Cyber-security VCs are holding onto their cash – but that’s OK

Cybersecurity has never been hotter. Analysts say that $3.8 billion went into cybersecurity companies in 2015, a year which saw five private companies in the market reach more than $1 billion in valuations, and others – such as Rapid7, Sophos and Mimecast — filed for IPO.

The market’s rise has been impressive – CB Insights says that last year’s funding figure represented a 235 percent increase from the $1.1 billion ploughed into 166 deals in 2011. No surprise then that big firms like Intel Capital, Google Ventures and Qualcomm Ventures have become the sector’s most active investors, all eyeing up the next potential unicorn.

This explosion in funding hasn’t solely been confined with VCs, with the cybersecurity M&A market exploding in recent months. PwC reports that total deal activity since 2008 has exceeded $22 billion globally, with 451 Research noting that the number of security acquisitions has risen 41 percent in the last two years.

Most notably in 2015, Symantec gobbled up the Bain Capital-backed Blue Coat for $4.6 billion.

In many ways, none of this should come as any great surprise. After all, over the last three years we’ve seen a record number of data breaches, including some of the most notable such as OPM, Target, Sony and JP Morgan, some of which have resulted from the discovery of (and exploitation of) zero-days like Shellshock and Heartbleed.

All of the above may point to a booming cyber-security market, but this is not strictly the case.

Recent figures suggest that while funding does continue to flow to more established vendors, and promising start-ups, deals now take longer to piece together. Market consolidation is on its way and VCs, it appears, are not parting with their cash as easily they once were.

Does this mean that the big boom has stopped? And could that actually be a good thing for the market as a whole?

Funding slowdown

Cybersecurity has been on a rocket ride, but the record growth of 2015 is petering out. CBI says that cybersecurity deals peaked last year but slowed down in the first two quarters of this year.

But the market isn’t slowing down too much – CBI still expects funding for such companies to surpass $3 billion of investment, across more than 300 deals, by the end of 2016. This is admittedly below the level of the 2015 but still “well above” those figures reported for 2014.

But is this slowdown actually a good thing? Is this a sign of a maturing market, or perhaps or more considered, thought-out investments? Experts seem to be split.

William Altman, tech industry analyst at CB Insights

William Altman, tech industry analyst at CB Insights, explains that the slowdown is because VCs are essentially becoming more picky in who they invest in.

“The overall slowdown in funding is happening because VCs are becoming more discerning with their cybersecurity investments,” he tells CSO Online.

From 2012 to 2015 the rising number of high-profile attacks prompted cybersecurity spending across both government and corporations to increase, creating massive potential for start-ups promising “next-gen solutions.” Consequently, lots of new companies with overlapping products and services emerged — especially in endpoint protection — and VCs flooded the market with cash in anticipation of the windfalls.

Consequently, Altman says that VCs are now spending more time on due diligence and scrutinizing possible investments. He adds that they are looking for technology differentiation amid an over-saturated market of similar players, and admits there is now less appetite for single-solution vendors.

“VCs are holding out for companies that are merging to offer more unified-security platforms.”

Furthermore, he continues that early-stage companies that were funded in 2015 have since slipped below expectations, with their products quickly shown to be copies, obsolete or simply with revenues that “were not up to expectations.”

Jack Gold, principal analyst and founder at J. Gold Associates, agrees that VCs may have got swept away with market hype.

“Here’s the problem…if I as a VC find a nice cool company with a new twist on security and I invest in them, there’s a chance I will find six other companies doing the same thing in the same marketplace.

“There is an over-abundance of companies trying to get a different bite of the same security meal.”

Alex Van Someren, managing partner of the early stage funds at Amadeus Capital, believes though that the market will continue to grow.

“Cybersecurity remains a very active investment area which has no trouble overcoming any slowdown, perceived or real, in the general investment environment.

“[It] will continue to be a significant investment area for the foreseeable future, since it is a horizontal technology required by many vertical sectors.”

AI and IoT security drive new VC dollars

If, as Gold suggests, there is an over-supply of vendors competing for cash in this space, it would seem that the successful ones will tweak their products for an evolving threat landscape. After all, all companies must move with the times.

Sean Cunningham, managing director of Trident Capital, illustrated this perfectly when speaking to new site Third Certainty last month, saying that the cybersecurity world has moved on from prevention to detection and response.

“Cybersecurity is moving away from the era of building walls toward more flexible and proactive approaches,” he said. “This requires constant monitoring for breaches and vulnerabilities and remedial responses. So we’re seeing a wave of consolidation among cybersecurity companies of all sizes.”

The insatiable pace of new technology has not only caught the attention of existing security suppliers – eager to boost their IP and stockpile talent — it is also shaping the security firms of tomorrow.

CBI reports that established market sectors like enterprise data and network security still see big deals from VCs, such as the $130 million going to network monitoring firm LogicMonitor in June, but also highlights growing interest in predictive threat intelligence, smartphone security, the Internet of Things (IoT) and Big Data.

Some firms are already seeing significant deals in this area. Cylance, the predictive threat intelligence company which uses AI to predict, identify and stop malware, secured a $100 million series D investment in June, while UK-based Darktrace, which relies on machine learning, continues to source new investment from backers including Autonomy.

Last year there were mega rounds for threat intelligence outfit CrowdStrike ($100 million series C), Illumio ($100 million Series C) and endpoint specialists Tanium ($117.5 million Series G). Cloud security provider Skyhigh Networks, identity management specialists Centrify and cloud experts Ionic Security also received significant funding.

Analysts say there has also been investment in IoT, endpoint security, cloud, authentication and deception technology.

“IoT security and cloud security are both significant opportunity areas,” adds Van Someren. ”Behavioural security, including gamification of good practice such as email hygiene, is also important.”

Van Someren’s last point is interesting because it alludes to the age-old problem of the human becoming the weakest link. Enterprises have tried (and largely failed) to address this in-house, but now start-ups see this as an opportunity to grab market share.

Neill Gernon, founder of innovation agency Atrovate and organizer of London’s Cyber Startup Summit, tells CSO that recent conversations at his summit between enterprise, academia, investors and start-ups have been on fixing the human factor. And, pointing to the success of Paladin-backed social engineering company PhishMe, he said that start-ups are starting to take note.

“Companies have identified that people are the weakest link, but that also reflects on the innovation ecosystem and start-ups. We’ve seen start-ups starting to prioritize the area of people as the main vulnerability.”

Too much choice, legislation and VC inexperience hinder investment

There may be plenty of security companies and start-ups for investors to look at, but some VCs and analysts believe that this can make investing harder. Finding that ‘diamond in the rough’ is not without difficulty, and there’s the debate too (perhaps for another time) if security products are interoperable enough.

“Cybersecurity is a highly fragmented market and so many companies make niche products. The problem is that they don’t talk to one another,” said Cunningham. “A corporate CISO is forced to stitch together a number of different products. That’s inefficient. Increasingly, large enterprises want to buy platforms that can do more than one thing and also work with other products.

Menlo Security’s managing director Venky Ganesan added in the interview with Third Certainty that VC inexperience is also to blame.

“There are a ton of folks who are now starting to invest in cybersecurity who don’t have prior experience. This has resulted in a “Game of Clones” when it comes to each security sector. “This is not sustainable because we now have eight to 10 companies in each space and CISOs are experiencing PowerPoint fatigue.”

Gold believes that VCs are, as a result, stepping back.

“If I was a VC I would be very careful before investing in any security company. New technology companies can be very unproven and siloed. They have 10 seat case studies, but they need 10,000. They can’t become the next RSA or Symantec because that doesn’t happen overnight.”

CBI’s Altman also highlights the challenges of skills shortage (“VCs may have trouble funding early-stage companies composed of qualified veteran teams”), longer time to achieve ROI and finding companies that are different and offering comprehensive solutions.

Start-ups prosper with right support

Gernon believes there is more awareness of cybersecurity start-ups, accelerator programs and the infrastructure needed to support them.

“It’s healthy to see at lower level there is now structured mechanisms to put in place to enable more innovation in cybersecurity, like [cybersecurity accelerator] Mach 37 in the United States, and in the UK likes of CyLon, the accelerator. That can only be a good thing.”

He also suggests that more start-ups could come from universities, where some (including Dublin’s Trinity College) are pushing for cyber to play a more prominent role in computer science courses.

Gold though warned: “It’s a very mixed bag which is why at the RSA show, there are hundreds of companies, and if you go back two years later, there are hundreds more.”

“It’s a very difficult market to prove yourself in,” he said of start-ups, saying security chiefs would naturally be skeptical if their software is going to work.

“You can’t play around with it like a new smartphone. Small guys find it’s hard to scale and to differentiate messaging in a crowded marketplace.”

The future’s bright for cyber-security market

CBI’s Altman suggests that some of the top VCs in cybersecurity are on pace to participate in fewer deals with not much less money invested compared to 2015.

“There will be a persistent need for better solutions as high-profile attacks continue. Start-ups will still be the go-to-players for innovative tech in the space but they will be more scrutinized by investors for their effectiveness. 

“There will be less reliance on companies that build walls and block the bad guys from entering a network or system. Instead, attitudes will shift to account for the idea that everyone is hackable and likely already penetrated. So, valuable companies will be those that can leverage big data on threat intelligence, plus AI, and machine learning to help predict attacks, before they occur. Also, recent advancements in the field of quantum encryption mean that the few start-ups already operating in that field could also turn out to be highly valuable for securing sensitive communications.”

“In terms of investment — VCs are going to be interested in emerging market segments like cybersecurity for IoT/ IIoT, and looking for differentiated tech as well as more unified platforms.”