Duet Partners
Tel: +44 (0) 20 7416 6630 / Email: partners@duetpartners.com


Weekly Briefing Note for Founders

10th December 2020

This week on the startup to scaleup journey:
  • European VC valuations in Q3 - the haves and the have nots
  • When should enterprise startups transition to top-down sales?
  • How VCs manage their deal pipelines
  • How long does a capital raise take?

1. Insights of the week

European VC valuations in Q3 - the haves and the have nots

VC valuations across all financing stages have powered on amid the COVID-19 crisis. According to Pitchbook, startups that have been able to demonstrate pandemic-proof revenue growth in tech-enabled sectors have enjoyed rising valuations, while traditional industries have struggled. Investors have pumped in capital to ensure select startups have the necessary funding earlier in their life cycles to compete in hotly contested markets. The increasing importance of healthcare and the acceleration towards a digital future have been major accelerants. Many flagship startups have completed huge rounds, with an increasing percentage of nontraditional investor participation, which is on course to set a new annual record in 2020. 

As the pandemic hit and the recession commenced, many thought that this would impact valuations across the board. In practice valuations have actually increased and it's deal volume that has been severely impacted. Whilst investors have not been deterred by early-stage startups that may carry negative cash flow profiles and require significant long-term backing during the pandemic, they have been far more choosy in which bets they place. After three successive quarters of decline in the number of transactions, Beauhurst expects deal numbers for 2020 to land somewhere between those of 2016 (1,607) and 2017 (1,856) by the end of the year. As a result average deal sizes are pacing much higher through Q3 2020 versus 2019.

Startups perceived as winners from the pandemic could continue to attract greater quantities of capital and accelerate their transition through financing stages. Developed startups that can demonstrate traction in a niche area and highlight operational synergies for strategic partners such as Corporate VCs (CVCs) have become increasingly popular. In contrast, startups unable to benefit from pandemic-induced disruption may find themselves postponing ambitious expansion plans and managing costs to ensure operations can continue, leading to slower growth and potentially longer time periods between financing stages. As a result, a reduction in quality deal flow is creating some anxiety for VCs, so those readying hot propositions for the New Year will be in great demand.

When should enterprise startups transition to top-down sales?
A product led growth strategy is an increasingly popular starting point for early-stage enterprise startups. Letting the product do the talking with the first wave of users is now a proven 'go to market' approach to drive early adoption in certain sectors. The likes of Dropbox, Github, SendGrid, Slack, Stripe, Twilio, Zendesk, and many others have used this method. But while a product-led innovation strategy certainly gives startups an advantage in winning initial users, it doesn’t fully unleash the market because enterprise-wide adoption often hits a wall without the approval of centralized, cross-functional decision-makers like executive leadership or procurement. At a certain point the introduction of top-down sales becomes a necessity and with it comes big implications for product development, cross functional collaboration, and operating costs. Experienced enterprise sales execs come at a price.

To accelerate growth many companies layer in a top-down sales model alongside the initial bottom-up user-driven model. A recent article by a16z provides real insight: Enterprise-wide deployment creates new users and use cases (especially among those not naturally early adopters); enables features across the broader organization that aren’t compelling at an individual level but are in aggregate (such as access control); and makes key features visible to different parts of the organization where they may be most relevant — particularly for IT, management, or larger group collaboration features. At Dropbox, usage data was critical for enterprise-level deal crafting, which started by identifying the top companies by current usage and the top 10 power users within each company. Only enterprise sales teams can expose, recognize, and create the market for the product in the whole enterprise. These can be long sales cycles, but the payoff is big-ticket multi-year deals that lock out competition.
The hot question is at what point do you add in top-down sales? Those that have successfully made the move will say there are two key conditions: (i) The bottom-up ‘flywheel of user adoption’ is working (end users love the product and will stop at nothing to get their hands on it), and (ii) customers are demanding a top-down solution (enterprise features such as improved security, nuanced access control, and enhanced transactional support become essential as user numbers grow). But the biggest challenge is created by moving too quickly - not having a base of strong user adoption to reference in the corporate sales process. Some startups, for example those targeting heavily regulated industries such as banks and insurance, may have little choice -  an enterprise level sell is often necessary right from the off. Quickly establishing the value of the use case is then critical to avoid the risk of early churn. But once this bridge is crossed the core offering will become embedded, providing a solid base for expansion.

How VCs manage their deal pipelines

Just like their investee companies, VCs have their own pipelines of prospective deals that they are constantly working on. In the current environment the funnel is very wide at the top and very narrow at the bottom, with several key stages or 'filters' in between. How companies progress through these stages is important for founders to understand. Whilst different investors will have their own take on how they filter, there seems to be a good deal of commonality. The top of the funnel captures investment opportunities from the VC's own outreach, direct inbound approaches, and introductions from other investors, founders, angels and advisors. By applying some basic filtering based on stage, sector, and business model, some will then pass through to the next stage, the face to face meeting. For example, one VC we know well (let's call them 'VCx') that has a Series A & B focus, will meet 1 in 10 companies that come into the top of the funnel.

The first face to face meeting is obviously crucial for both parties, as it reveals common ground and chemistry. This will be a combination of an objective view and an 'emotional buying decision'. VCx will then take 1 in 3 of these companies through to the next stage for initial due diligence (DD), where they will work on validating the opportunity and building up a more detailed picture of the business. This will primarily focus on commercial matters and will include a review of the financial model. At that stage an investor will usually know if this is going to be a fit or not. Once again, only 1 in 3 will progress to the next stage for more in depth DD with the intent being to make an offer. The CEO and selected members of the leadership team will usually be invited to meet the Investment Committee (IC) before a final decision is made. At VCx about half the companies that go through the IC then receive a Term Sheet (TS). Our general experience is that the IC pass rate is more like 75%.

VCs will not offer a Term Sheet lightly and they will want to convert all that they do into deals. The reality is that if the company has managed a competitive process they will hopefully have other offers on the table. In practice, VCx converts around 3 out of 5 Term Sheets into deals. A small VC (like VCx) may have 800 or more opportunities coming into the funnel every year, but a large, high profile fund may easily see 3x this amount. Whilst the numbers may vary, the consensus view is that VCs convert about 1% of their annual funnel into deals. A big swing factor is where the particular fund is in its life cycle - new funds tend to be more active. To progress successfully through the funnel, founders must make the VC's job as easy as possible and keep their appetite keen. This means first class preparation and providing the key validation information at the right points in the process. Some competitive tension will then work wonders to drive the final deal over the line. 


How long does a capital raise take?
This is the proverbial ‘piece of string’ question. As a fund-raising advisor it’s one of the questions we get asked the most. There are 3 main phases to plan for: Preparation, Pitching, and Closing. You should allow for a high degree of time elasticity in each phase. Conscious that some highly sought after startups are seeing a surge in interest from investors, our observation is that such 'deal chasing' is the exception. For the vast majority, founders must have their feet firmly on the ground when planning: Assume each phase will take between 2 and 3 months. So, all things being equal, you will need around 6 months if you are fully 'investment stage ready' at the beginning and every other step goes smoothly. But of course all things are rarely equal, so it is prudent - and in the current environment, necessary - to plan for up to 9 months. Why? To summarise each phase:

(1) Preparation: This is the moment to stand back and ask some critically important questions. In priority order; What is the prime investor audience given the sector, stage and business model? How are they going to assess my business? How will it stack up when they test it? What should the funding strategy be for this round? (For example: What contribution will existing investors make? Will I need to syndicate? What will be the funding period and the use of funds?) And taking all this into account, what is the story that I will tell? i.e. How will I now capture this narrative in my pitch deck and other investor materials?
(2) Pitching: This includes the outreach process, time spent on calls/meetings, chase ups and follow ups with investors, undertaking due diligence, and progressing your way through the investor funnel and Investment Committee to the point of a Term Sheet. When only 1% of an investor’s funnel converts into deals, it’s clear that you will have to play the numbers game. For a Seed stage investment, it’s not unusual to reach out to 60 or more investors. If you have been very proactive and have already warmed up some friendly investors, you may have less of a hill to climb.Then, finally;
(3) Closing. Reviewing/negotiating Term Sheets to a final selection. Moving from a Term Sheet to a set of legal documents that are agreed by all parties - existing investors as well as new investors - finally resulting in the transfer of funds.

Much is written about the pitching phase and this may explain why founders so often underestimate Preparation and Closing, so a few words on both. On Preparation, founders are not always in tune with the latest criteria associated with the next natural stage of investment, especially at the final Seed, Series A and B rounds. This is because the rationale for investment, especially in the current environment, is often less about making the transition to the next stage and more about not running out of money. Currently, with first financings at a new low, companies are requiring longer preparation phases to marshall the critical evidence of progress. On Closing you must remember that once you have signed a Term Sheet and you have gone ‘exclusive’ with a particular fund or syndicate, there is no longer any incentive for them to progress things quickly. You must have the patience - and cash runway - to stick it out through the legal toing and froing so you can end up pulling the best possible deal over the line.

2. Other pieces that are really worth reading/listening to this week: 

The State of European Tech
This year's report is out and is available here and a synopsis of the top 20 findings has been compiled by Sifted. As anticipated, 2020 is on track to hit a record level of investment. "Projections suggest that total investment could reach $41bn. The success of 2020 has been driven by the increase in $100M-250M “megarounds” — the top 10 largest rounds alone raised $4.1bn, equivalent to 16% of capital invested in Europe in the first nine months of 2020."

New strand of Innovate UK loan funding available
Innovate UK has new loan funding available for SMEs and third sector organisations that have been impacted by the Covid-19 pandemic and are facing a challenge in continuing, completing or following on from innovation activity. Details on all strands are here. "We have broadened our eligibility criteria and launched our Strand 3 competition which is now open to businesses who are continuing, completing or following on from innovation activity that has not been supported by an Innovate UK award in the last 36 months and require loan funding between £250,000 and £1.6 million."
Deadline for submission of applications to all 3 competitions is 13th January 2021.

APIs All the Way Down
A highly educational primer on the power of APIs by Packy McCormick. "Stripe x Shopify deepening their partnership led me down a deep rabbit hole on APIs, strategy in an API-first world, API-first business models, Factorio, and Twilio. It's APIs all the way down."

The Secret to Becoming a Market Leader
An excellent article in HBR that is as relevant to established businesses as it is to startups. "Winning companies aren’t led by customers. They target the customers they want, they then do as much as they can to satisfy those customers’ needs, and they don’t let themselves get distracted."

Individuals or Teams: Who’s the Better Customer for SaaS Products?
A must-read article for B2B SaaS business founders, by David Sacks on Substack. "In general, B2B SaaS companies should focus on Team plans, with their magical property of compounding revenue. Team plans build on a solid long-term foundation whereas Individual plans are the definition of a Leaky Bucket. In those cases where it makes sense to build the Individual plan first, try to find the use cases for sharing and collaboration as soon as you can. Teams are the ultimate destination."

Happy reading!

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