VC investment in deep tech is on the rise. But how is deep tech defined? My favorite definition of deep tech is provided by Nathan Benaich (Founder and General Partner at Air Street Capital) ‘For a startup to earn the ‘deep tech’ label, there must be science or engineering risk in getting the idea to actually work and, assuming it does, risk in proving market demand for that product. If there is only one of these risks, but not both, then we’re not talking about a deep tech startup’ (Source). In other words, deep tech is fundamentally new science and engineering (Source).
But before going deeper into why deep tech is more relevant than ever, let’s go back in time. The VC ecosystem in the US is traced back to the founding of American Research and Development Corporation (‘ARDC’) in 1946, the first VC fund established in the US (Source). According to Hsu and Kenney (2004), during the first 5 years 66% of ARDC’s investments were focused on traditional industries (chemicals and industrial equipment). Post-1951 ARDC was investing in what we would call today ‘deep tech’ inventions. One of ARDC’s most successful investments is Digital Equipment, which IPO’d at $38M valuation in 1966 (ARDC had only invested $2M in 1957). Digital Equipment was acquired by Compaq (which later became Hewlett-Packard) in 1998 for $9.6B.
In Europe, the VC industry was developed in the 1990s, facilitated by the boom of high tech industries ‘thereby financing and nurturing a significant number of European companies at an early stage of their development’ (Source). Therefore, VC core focus (in Europe and the US) was deep tech, driven by significant developments in scientific and academic research.
As a result, both in US and Europe, deep tech goes back to the roots of venture capital.
Overall, the ‘low tech’ B2C market was developed in 2000-2010 when Facebook, Youtube and the likes started gaining significant traction and penetration in global population. Indicatively, in Europe alone the total VC investment in B2C start-ups escalated from $1B and 258 investments in 2011 to $7B and 1,012 investments in 2016 (Source). A similar trend is observed in B2B start-ups, a category where most ‘deep tech’ startups would fall into: $1B and 283 investments in 2011 to $5B and 1,192 investments in 2016. Thus, European VC investment in B2C has been greater than VC investment in B2B since 2012:
So, why has B2C become so popular among investors?
Going back to the definition of deep tech: startups defined as deep tech are inherently technologically and commercially risky. From a technology standpoint there is a long development time frame until a minimum viable product is reached (from securing IP protection to design and prototyping). From a commercial perspective, product-market fit and business model need to be validated prior to market entry. Upon market entry, the level of adoption by ‘innovators’ and ‘early adopters’ (diffusion of innovation theory) is the key indicator of commercial success.
B2B products appear much more attractive from an investment perspective. Technology risk is lower, technology development timeframes and product-market fit can be validated much faster compared to B2B deep tech. Although sales and marketing expenses can be excessive (as can be the case for R&D expenses in B2B deep tech), commercial risk may also be lower compared to B2B deep tech.
Given a VC fund’s goal to provide excess returns to its LPs both in terms of fund multiple and IRR, a B2C investment focus seems ideal.
So, what makes deep tech attractive for investors and why do deep tech VC funds even exist? Investing in disrupting technologies, although riskier and more time consuming than B2C solutions, can produce more ‘instant’ returns once they overcome technology risks and achieve validation of product-market fit. A deep tech startup may realize an exit event at the pre-revenue or low-revenue stage, once a strategic buyer recognizes that significant technological and/or commercial synergies can be achieved. Instead, B2C solutions, in most cases, should demonstrate exponential revenue growth before they are acquired or go public.
But the benefits of investing in deep tech go beyond generating VC returns. Nurturing ecosystems towards scientific and industrial progress with high-tech at their core, produces multiple socioeconomic benefits including increased employment, labor productivity, R&D productivity, innovation boost, and knowledge spillover. These effects, while not immediate, can be detrimental to the long-term survival of a startup ecosystem and thus, to domestic VCs that are constantly looking for high quality deal-flow in the long-term.
But the market (VCs and buyers) is already turning back to deep tech.
According to Atomico’s State of European tech report, in Europe, the number of B2B unicorns surpassed the number of B2C unicorns for the first time ever. The funding gap between the two groups is also widening. In 2017, for every $1 invested in B2C companies, B2B companies got $1.60; in 2023 (Source).
Given these past trends and the current normalized market, what does the future hold for deep tech?