Slump in VC Spending on Cyber?

Venture capital funding in cybersecurity is cooling. And it’s show-me time for startups battling for the dwindling pool of funds. While the cybersecurity market is maturing, startups are still innovation drivers and venture capitalists are keen on finding the next big unicorns. Large enterprises’ tendency to juggle products from multiple vendors—despite their wishes for seamless, one-vendor-only solutions—leave the market perpetually fragmented. And the fact that cybersecurity threats are evergreen enables venture capitalists who specialize in the sector to operate with little regard for broader macroeconomic conditions. Still, the ample opportunities afforded by the fragmented, constantly shifting market have bred too many me-too companies and fast followers, driving some venture capitalists to pause and reflect on the next phase. “It’s definitely overfunded, massively so,” Ravi Viswanathan of New Enterprise Associates told a panel at CB Insights’ Future of Fintech Conference last year. After growing steadily since 2012, venture capital funding in cybersecurity dipped in 2016, alarming entrepreneurs. The cybersecurity market captured roughly $3.1 billion of venture funding in 2016, down from $3.8 billion a year earlier, according to research firm CB Insights.“You saw a material pause in the fourth quarter,” says Bob Ackerman, founder and managing director of Allegis Capital, which specializes in the sector. “You have too many undifferentiated companies. There’s a level of noise that develops as a result of that. … Cybersecurity is one of those areas where experience and domain knowledge matter a great deal.” See also: Quest for Reliable Cyber Security   The cybersecurity market will undergo a few years of retrenchment with a host of companies shutting down, VCs say. More judicious spending But the market is hardly mature. Money will still be spent, just more selectively. At this phase, fewer deals will be struck. But those deals will be reserved for larger companies, with proven products further along in development. “The deal size and valuation is coming down a bit,” says Sean Cunningham, managing director of Trident Capital Cybersecurity, which raised $300 million this month for a fund to invest in cybersecurity startups. “I don’t think there’s any shortage of capital for the right type of companies. But the dollars being invested are smaller.” Appthority is one of the companies that made Trident’s cut. Appthority, which develops mobile threat protection software for corporations, didn’t land its first paying customer until more than a year after it was founded in 2011. Four years later, its customer renewal rate stands at 98 percent, with about 20 percent of its revenue coming from the government sector. Heartened by solid proof of growth, venture capitalists poured in another $7 million in Series B funding last July, led by Trident Capital Cybersecurity. “You’re going to see a lot of startups out there, and good ones will rise to the top,” Cunningham says. “There’s ample supply of capital to fund them. They can get traction.” Innovation niches As seen in the early days of the internet, the cybersecurity market is recalibrating for a second wave of innovative technology that’s more comprehensive and cohesive. And that means more seamless products for large clients who are eager to cut down on the number of vendors. “Companies that can stand on their own two feet, deliver value, and have deep knowledge will do fine,” Ackerman says, citing one of the companies he’s invested in, EnVeil, which uses “homomorphic encryption” to secure data in operation. As more companies employ automation and “big data” to enhance efficiency and find new markets, data encryption products will continue to be in heavy demand. The emergence of the industrial internet—the integration of complex machines to network sensors and software—also will breed startups eager to provide cybersecurity solutions to power and water grids, refineries and pipelines. In May, Trident helped raise $6.6 million in Series A funding for Bayshore Networks, which develops cloud-based software that offers “visibility” into operational technology infrastructure, networks, machines and workers. Meanwhile, the proliferation of enterprise mobile devices will continue to see vulnerabilities and pose a ripe market for startups like Appthority, Cunningham says. Early investors haven’t gone away That VC dollars are chasing more evolved companies doesn’t mean early-stage investing is passé, Ackerman says. “That’s where the new things get started.” But cybersecurity, unlike more consumer-oriented technology sectors, is a competitive and difficult market, rife with startups struggling to recruit and market products. See also: Paradigm Shift on Cyber Security   That’s partly why Allegis funded DataTribe, a startup studio based in Fulton, Maryland. It was designed to tap into the wealth of cybersecurity-savvy technologists in the region with experience or ties to the federal government and intelligence agencies. Ackerman also anticipates more mergers and acquisitions activity from large cybersecurity companies that may find it easier to acquire smaller niche players as they seek to add new product lines. As venture capitalists squeeze their wallets, startups lucky enough to land Series A funding also will have to justify more vigorously their pursuit of Series B funding, Cunningham says. “And unicorns are in trouble,” he says, referring to startups valued at over $1 billion. The Trump factor Meanwhile, venture capitalists are hopeful that the federal government, with President Trump at the helm and promising a rollback in regulations, will cut steps in federal procurement and stay engaged in securing networks. “We think the administration understands the value of national cybersecurity,” Cunningham says. “We’re not counting on incremental increases in spending. But we’re excited about the awareness level.” This post originally appeared on ThirdCertainty. It was written by Roger Yu.