds were $19 million, $36 million, and $81 million, respectively, suggesting highly successful digital health companies require ~$250+/- million of invested capital.
As venture capital partnerships huddle to assess 1Q22 portfolio company performance, where they land on state of the markets will inform whether they assume a more defensive or offensive posture. In either scenario, entrepreneurs will be well-served to be manically focused on knocking down value-creating milestones. In this environment, that list may need to be shortened to fewer milestones over the next handful of quarters until the situation becomes clearer. Like any good boxer, entrepreneurs will need to “bob and weave” carefully through this volatility.
By literally any measure the healthcare technology sector had an exceptional 2021. According to Rock Health, $29.1 billion was invested in 729 companies with an average round size of $39.9 million – all were highwater marks for the sector. There were 88 “mega rounds” (greater than $100 million) which further underscores both the attractiveness of the sector to investors and that we are in an “Anoint the Winner” phase for this category. Globally, StartUp Health identified $44 billion of investment in 990 companies.
The debate now turns toward what 2022 will look like as entrepreneurs and investors attempt to assess the impact of a rapidly deteriorating geopolitical environment and a less accommodating financing climate. The answer to this question directly informs how companies should think about growth and relevant milestones. Was 2021 an aberration or can we expect continued robust support for healthcare technology companies?
Arguably, the one of the more conservative approaches to determine how much will be invested in 2022 would be to simply look at the trailing five-year average for number of deals and average round size, and then assume that the sector immediately reverts to the mean. Such a simplistic approach would conclude that 2022 would look much more in line with pre-pandemic investment levels of $10 – $12 billion; that is, for the digital health sector, there would be just over 100 Series A financings that raise ~$12.5 million each, nearly 80 Series B rounds with an average round size of ~$30 million, etc. A trailing 10-year “look back” would suggest annual levels nearly half as much given far fewer companies and considerably smaller round sizes.
But that is not what is going to happen. Healthcare technology venture investing is now nearly 10% of all venture capital investments, up from 3-5% ten years ago. The pandemic has been a massive accelerant for technology adoption in healthcare. The strategic urgency to re-architect the healthcare system is palpable: the next two years will define the industry’s agenda for the next five years, and the next five years will define the next twenty years.
Therefore, another approach to determine what may unfold this year is to look at the companies which raised capital over the last two years and assume a “graduation rate” (that is, raise a subsequent round) consistent with the last five years (~80% of Series A companies go on to raise a Series B, ~50% of those raise a Series C, etc.) but that round sizes moderate to pre-pandemic 2019 levels but assume a consistent percentage of “mega rounds.” While 57% of the capital invested last year was in “mega rounds,” they only accounted 12% of the financings. The average size of a “mega round” was $190 million. Under these assumptions, the overall activity in 2022 could be $21 – $23 billion.
Simply annualizing preliminary year-to-date investment activity through February puts the sector on pace for $22.8 billion invested in 630 companies, perhaps due to later stage crossover investors moderating their activity.
Of course, the level of investment could be quite a bit lower should the capital markets really freeze up. One might expect to see the introduction of more onerous investment terms (increased liquidation multiples, seniority) before there is a dramatic reduction of the stated valuations. Additionally, there may simply be fewer companies financed: last year there were 729 financings in this sector, yet the five-year trailing pre-pandemic average was 400 companies. Should any of these companies stumble, expect to see a marked increase in private-to-private M&A activity. In 2021, there was on average 23 M&A transactions per month in the digital health sector according to Rock Health. Solomon Partners tallied 326 M&A transactions with an aggregate disclosed value of $152 billion inclusive of public companies. Of course, there are no shortage of companies from which to pick.
Notwithstanding all the exciting private market activity, the story is quite a bit different in the public markets, which have frowned on the healthcare technology sector these past few months. The “Anoint the Winner” phase may quickly fade into the “Prove It” phase as well-capitalized and recently public companies struggle to become cashflow positive. Investor sentiment seems to have moved from “growth at all costs” to telling a “path to profitability” story.
The public equity markets have discerned a significant difference between companies that sell technology solutions to pharma and providers, which performed relatively well in 2021, from companies focused on employers and payors. Value-based care and technology-enabled companies also struggled mightily in 2021, perhaps due to having had such a strong 2020 but also analysts have expressed concerns about the capital intensity of these models, ability to manage risk, and when these companies become profitable.
The news was even more challenged for the class of 2021 healthcare technology IPOs. Other than Doximity, all the companies underperformed the S&P 500 index, with six of them trading down by more than 20%. Since their market peaks, the public digital health, telehealth, technology-enabled primary care, and start-up health insurance companies have lost nearly $190 billion of market capitalization as of the end of January 2022, according to an analysis by A2 Strategy Group. Absent even a modest recovery, later stage investors may pause to see how the well-capitalized private companies perform over the course of the year. Additionally, many crossover investors may simply choose to invest in some of these public “fallen angels” versus continuing to pursue later stage private opportunities.
Setting aside these short-term atmospherics, venture investors are looking 5-10 years forward and see profound opportunities as the healthcare industry is re-architected. The transition to value-based care, improved data liquidity, empowerment of the healthcare consumer, more robust infrastructure, and innovation to improve labor productivity are powerful themes to drive new company creation.
And these markets are enormous. For instance, McKinsey estimates that over $265 billion of healthcare services will shift from traditional care settings to the home. That represents nearly one-quarter of all Medicare fee-for-service and Medicare Advantage spend. This is a 3-4x increase in what is being spent in the home today – and much of that capability needs to still be built and deployed. The home is one of the great frontiers to be conquered and entrepreneurs today will make that a reality.
According to U.S. Census Bureau data, over 5.4 million Americans filed applications to start companies in 2021, which was 53% greater than the pre-pandemic level of 2019. While Covid has been devastating for so many, arguably it was dramatic accelerant for innovation and entrepreneurship – either out of necessity or opportunity. Last year also witnessed the greatest level of venture capital investment in recorded history with nearly $330 billion invested in approximately 15,500 companies according to Pitchbook and National Venture Capital Association data, which once again underscored that only a small percent of all companies actually raise venture capital. Much of the anxious chatter now centers around whether we have just seen another bubble.
The economic signals are confounding, and it is near-impossible to descry a bright and obvious path forward. Gross domestic product grew 6.9% quarter-over-quarter which was up from the 2.3% in 3Q21. For the year, GDP increased 5.7% in 2021. Weekly jobless claims are trending downward and unemployment currently stands at 4.0%. Industrial output grew in 2021 at 5.5%, the highest rate since 1984. While analyst consensus expects a slight reduction in 4Q21 EPS for the S&P 500, U.S. corporates should report very strong earnings to end the year.
U.S. household net worth stood at $144.7 trillion at the end of 3Q21, according to Federal Reserve data, while total household debt was only $15.6 trillion. Coupled with a nearly 20% increase in home prices in 2021, the U.S. consumer should feel rather content notwithstanding that pesky inflation and pending interest rate increases.
Certainly, VCs do. The animal spirits ran wild in 4Q21, particularly with early-stage investors (below). Of the $88.2 billion invested in 3,356 companies in 4Q21, nearly one-third of that amount was invested in early-stage companies with an average round size of $23.9 million, which is dramatically larger than any prior quarter. Entrepreneurs may be signaling the need for longer cash runways heading into a more difficult financing environment or large capital raises are a point of differentiation in the market. Or there may simply be too much early-stage capital available. Early-stage median and average pre-money valuations in 2021 were $46.2 million and $119.2 million, respectively. Late-stage median and average pre-money 2021 valuations saw eye-popping increases to $114.5 million and $775.4 million, respectively. The 6.5x step-up in average valuations from early to late stage falls in the “unrealized” bucket, which has reinforced those animal spirits.
The pattern repeated itself in the 4Q21 angel and seed stages as well. The dramatic spike in amount of venture capital invested was just as notable as the fairly significant step-down in the number of deals which started in 1Q21. This may reflect a heightened sensitivity to risk for seed investors or that valuations for seeds have simply been priced too high. The average size of seed rounds in 4Q21 was $4.6 million; the median and average pre-money valuations for seed stage companies in 2021 were $9.5 million and $18.5 million, respectively, also significantly greater than any prior year. Five years ago, those valuations were $5.0 million and $6.9 million.
Undeniably, much of this enthusiasm is driven by extraordinary, head-spinning exit activity. In 2021, there were over 1,600 exit transactions valued at $774.1 billion – levels never before achieved – and nearly 3x the record-setting level of activity in 2020. The entire decade prior to the pandemic saw a total exit value of $1.07 trillion. Global M&A activity in 2021 was $4.9 trillion, according to Pitchbook, with $2.8 trillion of that activity in the U.S. Notably, technology M&A transactions increased more than 50% in 2021. Of the total exit values in 2021, $681.5 billion was due to public offerings across 296 offerings.
The robust public equity markets have clearly supported, even encouraged, an historic IPO market. Over the last six quarters, there has been $866.1 billion in IPO value generated, as compared to $126.4 billion in acquisitions and a mere $21.9 billion via buyouts. The extraordinary special purpose acquisition company (SPAC) activity, which has since summarily ceased, somewhat obfuscates the trend as many of those SPACs have yet to “de-SPAC” and still sit as public shell companies. In 2021, 556 SPACs raised nearly $135 billion and now have a two-year fuse to acquire an asset.
In order to achieve ataraxia, here’s the rub – most public listings involve significant investor lock-ups, so remains “unrealized” for extended periods of time. According to a Cambridge Associates (CA) analysis, over 90% of the gains in 2020 were unrealized. In fact, nearly one-quarter of CA’s U.S. Venture Capital index is comprised of public stocks, and therefore, generated significant mark-ups in 2021. Problems set in when high-flying public stocks experience significant volatility. The Nasdaq composite is down nearly 16% just in the past eight weeks – 60+ Nasdaq stocks are down more than 50%.
Notwithstanding the recent disturbing trading of the Renaissance IPO index, venture capital has been the best performing private capital asset class for the past three years (although the data are lagging). According to Cambridge Associates, the horizon pooled return U.S. Venture Capital Index as of 3Q21 generated 9.6%, 44.1%, 83.7%, and 27.6% IRRs for the prior quarter, year-to-date, trailing 12 months, and last five years, respectively. This performance compares very favorably to all common public equity indices. A Pitchbook 2020 analysis concludes that U.S. venture capital generated 71.7% horizon pooled IRRs versus 30.8% for S&P 500 and 40.4% for the Russell 2000 indices. Notably, venture capital returns were consistent across varying fund sizes.
Not unexpectedly this performance drove dramatic fundraising activity by venture firms. In 2021, 730 funds raised $128.3 billion, another highwater mark (in 2020, the prior record-setting year, 733 funds raised $86.9 billion). The riches were not shared equally, though. First-time fund managers only accounted for $9.1 billion (10.5% of total) raised across 172 funds (23.4% of total). The median fund size raised in 2021 was $50.0 million, which was an increase from the $42.1 million in 2020, while the average fund sizes were $188.1 million and $156.9 million, respectively. Clearly the more established fund managers are raising ever larger funds.
All this fundraising is conducted against a broader liquidity context. According to an analysis by the Financial Times, over $12.1 trillion of equity and debt was raised in 2021 globally, of which $5.0 trillion was raised in the U.S. Refinitiv data shows that $1.44 trillion of equity was raised globally in 2021, suggesting relatively high systemic debt levels. A Pitchbook analysis of the “dry powder” overhang in venture capital estimates that $222.7 billion has been raised but not yet invested by venture capital firms in the U.S., which may be important should VCs need to weather a prolonged recession. Coincidentally, the overhang is virtually the same amount of capital as was invested in late-stage deals in 2021 ($228.5 billion).
Not to be lost in all this activity, a recently released analysis from the Massachusetts Institute of Technology (MIT) of the Paycheck Payroll Protection (PPP) Program, which was launched with great fanfare at the outset of the pandemic, concluded that only ~25% of the $800 billion program actually went to pay wages for jobs that otherwise would have been lost due to the pandemic. While a relatively modest amount was directed to venture-backed companies, the National Bureau of Economic Research estimated that the PPP program spent $169k to “protect” jobs with an average salary of $58k. MIT concluded that 72% of the funds went to households in the top 20% income bracket.
With an increasingly speculative market many analysts are cautioning investors from being overly exposed to public equities. While it is likely too early to declare a “bubble,” it is informative to review the cycle of past bubbles (below). Arguably, there have been several boomlets in a handful of sectors over the recent past due to accommodative monetary policies, unprecedented stimulus spending, and investors searching for returns. While corrections of these boomlets may be uncorrelated, they point to systemic issues of ”too much capital chasing too few quality opportunities.” The Financial Crisis Observatory at the Swiss Federal Institute of Technology, which is tasked with tracking bubbles, recently flagged that a “green-energy” bubble burst in early 2021 as those stocks have plunged 45% from their peak.
A commonality to many of the recent sector corrections is the unmasking of “technology posers;” that is, companies dressed up as high margin “SaaS-like” business models. WeWork and Compass are not really technology companies, but rather slickly packaged real estate companies. Rent the Runway and Casper are retailers, not the “closet in the cloud” or a leading “sleep economy” company as both have described themselves. Nearly 98% of Oscar’s revenues are from insurance premiums. The U.S. affiliate of FTX, FTX Gaming, is poised to release a “crypto-as-a-service” platform. As broader public equity investors come to understand the fundamental economics of these businesses, a reset in valuations is likely not far behind.
Today’s shiny penny is non-fungible tokens (NFTs). According to Chainalysis, almost $41 billion was spent on NFTs in 2021; UBS and Art Basel estimated that there was approximately $50 billion spent in the global art market. Fortune estimates that the combined value of NFTs today is $16 billion, suggesting a high level of NFT trading. It is estimated that 360k owners hold 2.7 million NFTs, although only 9% of those people account for 80% of all NFTs purchased. Adjacent to this sector, venture capitalists have invested more than $30 billion just in 2021 in crypto companies according to Pitchbook – nearly 10% of all venture activity last year.
Breaking news this week was a massive leak of Credit Suisse private bank data of 18k secretive accounts that total over $100 billion of assets, $8 billion of which was deemed “problematic.” Setting aside that many of these accounts are held by despots, fugitives, and other international criminals, it would be fascinating to see where those “investors” placed their bets.
Gallup estimated that 118 million Americans went to church last weekend. The Hartford Institute identified ~350k religious congregations across the United States. Notwithstanding that level of activity, the country has clearly turned more secular; 2020 was the first year when less than half of all Americans (47%) identified as a member of a church, synagogue or mosque. In 1999, that number was 70% and had been consistently above that threshold for the prior 60 years.
This religious “shoulder season” between year-end holidays and Easter offers an interesting window to reflect on the role of religion in healthcare. The obvious societal crosscurrents and turbulence arguably have further polarized an already fractured country. Fewer Americans identify as Christian, now standing at 63%, while 29% of U.S. adults claim to have no religious affiliation. More than 40% are Protestant and 21% are Catholic. Other religions continue to be a relatively modest yet important slice of the overall population, according to Pew Research Center data. In large measure due to the pandemic, in-person attendance has declined between 30-50% according to the Barna Group, which studies religion in the U.S., and yet it is believed that 45% of Americans still pray daily (which is admittedly down from 58% in 2007).
Religion is also a big business. According to Cause IQ data, religious organizations employ 321k people and generated $46 billion in revenues and have cumulative assets of $133 billion. Many religious organizations have essential healthcare affiliations or have endowed important healthcare organizations, providing critical healthcare services. These are often found in communities that struggle with issues of access and quality. Religious organizations often serve as society’s safety net and play a profound role in coordinating with public health infrastructure. Over the centuries, clergy were known to provide healthcare services, in part, to supplement income earned from the church.
So, do those with religious affiliations have better health outcomes? Baylor University researcher and Pulitzer Prize nominee, Rodney Stark, identified $115.5 billion in healthcare savings for those who practice a religion (2012). Quite clearly, the deeply religious find emotional and psychological comfort in spirituality. Religious practice is thought to reduce depression, improve interpersonal relationships, and enhance a deeper sense of self-esteem, which are all shown to improve physical well-being. A pivotal Mayo Clinic study in 2019 concluded that “Most studies have shown that religious involvement and spirituality are associated with better health outcomes, including greater longevity, coping skills, and health-related quality of life (even during terminal illness) and less anxiety, depression, and suicide.”
Notwithstanding this study, the connection of spirituality and physical well-being are still somewhat indirect, and showing causality is still elusive. Most religions emphasize the importance of physical health, and in fact, many identify smoking, alcohol, poor diet, and unsafe sexual behavior as anathema to core principles. Such religions advocate abstinence, often encouraging meditation, which likely does have important physical benefits. Clearly, increased levels of depression or emotional problems directly contributes to poor physical conditions, likely leading to increased mortality and reduced quality of life. Increased sense of meaning and purpose afforded by religious practices can improve one’s ability to manage stress and depression.
Notably, a 2018 Forbes study identified a significant gap between providers and patients and whether they believe that God or a higher power exists. It was estimated that 64% of clinicians held such beliefs while more than 90% of their patients did. Importantly, the Joint Commission for the Accreditation of Hospital Organizations (JCAHO) requires that providers demonstrate respect for patients’ cultural and personal values, beliefs, and preferences (including religious or spiritual beliefs). It is estimated that 25% of providers expressed uncertainty in their religious beliefs. Over 75% of patients felt that providers should consider their spiritual needs when providing care.
Interestingly, against a backdrop of reduced stated religious affiliations but arguably a more energized and vocal religious community, investment in religious facilities has dropped significantly. A recent Axios analysis identified a precipitous decline starting a dozen years ago, further accelerated by the pandemic. According to U.S. Census Bureau data, twenty years ago construction spending on religious facilities averaged approximately $9 billion annually; analysts estimates are that there was only $3 billion invested in 2021.
As a point of comparison, the level of construction spending in healthcare has been relatively consistent over the past decade or so, running between $40 – $45 billion with a marked increase over the past few years, heading towards $50 billion in part due to needs exposed by the pandemic as well as an incredibly favorable financing environment. Curiously, construction spending for recreational facilities was nearly $11 billion in 2021, perhaps reflecting how society weighs the need to be entertained given the extraordinary pandemic pressures.
Have venture capitalists seen the light? According to Pitchbook, $175.3 million was invested in faith-based apps in 2021, which is rapturously greater than the $6.1 million invested a mere five years ago. It is most likely too convenient to conclude that the reduction in physical religious infrastructure is being replaced with virtual infrastructure (akin to ecommerce replacing Main Street retail) but many congregants have turned to virtual solace when lockdown during the pandemic. The YouVersion Bible app claims to have been downloaded over 500 million times.
Setting aside the obvious tension surrounding for-profit religious apps, and whether they can be deemed exploitive, there were a handful of notable venture financings in 2021. Glorify, which is a subscription “well-being” app offering meditation and Christian content, closed a $40 million round with Andreesen Horowitz and SoftBank as lead investors. Not to be outdone, Hallow, claiming to be the #1 Catholic app, also raised a $40 million round with Drive Capital as the lead investor. Pray.com closed on a $34 million round, while Ministry Brands (a provider of software and services for faith-based organizations, which had been acquired for $1.4 billion by Insight Partners in 2016), sold a majority stake to Reverence Capital Partners. Published interviews with these companies’ founders consistently reference the potential to build robust social networks and dating tools with their members, sort of “monetizing the flock.”
Gloo, launched by the founders of Blockbuster Video and Boston Market, provides software to 30k church clients that identifies and markets to potential new members based on sophisticated algorithms that profile individuals based on thousands of data points.
Undeniably, the sense of community is powerful, even therapeutic. Much of the promise for digital health tools involves engagement, activation, navigation, and providing information to its users. Perhaps digital religious tools will provide similar utility.
Of course, all of this risks going too far. The quest for palingenesis can be tricky. The “Way of the Future” was considered the first AI church, developed by Anthony Levandowski, who achieved some notoriety after being convicted for stealing autonomous vehicle trade secrets from Google when he was hired by Uber (and subsequently pardoned by Trump). This “religion” envisioned a future for humankind that is to be overseen by benevolent algorithms. What the…?
Having recently returned from Germany, I was quite surprised to learn that record Covid-19 daily case counts (37.1k) were set there last week – twice. Notwithstanding the current political turbulence with three parties attempting to build a governing coalition after recent federal elections, everything seemed in good order with relatively robust investment activity. While it certainly appears that the Social Democrats (SPD), the Free Democrats (FDP), and the Green Party will come to an accommodation, there are real debates about reducing Covid-related stimulus and whether to start to limit expansionist policies.
The somewhat unsteady economic indicators are not helping. Industrial production declined 1.1% in September over the prior month, which had declined 4.1% in August. With unemployment now at 5.4%, supply chain issues continue to hamper the recovery. The Halle Institute for Economic Research, one of Germany’s leading research firms, recently reduced its 2021 GDP growth forecast from 3.7% to 2.4%, and now expects the German economy to not reach pre-pandemic employment levels until 2023.
Furthermore, there are significant debates roiling the broader European Union. Over the next two years most of the major countries in the EU will have national elections which, like in Germany, could see fundamental political changes. Today, for instance, Poland is aggressively challenging a number of EU laws which the country’s leadership considers to be in opposition of Poland’s national interests, perhaps threatening the sanctity of the EU altogether.
Against this backdrop it was encouraging to see the level of venture capital investment activity across Europe by American investors, who appear to be convinced of the attractiveness of that market. Pitchbook recently announced that through 3Q21 US VCs participated in 50.8 billion euros ($58.9 billion) rounds of financings in European companies. It is estimated that 21.2% of all European deals in 2021 had at least one U.S. investor in the syndicate as compared to 17% in 2020 and 15% in 2019 – a marked increase in U.S. participation. Could not help but think that the dramatic liquidity created in the U.S. may now be spilling into other important markets.
Consistent with what investors are witnessing in the U.S., there has been an explosion in exit activity across all of Europe as well. Through 3Q21, it is estimated that there have been in excess of 12k M&A transactions which is driving nearly 120 billion euros of exit value across Europe. Notably, much of this activity is being driven by robust public listings; leveraged buyouts tend to still be a rather inconsequential source of investor liquidity. The 2021 exit levels are likely to be nearly 5x that of 2020.
Data: Pitchbook, Axios
According to BVK (the German Private Equity and Venture Capital Association), nearly 1.9 billion euros of venture capital was invested in 654 German companies in 2020, which was a marked decline across all stages from 2019. Quite surprisingly, less than 6% of all investments were in seed stage companies. One might expect that there may be a future resurgence of entrepreneurial activity given the dramatic influx of immigrants over the last handful of years. In 2015, Angela Merkel facilitated the resettlement of nearly one million immigrants, making Germany the second most welcoming country in the world. Importantly, it is thought that nearly 25% of all Germans have immigrant roots. As has been proven in other innovation hubs, robust immigration policies often lead to strong entrepreneurial ecosystems.
Given the impressive technical capabilities of both the academic and industrial sectors in Germany, one might have expected a greater level of novel intellectual property licensing to early stage companies. As shown below, according to analysis prepared by Frontline @ SpeedInvest, Germany is a powerhouse in terms of the number of patents filed each year.
German venture capitalists have historic strengths in industrial automation, cleantech, and increasingly, in healthcare, most notably in medical technologies. Notwithstanding those attributes, according to BVK data, the German venture capital industry raised less capital in 2020 (1.6 billion euros) than it did in 2019 (nearly 3.0 billion euros). Of the various private capital asset classes, venture capital is consistently the largest segment of overall fundraising, which may be poised to increase dramatically. Earlier this fall, German-based World Fund set out to raise the largest European cleantech fund, targeting 350 million euros.
Healthcare has been one of the most important sectors of the German economy. Overall healthcare expenditures in 2019 were estimated to have been 410 billion euros or 12.5% of GDP. The German medical technology sector is thought to be $35.8 billion in size and accounts for more than 25% of the entire European industry, according to Germany Trade & Invest. Of the more than 83 million Germans, it is believed that 7.5 million of them are employed in the healthcare industry.
As is the case in many other developed countries, the digital healthcare sector is witnessing explosive growth. Germany Trade & Invests estimates that the sector will be 57 billion euros by 2025. All of the urgency exhibited by providers and payors in the U.S. healthcare technology sector triggered by the pandemic are appear to be evident in Germany. Furthermore, the German legislature instituted a series of reforms that have facilitated the advancement and adoption of this important sector. In particular, there were three important pieces of legislation: the 2019 Digital Healthcare Act, the 2020 Hospital Future Act (KHZG), and the 2021 Digital Care Modernization Act.
In addition to meaningful financial incentives of 4.3 billion euros to accelerate the adoption of digital solutions for providers (EMRs, etc), important reimbursement frameworks were established for digital therapeutics. The push for the German healthcare system to be more virtual, more responsive, more intelligent, and more predictive should have profound benefits for the population.
A whirling dervish…a ball rolling downhill. The investment activity in the digital health sector is extraordinary – and arguably overdue given the enormity of the market opportunity and the urgency created by the pandemic to re-architect such an important sector. According to Rock Health data, this past quarter saw $6.7 billion invested in 169 companies for an average deal size of $39.4 million. The investment activity for 2021 is on pace to reach $28 billion, which would effectively double the 2020 highwater mark of $14.6 billion.
And the robust investor enthusiasm is not exclusively a U.S. phenomenon. According to CB Insights data, across all of healthcare globally there has already been $97.1 billion invested, putting this on pace to be nearly $130 billion, which would be nearly 60% greater than last year’s highwater mark of $79.9 billion. Interestingly, CB Insights flags that the 3Q21 investment of $30.5 billion marks a deceleration from the prior two quarters although the number of deals spiked to 1,901, which is 15% greater than 2Q21, and itself the most active quarter ever.
As highlighted with the Rock Health data, we should pause on the average round size to better understand what appears to be unfolding. Year-to-date there have been 62 “mega rounds” of financing (greater than $100 million) which represents nearly 12% of all financings. Arguably, the digital health sector is entering an “anoint the winner” phase. Entrepreneurs and investors today experience greater urgency than ever as the next few years may well define the sector’s strategic agenda for the next five years – and the next five years will quite likely define the landscape for the next twenty years.
This commentary is too central to be incidental and influences financing strategies and product roadmaps. The irony of the need to accelerate development cycle times in an industry that confronts crushingly long sales cycle times is not lost on many investors. Companies today appear to be raising larger rounds to bridge this divide. Typically, product/market fit is clarified during the Series A and B rounds. Rock Health data (below) illuminates this dynamic: early stage round sizes have significantly increased in size, yet the average age of the companies has remained relatively constant – plus or minus a quarter. Focusing just on averages can at times be misleading, but directionally the average Series B company had raised just under $50 million in 2020 and now in 2021 that amount is running just over $60 million. Building an enterprise-ready digital health company will take over five years and $60 million – no small undertaking.
The Series C round, in general, is considered to be the “commercialization” round. Of course, management is selling throughout the life of the company, but the first handful of years are mostly spent nailing down product/market fit. The implication of the chart above is profound: nearly eight years and now another $100 million is required, thus the increased incidence of the “mega rounds.” This is compounded by the heightened levels of investment between 2018 – 2020 as all of those companies are coming back to market.
One might also expect an increase in “private-to-private” mergers as many companies struggle to get through this knothole. Typically, each round of financing provides another 15-18 months of runway before management needs to think about the next round; not a lot of time given the intense competitive dynamics of the digital health sector today. A common critique is that too many companies have built too narrow an offering: it is a more limited point solution, and the customers require a broader, deeper set of capabilities. Expect also to see horizontal acquisitions that seek to expand into adjacent customer bases (providers + payers) or bolster distribution capabilities, especially for those companies that may not have sorted out product / market fit (see below).
Notwithstanding those concerns, there is ample evidence that the healthcare technology sector has created a number of important companies that are reducing clinical and administrative costs, while improving outcomes – while creating extraordinary shareholder value. According to an analysis prepared by Flare Capital, these last five years (2015 – 2020) has witnessed a 4.4x increase in market value of both private and public companies to $271 billion. Over the course of that same period, per Rock Health, $42.3 billion was invested in this sector. According to EY, there have been 132 healthcare start-up IPOs already in 2021 (admittedly, though, a number of them were biotech companies).
Essential to the healthcare technology sector’s success has been the emerging evidence of impact that these solutions are having in the market. Clearly, the pandemic has also super-charged the need for a more responsive, intelligent, predictive, and virtual healthcare system. In a recently published report by the Centers for Medicare & Medicaid Services, the CMS Innovation Center reflected on the more than 50 test models introduced over the last decade. While only six of them are considered to have created material savings to the system, just in the last two years alone over 28 million patients have been served. The insights from these models support a narrative that technology will be able to drive important improvements to care delivery in profound and systemic ways. This augurs well for an important upcoming decade as these lessons are more broadly deployed.
Notably, the research firm ATI Advisory recently released an assessment of how Medicare Advantage (MA) members have managed through the pandemic as compared to traditional “fee-for-service” (FFS) members and the results were striking. Mortality rates for hospitalized MA members with Covid were 15% as compared to 22% for FFS members. This is in light of the fact that 7% of all MA members have tested positive for Covid as opposed to only 3% for FFS members. Much of this improvement is attributed to the fact that risk-bearing models tend to provide more responsive, flexible care and offers a more-appropriate menu of supplemental benefits.
Naturally, investment capital has tended to be directed toward diseases that either exhibit the greatest urgency or burden on the healthcare system. Year-to-date, according to Rock Health data, $3.1 billion has been invested in companies that are addressing mental health conditions, while cardiovascular disease, diabetes, and primary care have attracted $1.4 billion each. Oncology ($1.2 billion) and substance use disorder ($0.8 billion) make up the next largest categories tracked. These six clinical indications accounted for nearly 45% of all digital health funding in 2021. Mercom Group (below) tracks venture investment by technology category, highlighting that telehealth investment activity was both the most active sector these past two years and also spiked in 2021. This is not at all surprising given the urgency to create robust virtual care offerings.
Finally, the lingering question for entrepreneurs and investors centers around what the next handful of years will look like. With nearly $4.0 trillion of healthcare expenditures in 2020 (per CMS data), the enormity of the need coupled with the size of the market opportunity strongly suggests a continued robust investment pace. Undoubtedly, in certain sub-sectors and with certain companies, valuations are heady and arguably ahead of the reality of those companies, but directionally this is a category that can productively support investment levels at this pace.
I have been a broken record on this analogy. The U.S. advertising industry is a massive industry – $240 billion spent annually – and over the last twenty plus years as that sector was re-architected over $10 trillion of venture-backed public market capitalization (Google, Facebook, Apple, Twitter, etc) was created.
The U.S. healthcare industry is nearly 17x larger…
Obviously, the venture market is on fire, likely to shatter all records this year. So far nearly $239 billion (yes, with a “2” and a “b”) has been invested in 12,837 venture-backed companies in 2021. Against a backdrop which saw the U.S. Small Business Optimism index fall to its lowest level in the last six months due to spiking inflation and labor force dislocations, venture capitalists have invested at a frenetic pace and enjoyed an extraordinary exit environment.
Contributing to this paradox has been the enormous levels of government support over the last 18 months which has allocated the risks and costs of the pandemic broadly across society. The level of support provided since the start of the pandemic increased disposable household income 11% greater than the 18 months prior to the pandemic. In fact, after-tax profits generated by non-financial companies was 7% greater in the 18 months during the pandemic than the 18 months prior. This extraordinary liquidity and strong earnings environment has led to a marked acceleration in the S&P 500 EPS, further boosting investor confidence.
Data: S&P Dow Jones Indices division; Chart: Axios Visuals
The heightened venture investment activity was broad-based, impacting all stages and all sectors. While the overall number of investments continued its modest decline started six months ago, the dollars invested set another record and is now on pace to reach nearly $320 billion in 2021, which would be nearly 10x the amount invested in 2010 (yet only 3x the number of companies). According to Pitchbook (below), it certainly appears that we have entered a new “pandemic” phase of investment activity, arguably as important segments of the economy are re-architected.
There are a number of important implications that arise from this current fundraising environment. First and foremost, this frenetic pace has shown up in significantly increased pre-money valuations and round sizes. The median pre-money valuation for early stage deals was $30.0 million in 2020 but increased to $45.0 million in 2021 year-to-date. At the same time, the median round size for these companies increased from $7.0 million to $10.0 million (below). For late stage investments, the median pre-money valuations increased from $70.0 million to $120.0 million over those same time frames, while the median round size increased from $10.0 million to $16.5 million.
The tremendous number of “mega rounds” (rounds greater than $100 million) over the last three quarters clearly has skewed the data. The average pre-money valuation of late stage rounds increased from $446.2 million in 2020 to $800.3 million in 2021 year-to-date, with the average round size jumping from $37.5 million to $56.4 million. In 3Q21 alone, there were 207 “mega rounds” that totaled $49.5 billion (chart below). In other words, nearly 60% of the capital invested in 3Q21 went to only 0.6% of the companies this past quarter. As entrepreneurs weigh the benefits of raising such a large round, the level of personal dilution is balanced by the competitive differentiation such a financing is likely to create. Of course, this incremental capital also creates a burden to drive considerably more shareholder value.
This heightened level of investment has led directly to the creation of a significant number of “unicorns;” so much so that it has become somewhat passe…almost no longer remarkable. Year-to-date, 597 “unicorns” raised $136.5 billion or on average $228 million. Notwithstanding there were fewer “unicorns” in 2020 (only 333), the average round size was nearly equivalent to 2021 activity.
Number of “Unicorns”
Contributing to all of this investment activity has been the important role of non-traditional venture capital investors such as hedge funds, mutual funds, sovereign wealth funds, and strategic corporate investors. Year-to-date nearly 77% of all capital has been invested in rounds that included one of these investors. Corporate investors alone participated in 26% of all deals and those deals accounted for 51% of all capital invested. Arguably, these strategic investors are looking to access innovative solutions that may well inform their core product roadmaps, while the financial investors, in a world of nominal interest rates, are seeking greater returns above and beyond public alternatives.
And those returns have been plentiful. For 2Q21, the most recent quarter tracked by Cambridge Associates, the preliminary early stage and late stage venture returns have been 14.3% and 15.6%, respectively. Overall, the level of exit activity in 2021 has been nothing short of staggering. Exit value year-to-date is $582.5 billion, of which nearly 90% has been via public listings. Not to be lost in all of this activity is the SPAC (special purpose acquisition company) phenomenon, which has suffered somewhat over much of this year. To date, 413 SPACs have raised $109.4 billion and is estimated that there are 549 SPACs scurrying around looking for companies to acquire.
This virtuous cycle, driven by extraordinary levels of liquidity and supported by extraordinary levels of innovation, comes full circle with fundraising by venture capital firms. Pitchbook estimates that 526 funds have raised over $96 billion year-to-date for an average fund size of $195 million (while the median is only $50 million). This pace suggests that the venture capital industry will raise nearly $130 billion; ten years ago, venture capitalists raised $22.9 billion. Yet again, the average is somewhat misleading as there have been a record 19 funds raised that were greater than $1.0 billion in size coupled with a notable reduction in the number of regional and micro-funds. Another sign that there is “capital aggregation” around a more limited number of venture funds is that there may only be 150 first-time funds raised this year, which would be the lowest level since 2013. Industry analysts estimate there is now over $220 billion of “dry powder” held by venture funds.
One other indicator of industry consolidation is reflected in geographic concentration of venture capital investments. There are 24 states, nearly half, which recorded less than 50 total venture deals in 2021. Fifty deals is a mere 0.3% of all deals. Therefore, half of all states accounted for only 9% of all venture-backed companies. California alone was just under 30%. Mississippi had two companies.
When there is a correction, and there always is a correction, analysts may observe in hindsight that with flashing red lights of economic concerns, investors became complacent during the pandemic and simply invested too much, too quickly. Or some may say that the forces unleashed by Covid to restructure important sectors of the economy required the best minds to raise extraordinary amounts of capital given the enormity of the market opportunities and that these large rounds will enable the companies to power through the correction. However that plays out, it is clear that disparities are emerging: a relatively select few companies will have raised much of the capital, often times invested by a relatively select few venture firms.
Setting compensation and incentive plans may be one of the trickiest, most nuanced aspects of the CEO and board’s responsibilities – made even more complicated by the pandemic and the move to remote and/or hybrid staffing models. The dramatic workforce dislocations with surging unemployment 18 months ago and the grindingly slow recovery makes a tough situation worse.
It has been a tale of two cities since February 2020. There were 10.93 million open positions or 1.3 positions for every unemployed American at the end of July 2021. While the average hourly wage has increased 8.0% to $30.73, according to U.S. Census Bureau data, this marked increase was in large part due to significant layoffs of low-skilled hourly workers and to a lesser degree, increased wages required as employers struggled to re-staff. The dramatic increase in stock market and real estate values pushed U.S. household net worth to yet another record of $141.7 trillion at the end of 2Q21. Of the $5.8 trillion increase in 2Q21, $3.5 trillion was attributed to the increase in public equities and $1.2 trillion to increased home values. Of course, not all Americans own equities or homes, exacerbating the yawning inequity gap.
Data: Federal Reserve Bank of St. Louis; Chart: Thomas Oide/Axios
As year-end approaches, many corporate boards now are deliberating over 2021 bonuses and architecting 2022 compensation plans. In collaboration with my good friend Jody Thelander of J. Thelander Consulting, a leading private company compensation consultant, a review of the data she has collected offers insights into emerging compensation themes. And there were some quite unexpected insights that revealed themselves.
“I was most struck by how stable the data were and the impact of the amount of capital raised has on overall compensation” observed Thelander, who tracks nearly 1,300 private companies, half of which are technology companies. The extensive database aggregates all reporting companies by number of employees, title, sector, and amount of capital raised: all of which directly inform the composition and size of incentive plans. Against the obvious pressure to retain talent, one might expect a dramatic increase in annual compensation – that is not the case. In fact, Founder CEO 2021 levels were either flat or slightly lower than 2020 levels (see chart below).
The narrative for public companies is similar. The Conference Board analyzed CEO salaries for both the S&P 500 and Russell 3000 indices from 2018 – 2020 and observed modest reductions, likely one-time, heading into the pandemic in early 2020. Notably, public CEO compensation is 2x – 3x that of later stage private company CEOs, and not at all unexpectedly, 5x – 6x that of early stage CEOs. Somewhat surprisingly though, public company CEO median salary for the Consumer Staples sector was twice that of the Health Care sector. The Conference Board data also highlight that CEO salaries often decreased to a much greater degree than other members of the executive leadership team, often as a sign of solidarity to the rank-and-file employees.
The Thelander data also compared CEO compensation by sector and stage. The more capital raised, the greater the compensation. The greater the prevalence of advanced graduate degrees, the greater the compensation. Later stage biotech companies reported meaningfully higher compensation across all executive positions; Founder CEO median compensation for later stage biotech companies was nearly $500k and 60% greater than later stage technology CEOs.
Founders tended to receive lower cash compensation but enjoyed significantly greater equity ownership positions. For companies that had raised less than $14.9 million, the median Founder CEO ownership level was 24.0% versus 5.9% for non-Founder CEOs; median cash compensation was $200.0k (Founder) versus $218.5k (non-Founder). Similar story for later stage companies that have raised more than $70.0 million: Founder versus non-Founder median compensation and equity ownership were $400.0k versus $444.0k and 8.0% versus 4.6%, respectively.
One other quite surprising finding in the Thelander data involved geography. There is clearly a “coastal premium” paid to CEOs of biotech companies on both coasts, perhaps reflecting the relative concentration of the life sciences sector in certain key locales such as Boston, San Francisco, and San Diego. The reverse was true for the technology sector – there appears to be a modest premium paid in geographies in secondary venture capital regions. This will merit further analysis with Covid-inspired virtual workforces.
Given the obvious implication on wealth creation and shareholder alignment, most of the attention in compensation schemes is focused on equity. A recent Harvard Business School study concluded that companies with widely held equity were more likely to be successful. The Thelander data show that 78% of companies use Incentive Stock Options (ISO) versus only 11% with Restricted Stock Units (RSU), which is more prevalent with public companies. Not surprisingly, 94% of respondents have vesting with 83% using time-based vesting versus a mere 1% using only performance-based vesting – the remaining 16% have a hybrid vesting approach. Nearly 79% of those companies reporting have four-year vesting schedules, while 12% have three-year schedules (3% have one-year vesting and only 1% have more than five-year vesting). One-year cliff vesting was indicated for over 90% of companies.
The distribution of ownership by stage is tricker to discern across various cohorts given differences in the number of companies reporting but yet certain patterns do emerge. An enduring rule-of-thumb for early stage companies is that the employees receive up to 20% of the fully diluted ownership via the option pool. Initial Founder ownership levels are significant and absent further investments, will be meaningfully diluted. Companies in the Thelander database that have raised more than $90.0 million show Founder ownership levels of 4%, 8%, and 22% by quartile, respectively, as compared to initial early stage ownership stakes of 20%, 34%, and 47% (see below). Importantly, the employee ownership level remains relatively constant as companies raise additional capital, highlighting the necessity to “re-fresh” the option pool with each successive financing.
The impact of equity on overall executive compensation is most startling for public company CEOs. Base cash compensation accounted for only 22% of overall pay for CEOs of the Russell 30000 and only 10% for S&P 500 CEOs. Not surprisingly, the compensation levels for CEOs has tracked the public equity markets (see below), until very recently. The full effect of the dramatic increase in the stock market over the last three years has not yet been fully reflected in CEO compensation, as hard as that is to believe.
Source: Economic Policy Institute
And size matters – in 2020 the top 350 CEOs averaged $24.2 million in total compensation, an increase of 18.9% over the 2020 level, while the broader S&P 500 cohort earned on average $15.5 million according to Thrive. The Conference Board analyzed CEO compensation for public companies by aggregate revenue, and perhaps not surprisingly, determined that has companies scale, so did CEO compensation. It is true – bigger is actually better.
The size of CEO compensation packages has become a visible and highly charged topic, bordering on perfidy in some circles. The Financial Times recently cited a London Business School survey of public equity investors that determined 75% felt that compensation was too high while only 18% supported high pay to “recruit and retain” leadership talent. Critics of executive compensation have focused on the relative compensation of CEOs as compared to the average employee. The Economic Policy Institute calculates that the current ratio sits at 351:1, an increase from 307:1 in 2019 and a mere 21:1 in 1965. Aptiv Plc tops the leader board at 5,291:1.
Source: Economic Policy Institute
At the risk of wading into a public policy debate, executive compensation is under an even brighter spotlight now that three federal unemployment insurance programs are set to expire. This will cause up to seven million Americans to lose a variety of unemployment benefits while another three million people will see their $300 weekly payments come to an end. Somewhat unexpectedly, the U.S. is at a record low in the poverty level at 9.1% of Americans living poverty, down from 11.8% in 2019. This is largely due to the social safety net programs that were unfurled since the onset of the pandemic. Were it not for this government support, the effective poverty rate would be 11.4%, according to a recent Columbia University study. Due to the Great Recession a dozen years ago, the poverty rate hit 16.1% in 2011.
The U.S. Census Bureau reported that 11.7 million Americans were lifted out of poverty while another 10.3 million were kept from falling into poverty by the stimulus programs over the past 18 months. In 2020, median household income declined 2.9% to $68k. If one was able to keep his/her job during the pandemic, their effective income increased 6.9%. These inequities have caused many policy makers to craft proposals to attack the “corporate greed” associated with equity compensation. One recent proposal was to aggressively tax share buybacks which, if enacted, might influence senior executive compensation plans. In 2018, the S&P 500 reported $806 billion of share buybacks as a way, in part some would argue, to prop up stock prices.
To come full circle, what will be the lasting impact of Covid 19 on compensation plans? As Thelander highlighted, the impact on executive compensation over the last 18 months has been fairly muted. Of the respondents to a recent Thelander survey, 91% of companies do not expect to modify current compensation frameworks for employees who have relocated away from company headquarters, although 87% expect to adjust cash levels based on that new location. Notably, only 10% expect to require a return to the office, while 59% expect to institute a “flexible” hybrid arrangement (only 12% expect to stay fully virtual through year-end 2021, with nearly half of those respondents already concluding that it will be permanent). Of those utilizing a hybrid approach, 72% expect that less than 50% of the workforce will be fully remote.
All of this will be closely tracked and analyzed by Jody, and you can take that to the bank…
“Battre le fer pendant qu’il est chaud…” is one of the more popular French expressions and roughly translates the title above. It also precisely captured the tone I witnessed while in France a few weeks ago. While most everyone seemed to accept the circumstances imposed by the pandemic and were dutifully masked and distanced, there was a distinct sense of enthusiasm, which is also borne out in some of the recent economic and financial data. Ironically, it is considerably harder for the French to travel to the U.S. and yet case counts there are relatively low and declining. The Covid infection rate is 106 per 100k residents as compared to 313 per 100k in the U.S. The ability to visit France now appears to be changing as the European Council just restricted Americans from non-essential travel to Europe (and France just banned all unvaccinated travelers).
Over the last few years there has been a concerted effort to strengthen the French start-up ecosystem, in part as an acknowledgment that France over the last decade has been a distant #2 (or #3) to the United Kingdom, flip flopping with Germany for runner-up status. According to EY data, 5.4 billion euros was invested in 620 companies in France in 2020, as compared to 12.7 billion euros in the U.K. and 5.2 billion euros in Germany (over $156 billion was invested in 11,024 U.S. companies in 2020). Of the 620 investments, 436 (~70%) of them raised less than 5 million euros. Between 2019 – 2020, the level of investment activity increased over 25% in France while Germany only grew 10.9% with the U.K. increasing a mere 1.7%, according to Pitchbook analyses (which also had Germany slightly ahead of France in 2020). Like many other regions, the average round size for French companies has increased significantly and in 1H21 was 32.6 million euros, in part due to the impact of the eight mega-rounds (greater than 100 million euros in size).
The formula for France’s resurgence and increased relevance in the venture capital landscape is one that other regions around the world have deployed, as well as many secondary American cities. Analysts have pointed to three significant contributors in France: (i) tax reform which has lowered rates on dividends and wealth; (ii) retention of talent via “fast tracking” immigrant visas and programmatic outreach to recent graduates; and, (iii) public sector investment to support entrepreneurial ecosystems around the country. It is estimated that Banque Publique d’Investissements (BpiFrance) was one of the top ten venture investors in France in 1H21, accounting for 20% of all early stage funding according to the Financial Times. In 2019, President Macron earmarked 5 billion euros for later stage investments with another 2 billion euros for early stage. In response to the pandemic, another 4 billion euros were set aside for entrepreneurs.
The entrepreneurial ecosystem in France now counts 13.2k start-ups and 342 venture capital firms, with 44 angel networks and 149 incubators and accelerators, according to Tracxn. This distributed infrastructure has clearly contributed to the strengthening of the French innovation ecosystem. CB Insights reported that there was a 6x increase in start-up activity in 2Q21 as compared to 2Q20. Dealroom has identified 27 “unicorns” now in France; there were only nine in 2018. And this activity is not lost on public equity investors with the MSCI France Index ahead over 20.8% year-to-date through August 2021 (trading at 24.8x P/E).
These efforts appear to be paying off. As the French venture capital market continues to mature, expect to see a greater proportion of the financings be later (and larger) stage, which is reflected in the breakdown below (Pitchbook data). Yet still, France continues to lag in relative attractiveness by foreign investors. It is estimated that 65% of venture financings included a U.S. venture firm as opposed to more than 75% in Germany. Dealroom calculated that 31% of all capital invested in French companies this year was from U.S. investors, up from just 13% in 2020, but below the more than 40% in the U.K. and Germany. The top five French venture financings in 2020 accounted for 22.2% of all capital invested – the continued surge of foreign investors should lead to larger round sizes.
While clearly a complicated continent, Europe was the fastest growing region for venture capital investment according to Sifted (part of the Financial Times) and Dealroom – obviously, not the largest region. McKinsey analyzed the top 1,000 venture-backed start-ups in Europe, 143 of which were based in France, and concluded that most European unicorns required between 100 – 200 million euros to achieve that status, and that for between 70 – 80% of them, they were able to get there in less than 10 years. Interestingly, 24% of these companies were in the life sciences/healthcare sector (put in the “Deep Tech” category in this analysis) and appeared to be more heavily dependent upon access to great (younger) talent. “Deep Tech” unicorns required 215 million euros of funding (median) and yet only realized 8 million of revenues (median).
Laissez-faire does not seem to be the current approach in France – and the more directed strategies appear to be paying off with a more robust venture capital and entrepreneurial environment. Only hope that I am allowed back in the country at some point.