One of the most disturbing revelations in The State of European Tech 2016 report published by Slush & Atomico was the clear decline in the graduation rate of Seed companies to Series A in recent years. Data sourced from Dealroom for this report showed that the rate had fallen from around 1 in 3 companies of 2009 vintage to 1 in 5 of 2013 vintage.
Dealroom’s March 2017 update highlighted that the number of companies raising Seed rounds has doubled in the last 5 years but the proportion of startups continuing to Series A has declined - again.
Recent data from Pitchbook (2Q 2017 Venture Report) also suggests this rate is under further pressure as the number of first financings (the first institutional investment in a company) has dropped off steeply during the past 2 years. Across Europe, just 343 first financings took place in 1H 2017, 47% fewer than during the first half of last year.
With such a high fallout rate, what can today’s Technology businesses do to improve their chances of funding success at Series A?
Understanding investor needs is vital
At Duet, much of our time is spent advising early stage companies. Since our first client engagement in 2010, we have helped young businesses raise over £50m and have worked closely with many startup CEOs and investors. Understanding how to positively influence the graduation rate from Seed to Series A is therefore of great importance to us as well as our clients.
Our experience is that only very few start-up CEOs are fully in tune with what investors are looking for at Series A, and are ready to deliver this at the point they make their investment pitches. These CEOs tend to be serial entrepreneurs who have been through the process before, have an investor following based on their previous exit(s) and have a well thought through funding strategy right from the start. By the time they are meeting Series A investors their investment proposition is hitting the right notes.
For many first time CEOs - who are understandably preoccupied with trying to assess the needs of their prospective customers and how they should be fulfilled - doing the same homework for their potential investors just isn’t a priority, until the company starts to run low on cash. Then it’s often too late to get the house fully in order.
Some investors, notably VC firms, try to help by publishing their investment requirements, although many early stage investors such as Corporate funds, Family Offices and other private investment vehicles are often not as forthcoming – some don’t even have websites. Whilst these investment requirements can sometimes be hard to come by, it is essential to learn as much as possible in advance. Perhaps more useful insights can often be found by looking at recent transactions that may be relevant to a company’s sector and stage.
Is your investment profile competitive?
At Duet we have developed the ability to efficiently research the thousands of early stage transactions that occur every year. This analysis enables us to create an aggregated view of what investment parameters are important across different Technology subsectors at each investment stage – in particular Series A – based on historical investment activity. We are then able to build an ‘ideal’ investment profile in each investment case and compare this to our client’s profile at the beginning of every engagement.
In the profiling exercise we assess four key areas that early stage investors will likely evaluate prior to investment: Stage, Opportunity, Capability and Scalability, and for each we drill down into the top investor questions. Stage covers the degree of maturity of the business, in particular relating to product development and commercial engagement. Opportunity covers not only the market potential for the Company but also the investment return potential for the investor. Capability centres on the talent and operational competency, and finally Scalability, as the name suggests, looks at the financial outlook and how the business is going to scale up.
This ‘gap analysis’ enables us to see what issues need to be addressed in the preparation stage, well before we start thinking about meeting investors. Later on it identifies where the strong matches are between the startup and prospective investors. This approach has lead to some great outcomes: we have funded companies that other advisors said were impossible to fund; syndicated deals involving multiple investor types (VCs, Corporates and Family Offices), and introduced new US investors into the UK.
Whatever methodology is used companies must, at the earliest possible stage, step back and consider how competitive their investment profile is. Getting investment ready takes time and often much longer than anticipated.
The funding plan should be part of the business plan
Successful startups - the 20% that make it to Series A - understand that capital raising is an ongoing process that needs to be an integral part of the business plan, where all the anticipated funding events through profitability are carefully aligned with the key company milestones. Given that the average time between funding events for an early stage business is around 18 months, this is a good time constant to build in.
Above all, CEOs need to start developing the funding strategy for each round well before the capital is required. Given that it typically takes 6 to 9 months to raise early stage rounds - from pitch readiness to money in the bank - starting the preparation phase at least 12 months before cash is required provides that critical extra time to get the house in order.
Remember, young businesses fail because they run out of time, not money.