A Deep(Tech) Dive into the Future of VC - Part One

This report, written with input from leading VCs, operators, angels and founders from across the industry, explores the potential of VC-backed deep tech in a new era of technological, societal and environmental change, and the challenges facing VCs if they wish to be at the forefront of this new wave of innovation, and the value creation opportunities it brings. It was written primarily with a view to the UK ecosystem, but many of the learnings may be globally applicable.

This is a two part series – with part one looking at the potential of deeptech for VC and society as a whole, while part two explores the challenges deeptech founders, investors and operators are facing right now and our recommendations to help capture this opportunity.

Part two will be released in the coming weeks. Sign up to our newsletter here to be the first to receive it.

Why We’re Writing This

Invigorate is the UK’s first scaleup advisory platform, connecting hundreds of businesses to experienced tech operators and unicorn-builders. We wrote this report in response to the concerns and challenges of investors and founders in our community – 82% of which run technical businesses, invest in deeptech, or have a scientific or technical background.

Invigorate works at the centre of the scaleup and investor communities, and is committed to supporting advancements in the venture ecosystem by facilitating meaningful connections and knowledge-sharing. We’ve previously produced reports on other topical concerns, such as our 2021 report co-authored with Silicon Valley Bank, Frog Capital, Kindred and Anthemis ‘Harnessing the Power of Diversity and Inclusion’ and the 2020 report ‘How Scaleups are driving the Sustainable Economy’, written with Beauhurst. We also produce articles and regular newsletters on trends and opportunities in the venture industry.

Why Now?

Innovation currently stands at a turning point. Our society faces a host of existential challenges – from global warming, to resource scarcity, pollution and disease – and as these issues have become more pressing governments and institutions have accelerated funding, support and research into possible solutions. At the same time technological innovations have made technologies such as clean energy or pioneering new medical treatments not only possible, but cheaper and more efficient. Now, as software begins to mature as a technological frontier, the next great wave of innovations will be in ‘deep tech’ fields – working to tackle these existential challenges, and help businesses operate in our increasingly complicated economic landscape.

We have already started to see a real step change in funding for deep tech businesses covering topical issues. For example, cleantech saw a 47% funding increase in the first half of 2022. Brought to the forefront of both investor and consumer consciousness in recent years, it benefitted from concern around extreme weather events, high-profile media such as the G7 summit, and supply disruptions in oil and gas caused by the Ukraine-Russia war. Other deeptech industries have seen spikes of interest following public interest or high-profile successes – such as the boost in spacetech investment following media coverage of SpaceX.

But after years of focusing on SaaS businesses with fast and established routes to exits and revenue, there are several cultural and structural hurdles which VCs looking to invest in the deeptech revolution will need to overcome. These include adjusting to different business and funding milestones, finding the right expertise, supporting founders, and managing LP expectations. Ultimately, deep tech faces four key challenges across the funding cycle:

The potential rewards of deep tech are massive – with the next innovation wave predicted to surpass the peak of the software revolution. But success will be dependent on the ability of each business and its investors to meet these challenges (alongside the more conventional ones associated with any startup).

Venture capital has also come to a turning point. In the last decade, the number of VC firms operating in the UK markets soared – with high-profile and outsized valuations and returns from software and tech companies encouraging an influx of new entrants to the investment market. Venture capital has also come into competition from hedge funds, institutions, PE funds, and various other parties all looking to share in the high returns and encouraged by the perception of reduced risk. This has put pressure on the ability of VCs to source great investments, but also to deliver a competitive risk-reward ratio to LPs with increasing access to more flexible investment models. As the tech market becomes increasingly mature and accessible it seems probable that this trend will continue, encouraging more VCs to specialise into areas ‘tourist’ investors find harder to access, such as deeptech.

The greatest strength of venture capital has always been its ability to invest in real innovation – and to find these game-changing industries and businesses before anyone else. The first formally recognised venture capital firm, the American Development and Research Company, found its first success in 1946 (at the beginning of the fourth wave of innovation) with a pioneer in minicomputers (an important step in the transition between room sized mainframes and today’s desktop). The first venture-backed startup produced semiconductors. Even software was once a risky, specialised proposition, with no clear path to profitability. But through this constant innovation VC has not only backed the breakout stars of each wave – from minicomputers to social networks – it has ensured its continued growth while the companies themselves eventually peaked, stagnated, and have been surpassed.

Furthermore, with seven of the ten largest global companies by market cap built with VCs (as of May 2022), it is clear that venture capital does not just stand to benefit from new innovation – it is a vital mechanism through which new innovations can quickly grow and succeed.

So is deeptech really the future of innovation, and how can venture capital best place itself to help these businesses turn innovation into real value and growth?

The Future of Innovation

Innovation is often characterised as taking place in waves, with a few innovations opening up a new frontier that suddenly grows rapidly, before eventually reaching its full potential (or close to) and tailing off in favour of the next big thing.

It’s never really possible to predict what the next wave of technological innovation will be – back when the internet was first being developed by a handful of organisations for the US military, its current ubiquity would have been unimaginable – but it broadly responds to a) a pressing need and b) a new scientific opportunity. The rise of automobiles could not have come before the industrial revolution, just as digitalization was only made possible by innovations in radio and telephone.

Luckily we don’t need to predict the next wave of innovation – it’s already started.

As you can see in the below visualisation, much of recent history can be broken into waves of innovation – with the progress made in each wave allowing the subsequent wave to accelerate faster and reach further.

So while it’s too early to predict exactly how large the next wave will be, judging by historical data, it should be larger, further reaching, and even more valuable than the previous one. AI, robots and cleantech are singled out as the era defining innovations, not only due to current strides being made, but also as recognition of the probable significance of these innovations. After all, every era is also full of less significant innovations, technologies with limited impact, and discoveries that don’t really go anywhere at all. For example, the third wave resulted in the widespread development and adoption of electricity and internal combustion engines, but also the mainstream production of zeppelins. We can now confidently say that some of these innovations have been more successful and significant than others, but it might have been harder to judge in 1900 at the beginning of the third wave.

So why do we think cleantech and deeptech will be the basis of our next era-defining innovations?

⚙️ There is an increasing amount of societal and environmental pressure to address climate change and find less harmful ways of acquiring and using resources

⚙️ We are seeing increased investment in cleantech and other ESG-friendly ventures

⚙️ Improvements in related technologies, from computer chips to batteries

⚙️ The rapidly reducing ROI of many forms of fossil fuel extraction, as easily accessible reserves are depleted (In 1912 Energy Return on Energy Invested or EROI was 1:100, in 1950 it was 1:50 and now it averages about 1:9)

⚙️ The growing consensus that many of our remaining challenges cannot be met with software alone, but will require advances in hard tech and infrastructure

So What Exactly Is Deep Tech?

‘Deep tech’ is a way of grouping tech businesses whose products tackle significant scientific or engineering research. These products:

• Require significant technical expertise to develop
• Leverage intellectual property (IP) in a way that provides a barrier to entry for potential competitors
• Usually require multiple advanced technologies. The Boston Consulting Group have identified 96% of deep tech businesses as using at least two technologies
• Often tackle larger societal trends or challenges. According to research done by BCG and Hello Tomorrow, 97% of deep tech businesses are tackling at least one UN Sustainability Development Goal. You can see their breakdown of UN goals below:

As the graphic demonstrates, businesses are tackling a large variety of causes, from industry and infrastructure to climate, clean energy and poverty. Actual use cases vary significantly, and this data was self-reported, but evidence of progress can be seen in many of the better understood categories. For example, we’ve seen businesses that can clean up their supply chain partly funding themselves with carbon credits, and a surge in cleantech investment supporting growing innovation within that industry.

This focus is not just societally important, but can be a real business advantage. Government action and public awareness surrounding climate change is at least partly responsible for the 47% surge in cleantech investment in H1 of 2022 shown on the graph below, with businesses and investors taking advantage of grants, research, and public goodwill. Overall, there are lots of factors suggesting the market timing might be just right for sustainable and ethical business.

Deep tech covers a wide array of industries, from pharmaceuticals, to satellites, AI and industrials. For an overview of some of the categories attracting the most investment, check out the below graphs from Angular Investments and Dealroom:

As you can see from Dealroom’s market map, lots of value is being generated by deeptech across many of the most lucrative industries, with each vertical able to address multiple industries. When compared with the graph from Angular Ventures, it also reveals that investment appetite in deeptech tends to be strongest where it overlaps with traditionally lucrative or popular industries – with deeptech investment in financial products, health and industrials far outstripping the other industries.

Breakout Stars and Market Leaders

Because deeptech businesses are found across so many different industries, it can be hard to get a good sense of how many businesses actually already exist, and of how much value the industry currently represents. Atomico reported that European deeptechs raised $20bn in the first three quarters of 2021, while tech.eu, who employ a stricter definition of deeptech, recorded €12 billion raised.

In 2021 US-based deeptech investor Karthee Madasamy, published some of the research his firm had done into unicorns in the deeptech sector, identifying $463bn of value over 120 businesses globally (excluding China). The market map they produced is not exhaustive, and was published with the caveat that they may have missed some, but it amply demonstrates the huge value already present in this growing category:

In the European tech ecosystem, Dealroom shows the 10 most valuable deeptech unicorns as of October 2022 as:

🦄 Celonis – a process mining company valued at €13bn

🦄 Northvolt – an electric vehicle battery manufacturer valued at €12bn

🦄 Improbable – metaverse gaming business valued at €3.4bn

🦄 CMR Surgical – medical robotics company valued at €3bn

🦄 Graphcore – AI microprocessors business valued at €2.4bn

🦄 OCSiAl Group – graphene nanotubes manufacturers valued at €2bn

🦄 Exotec – robotics and automation scaleup valued at €2bn

🦄 Volocopter – electric flying taxis valued at €1.7bn

🦄 Cognite – machine learning for business operations valued at €1.6bn

🦄 MindMaze – virtual reality interfaces for medical rehabilitation valued at €1.5bn

At the time of writing, the UK has the most deeptech unicorns in Europe, with five currently in its herd – Improbable, CMR Surgical, Graphcore, Newcleo and Tractable – with a combined valuation of approximately €11bn.

Deeptech is also responsible for a number of noteworthy acquisitions. The graphic below depicts UK deeptechs and the organisations which acquired them, such as DeepMind which was acquired by Google for a reported £400m in 2014, and WaveOptics which was acquired by Snapchat for over $500m in 2021.

However Europe generally is behind the rest of the world, with the US and China both possessing a significantly larger number of deeptech startups – and consequently breakout stars.

The Deep Tech Challenge

As deeptech spans such a large number of industries, it can be difficult to make generalisations across the category. However, most deep tech businesses do share a few significant uniting factors:

• Complexity – The product is complex and can take a great deal of time and money to bring to market
• Product development – The product (or process to create that product) does not already exist. Deep tech businesses use new and experimental technologies to create their product rather than repurposing or rebranding existing solutions
• Risk – Because the product is both highly technical and experimental, it can be difficult for anyone without this knowledge to accurately judge the viability of the business and the primary risk factor for the first few years will be technical risk
• Team makeup – The relative importance of technical expertise to develop a deep tech product reduces the probability of founding team members coming from commercial backgrounds

These characteristics are shared by nearly all deeptechs, regardless of industry, vertical, or sector. They are also the basis of most of the challenges unique to deeptech and deeptech investing – from organising funding for products which don’t fit traditional funding milestones to securing deal flow in an industry heavily run on academic – not business – networks.

Part two of this report will go into the problems faced by deeptech founders and investors in detail. It will lay out the primary challenges both parties face at every stage of the value chain, how investors and businesses are overcoming them, and our recommendations to solve these issues and accelerate the pace of deeptech innovation.

Final note

Deeptech startups and innovation represent an enormous opportunity to investors and to our society as whole. We have seen the enormous value and impact they have already created across the global ecosystem and particularly within the UK, but also deeptech’s incredible potential to do so much more.

At this point, it is impossible to predict exactly where deeptech will take us, but an analysis of the factors driving deeptech adoption reveals many areas ripe for serious innovation. Analysis of deeptech’s specific characteristics and challenges also reveals both how venture capital is perhaps uniquely positioned to support it, and how this will likely shape not just the future of deeptech, but the future of venture capital itself.

In a sector that spans so many industries, a robust understanding of the demands and risks of deeptech and how it fits into the larger venture ecosystem is integral to ensuring it can reach its full potential. It is only with a full understanding of deeptech’s unique challenges that we can ensure support and investment are efficient, equitable, and effective. That’s why in part two of this report, released in the coming weeks, we will be detailing the primary challenges facing deeptechs from each stage of the value chain, and our recommendations to founders, investors, institutions and policy-makers to accelerate growth and value creation and provide vital support.

Or if you’d like to be a part of our efforts to shed some light on the depths of the deeptech ecosystem and help more innovative businesses succeed, we’d love to hear from you. You can get in touch with us at [email protected]

Let’s scale more game-changing business. See you in part two.

Acknowledgements

With special thanks to the following individuals who shared their experiences with us…

• Christina Franzeskides for her perspectives from both sides of the table as both a deeptech VC at Lakestar and the co-founder of a neurotechnology startup
• Dave Neumann at Molten Ventures for his perspectives as an LP into other VCs funds
• Pete Hutton for his insights from investing in deep tech startups as an angel, working as a NED and as an ex-deeptech operator
• Rick Jingchun Hao at Speedinvest for his insights into deep tech investing and fund structures.
• Robin Dechant, founder of Kwest and previously at Point Nine Capital for his perspectives from the German market and his Future of Manufacturing industrial focus
• Simon Thorpe, a prominent player in Cambridge’s ecosystem and until recently Chair of Cambridge Angels for his insights on supporting more deep tech businesses from the early stage
• Zoë Reich from Octopus Ventures for her investing insights across multiple stages of a deeptech’s growth journey