1. Insights of the week

European venture funding bucks global trend in Q1

After a blockbuster 2021 in VC, all eyes have been on 1Q 2022. Initial market data from CB Insights shows that global funding to startups reached $143.9B in 1Q22, down 19% from 4Q21 (but up 7% from 1Q21), making it the 4th largest quarter for funding on record. Deal activity was also down quarter on quarter, from 9,256 deals in 4Q21 to 8,835 in 1Q22.  Valuations overall have faired well. Companies raising new financing have gained a median valuation increase of 2.6x compared to their prior financing round. Early and mid-stage valuations continued to trend up strongly but late-stage valuations stalled. This drop in late-stage sentiment is directly related to the recent turmoil in public markets. As a result, we have seen a dramatic reduction in public exits: SPACs and IPOs decreased by 45% quarter on quarter in 1Q22. On a related note, mega-rounds - those rounds over $100M that have become the signature of late-stage category leaders - were down 30%, representing just over half of all venture dollars invested in the quarter. Despite the IPO collapse, M&A activity remained strong with 2,983 deals in total and this is still, by far, the most likely exit route for startups.

Europe was the 3rd largest region with $26.8B in investment across 1,863 deals, after the US ($71.2B across 3,261 deals) and Asia ($36.3B across 2,875 deals). This means 49% of all investment went to US-based startups, accounting for 37% of all global VC deals by number. But the big news is that European funding in 1Q22 increased compared to both 4Q21 ($22.3B) and the same quarter a year ago, 1Q21 ($20.2B). This means the first quarter represented the second highest on record after 2Q21. Deal count was flat compared to 4Q21 (1,874), reflecting a further uptick in average deal sizes. Median valuations also rose, seeing a 2x increase compared to the prior financing round.  Whilst European IPOs dropped in a similar fashion to other geographies, European M&A exits reached a quarterly record high in 1Q22 of 1,049 transactions. At a global level, US investors dominated the top 10 deals completed in the quarter. Tiger Global Management continued to be the most active investor in 1Q22, investing in 120 companies, up from 107 in 4Q21. Global Founders Capital (Germany) ranked 3rd with 77 deals.

The UK also seems to have bucked the global trend in 1Q22 as the total amount of funding ($9.2B) increased over both 4Q21 ($6.9B) and the same quarter a year ago, 1Q21 ($7.1B), making it an all time record quarter. The huge $1B Series D for Checkout.com, whose backers include heavyweight US investors Altimeter, Tiger Global, Coatue and Insight Partners, dominated the deal charts. In 2nd spot was the GoCardless Series G ($312M) and in 3rd place was Payfit's Series E ($289M). Deal count in the UK was 538 in 1Q22, up marginally over the prior quarter (495) and 1Q21 (511), pushing up average deal sizes once again. The UK represented 34% of total European venture funding in 1Q, with France at 18% and Germany at 11%. France also hit record highs in Q1 but in Germany funding plunged 52% to $2.9B. The largest deal in France was Qonto (Fintech) at $552M, again involving US funds Tiger and Insight amongst others. In Germany the largest deal was Forto (supply chain and logistics) at $250M. We'll have further analysis on the UK and European outlook in the coming weeks.

Doing things that don't scale

In the early days of a startup, founders are on a mission to build something that will scale. But pushing a product out into the market in the hope that people will beat a path to your door is rarely the path to success. The mission is more incremental. After the initial creation comes the experimentation phase and the beginning of the journey to product/market fit. In this formative stage the reality is that founders don't know (yet) if they are building something that will scale. This means high degrees of manual effort are required to find out what works (for customers). In Paul Graham's timeless essay on the subject he describes how many of the most successful YC startups began with founder-driven initiatives to prime the demand pump. A whole catalogue of unscalable startup hacks has since been crowdsourced, providing founders with almost endless inspiration in how to build initial momentum.

Peter Thiel's book Zero to One provides real insight into the unique challenges associated with these early steps. Technology is often the catalyst in going from '0 to 1' and it enables what Thiel calls 'vertical progress'—it encompasses something new and better. By contrast, globalisation is an example of 'horizontal progress'—it entails taking something that works in a particular place and replicating it everywhere. This is the '1 to 100' or scaling phase. The common misconception about this journey is that it is linear - that the whole process is gradual and that you transition through the phases only once. First, if it feels gradual then the process - to find product/market fit - probably isn't working. For the most successful startups, this take-off point is often exponential - demand simply soars. Second, the transition will happen multiple times as the business grows - each time a major new product or service is layered into the offering. Experienced founders know there must be a conscious return to the experimentation phase and a studious avoidance of the 'big launch' scenario.

Investors are hugely wary of startups - and even scaleups -  that use the tactics of the big launch to drive growth. So why do founders think launches matter? Graham says, it's a combination of solipsism and laziness. "They think what they're building is so great that everyone who hears about it will immediately sign up. Plus it would be so much less work if you could get users merely by broadcasting your existence, rather than recruiting them one at a time."  The antidote to this mindset is to focus once again on a cohort of initial users and then to make an extraordinary (non-scalable) effort to have them fall in love with the new product or service. This is especially critical when the growth strategy is to exploit an adjacent market and grow the TAM. This requires a deliberate return to '0 to 1' thinking, with founders driving first for 'vertical progress' before pushing out once more 'horizontally'.

The key drivers of category leadership

Ambitious startups set out to become 'category winners'. The reasons are clear. Research has shown that category winners typically take in more than 70% of the category’s economics, capture most of the category’s market value and attract the best talent – and certainly get the most attention. Think Salesforce in cloud CRM, Tesla in electric cars, or Netflix in streaming content. But to become a category winner, the new category must first be defined. It is built around a problem no one knew they had, or a problem no one knew they could solve. Just as a product or a company is 'designed', so too is the category. This trifecta of product, company and category then work intimately together to create the category leader. Each component is crucial. Whilst product and company design have historically been the focus of attention for founders, it's category design that most interests investors. In the simplest terms it is how you identify a unique problem and show the market you have the solution. And for top-tier VCs to really pay attention, the potential scale of the new category must be global and measured in $B's, even though it may start very small.

Why has category design become so vital in recent years? Experts say there are 4 key drivers: First, technology, such as the internet, cloud and mobile devices, has been removing barriers to everyone being able to get the best (or perceived best) of anything. Everyone can shop at the category-leading retailer, get the category-leading app, use a category-leading service – so they do. "The category winner, gets all the momentum and invests in staying the winner, while the rest shrivel". Second, the incredible power of network effects; i.e. every time a new user joins the network, they exponentially increase the value of that network for all the other users. The first to harness network effects typically becomes the category winner - think Facebook or Airbnb. Third, is data effects, where AI is trained by huge volumes of user and usage data. The more data that is leveraged, the greater the feedback and the better the product, which yields even more data. The AI/data flywheel spins faster and faster to create dominance. Google is a champion at running user activity through AI engines to better tune its products such as search results and driving directions. 

But the most profound and least obvious driver is what some term 'the end of marketing'. This is because a company or product is no longer what the company says it is – it’s what the public or its customers say it is. "Not many years ago, a company could blitz the world with a marketing campaign to shape perceptions. But today, those perceptions are shaped by people’s social media posts, tweets, online reviews, users’ YouTube videos and so on." Now customers (often unwittingly) drive a major share of a company's marketing effort. Companies use software to listen to social media and glean data from user activity to help the company know what’s going right or wrong with its products and its image. Again, the flywheel effect accelerates insight, product enhancements and user satisfaction at an ever increasing pace. Eventually, category leadership becomes self-perpetuating as more user voices drive this organic marketing. Cognitive biases then kick in and many people will justify choosing the category winner simply because it’s the category winner. As a result, the winner becomes hard to topple and further cements its category leadership.

2. Other pieces really worth reading this week: 

Sorry, Startups — Investors Won’t Sign Your NDA
From entrepreneur and angel investor, DC Palter, further insights into the difficult NDA question and how to protect your business without one. "Once in a while, particularly for a hard tech startup, investors need to analyze the technology to validate the company’s viability. This will usually be done for the VC by a consultant who will sign an NDA.The VC itself doesn’t need to know the secret sauce; they just need to know that there is a secret sauce that works. The NDA should only be required as the last step in the diligence process and only with the consultant doing the evaluation, not with the VC firm."

Follow on in Venture Capital - the Importance of Pro-Rata Rights
By GoingVC, an in-depth analysis of pro-rata rights and how they play a critical role in reserve allocation strategy for VC funds. "Follow-on allocation in venture capital portfolio construction is critical. Being able to “double down” on the “winners” in a portfolio is an important factor in the success of venture fund managers, especially those at the seed stage. This is why so many managers fight for pro-rata rights to maintain their ownership stake in a company."

Q1 consumer tech multiples down
VC Sammy Abdullah of Blossom Street Ventures provides regular insights into all sectors within the consumer tech market. Here are the latest revenue multiples for publicly traded consumer tech companies (B2C). On SaaS; "..comps continue to be historically strong, but fell 24% from last quarter. Of the 123 SaaS companies we follow, the average public SaaS business is trading at 12.9x revenue while the median is 9.3x."

Happy reading!