Duet Partners
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Weekly Briefing Note for Founders

10th June 2021

This week on the startup to scaleup journey:
  • VCs know more than you do
  • Beware PE masquerading as VC
  • 2021 valuations blowing away 2020 records
  • Sell the problem not the solution

1. Insights of the week

VCs know more than you do

As a founder you'll undertake a fundraising process every couple of years. You'll pitch your story to investors who will be reviewing 20+ pitches every week, often more. If all goes well, you'll then negotiate one of the most important documents of you business career, a Seed or Series A term sheet, with a VC that's issuing maybe 2 to 3 term sheets every month. You'll negotiate against a set of terms that incorporate decades of accumulated 'lore' from the VC industry. The headline terms - the valuation and quantum - may draw your attention, but it's the protective provisions towards the end of the offer document where the investor essentially establishes how the company will be run for years to come. Experienced investors know how the game unfolds through future rounds and all the potential scenarios they will want to control. This is carefully embedded in a set of what can look like arcane, boilerplate terms. These should be carefully scrutinised before accepting any offer - even if it's non-binding.

As legendary entrepreneur Mitch Kapor says: "Having information that the other side doesn't have gives VCs an advantage... they take advantage of entrepreneurs who haven't been through this before... they were totally willing to take advantage of us."  As a founder, you may also have little or no experience of the VC 'dance' and how to navigate such terms. You'll also be under time pressure to pin down the cash and keep your company on course. Investors rarely have such time pressure. For everything they say about being a long term partner, investors are not in the business of giving you a good deal. They are in the business of making money for themselves and their investors, the Limited Partners in the fund. To be able to truly negotiate investment terms, you must ensure competitive leverage to the point of being able to walk away. Then FOMO will kick in and you will finally get to see how far the VC will bend.

This may all sound pretty obvious. Yet all too often this approach is more a hope than a plan. Developing competitive leverage requires a funding strategy that is both well targeted and respectful of the roles that different types of investor will play, especially if syndicating. Who will be the cornerstone investor? Who will be the lead? Who will we then crowd in to fill out the round? This all takes time to pull off. Time to figure out the strategy, prepare the investment proposition, engage and solicit offers from multiple parties. This is an exercise that should start 9-12 months before the cash in required. Having a plan and the time to see it through diligently will give you a huge advantage against other startups competing for the same money. Once time becomes your enemy, you allow all the leverage to pass to the other side.

Beware PE masquerading as VC

Private Equity (PE) investors are muscling in on traditional VC territory at early stage. As we highlighted recently, VC firms have been leading a smaller percentage of deals as venture markets have become increasingly attractive to their bigger cousins. In 2011, PE & other alternative investors led 15% of all global rounds. In 1Q 2021 this rose to a remarkable 24%. Almost a quarter of global Series A and B rounds are now led by 'Growth' rather than 'Venture' investors. Founders that are soliciting PE investment for the first time must be switched on to the PE investing mindset, which can sometimes be at odds with traditional VC. This can lead to all manner of strange terms in the offer, many of which hail from a culture of debt finance rather than equity. Debt financing - including debt instruments dressed up as equity - can have a profound impact on the attractiveness of a business to future VC investors.

In some cases PE firms have set up their own VC funds, but the heritage of debt models can be seen seeping through into offers that can poison the well. This is often not clear until the term sheet arrives. Instead of vanilla equity terms, you will find an element of debt sitting alongside. This can be small in comparison and almost appear innocuous. For example, there will be a convertible loan element (often at a very high 'yield' or interest rate), plus a (steep) redemption premium, and even dividends on shares. These 'debt-like' returns will often have payment deferred until a later stage or most likely the exit, so appearing to dilute any short term impact. But don't forget that an exit can be precipitated by an early sale of the business if things aren't going well. All these payouts will be in addition to the more conventional liquidation preferences on equity. External 'debt' like this, as well as any conventional bank loans, will likely be a red rag to any future VC investor who will want to invest into a clean balance sheet.

Dealing with PE can also be less predictable than VC. Well known technology entrepreneur and investor Elad Gil says: "One PE group in particular is known for signing a term sheet, then three weeks later trying to renegotiate those terms (after the company has told other investors it has selected a lead and lost leverage on negotiation). This firm got kicked out of at least one “unicorn” round recently and is known as a bad choice. However, their shenanigans are not fully public, so tread carefully when dealing with PE firms." As the competition for the very best deals hots up, the practice of issuing a term sheet very quickly in the process to 'block' other investor discussions is increasing. Many VCs use this as a legitimate tactic, but with honest intentions - they fully expect to execute the deal subject to DD. But certain unscrupulous players will not follow through or look to dramatically change the terms at a later point. Key signs are the use of vague language to provide high degrees of wriggle room after signing, such as the rider "in line with industry norms" or "in line with standard practice". This is all too open to interpretation. Look for precise wording in the term sheet so there are no surprises later.

2021 valuations blowing away 2020 records

European valuation figures for 1Q21, just released by Pitchbook, show big increases over 2020. Despite all the uncertainty related to macroeconomic conditions, VC backed companies have generally shown remarkable resilience over the past 12 months. Technological disruption has been accelerated in many sectors, including food, retail, healthcare, and the relentless shift to the cloud. A flood of capital has poured into the VC ecosystem as a result. Nontraditional investors, seeing poor returns with other investment strategies, have been investing heavily in what has traditionally been VC territory. The case of PE funds aggressively pushing into late stage deals in particular is now becoming a common feature, as we highlight above.

Founders trying to make sense of valuations as they plan funding rounds are seeing a constantly moving target. For those at Seed stage, median pre-money valuations were €4.7M (c. £4M) in 1Q21. That's 39% higher than the record set in 2020! For early stage deals (Series A and B), we are seeing valuations close to those of late stage startups of five years ago. And at late stage, numbers have really taken off. In the UK, median late stage valuations in 1Q21 were up 81.7% on 2020. If the current pace is maintained through this year, we will see nearly double the record set in 2020.  Whilst deal sizes at all stages have tracked valuation increases, time between funding rounds has remained stable - around 18 to 20 months through early stage and around 14 months at late stage. This confirms that companies are developing at ever faster rates.

In developing strategies for 2021/22 funding rounds, founders have many factors to take into account. Foremost is the size of the market opportunity they are addressing. Bigger rounds and bigger valuations demand bigger exit outcomes. This is only possible if the TAM is there to support the growth story. Investment criteria at every stage are being elevated, not just due to round sizes, but investor mix. European VC deals with nontraditional investor participation reached €14.7B in 1Q21, looking well on course to blow away the record €33.6B in 2020. In addition to more active Corporate VC (CVC) investment activity through the earlier stages, PE firms, hedge funds, pension funds, sovereign wealth funds and investment banks are crowding in at late stages. Whilst interest rates stay low and alternative investment strategies remain lacklustre in comparison to VC returns, these trends are all set to continue.

Sell the problem not the solution

Solution fixation is one of the killer mistakes in any investor pitch. We become so excited about our product that we sometimes forget the mission. Without deep customer insight and a true understanding of the problem we are solving, investors will almost certainly switch off. Painting a picture of how much better the world will be when the business is successful is a critical hook. Without this emotional connection, whatever else we say will count for little. Steve Jobs himself once said: "You have to start with the customer experience and work backwards to the technology." Jobs understood that when you try to reverse-engineer the need statement from the product, it’s too easy to lose touch with reality. The foundation for any great pitch is therefore ensuring investor buy-in to the problem. With this in place we can confidently progress to the problem/solution thesis - how our unique insights have helped us shape our solution and how we will deliver this to customers.

Yet the reality is that for some tech companies, especially university spin outs and others that are pioneering new scientific discoveries, life often starts with 'the solution' - a breakthrough discovery, some unique IP, perhaps a patent and some special know-how. For these businesses, founders have a particular challenge in identifying the most lucrative way in which to commercialise the technology. This quickly becomes the most pressing priority because most investors now see capital efficiency as a key metric. A 5-year development cycle without any customer engagement isn't going to cut it. There is a rare breed of Deep Tech investors that will get turned on by the pure breakthrough potential alone, but this is an ever-decreasing pool of patient capital - particularly in Europe. Founders must therefore become a lot smarter (and quicker) at searching for the business model and presenting this progress in a compelling way, based on clear evidence.

The twist is of course that not all problems are created equal. Unless you're building a solution to a problem that is worth solving, you will still struggle to excite investors. Capturing the scale of the opportunity is therefore a critical aspect of business model discovery. How big a market can we reach? How fast might it grow? With emerging markets it's not the scale today that necessarily matters but the growth rate. This is a critical aspect to the pitch and needs to be delivered up front. Without the potential for real scale, downstream valuations will effectively be capped - as well as the pool of potential investors. Review your deck and check that you have identified a market that will ultimately be measured in $B's not $M's. If you can't sell the problem, you'll never sell the solution. 

2. Other pieces really worth reading this week: 

Customers Love Free Stuff ... But That’s Not Your Problem
From the pen of legendary VC Bill Gurley, a definitive essay on the underpricing of the IPO model and the superior alternative, the Direct Listing. "Across 2,908 VC-backed IPOs the first day underpricing (euphemistically referred to as a “pop”) is 28.3%. With the 7% banker fee that is a 35% AVERAGE cost of capital...for the past four decades, VC-backed companies have been exploited with 3X the underpricing of buyout-backed companies."

Designing A Better Chip: Venture Dollars Flood Into Semiconductor Space
By Chris Metinko in Crunchbase News, signs that semiconductor startups are back on the menu. "The global computer chip shortage is not just causing headaches for laptop and smartphone makers. It also appears to be pushing significant venture capital dollars into a space often shunned by investors fixated on the next big software play or social app."

China Investing Is Like Checking Into Hotel California
A really insightful interview with Hoover Institution Senior Fellow, Niall Ferguson, on Bloomberg News this week about the impending cold war between China and the US. He thinks that investing in China might have its opportunities, but warns that the capital controls make it like "Hotel California." For any startup with Chinese operations or looking for Chinese investment, this is really worth a listen.

Why a people person should be one of your first 10 hires
Ben Butler is head of talent at Evervault. Previously, he spent over 5 years at Stripe building out the Dublin and Seattle offices. This week in Sifted he writes about the importance of resourcing the hiring function from a very early stage. "Founders, imagine there’s a product that takes up to 50% of your time every week and, after AWS, is one of your largest expenses. Imagine that product is the infrastructure that you build everything on top of. Now, imagine not dedicating any headcount to that."

Happy reading!

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