Duet Partners
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Weekly Briefing Note for Founders

12th January 2023

This week on the startup to scaleup journey:
  • Founders digest global funding reset in 2022
  • Due Diligence is back
  • Value creation: Not all revenue is equal

Founders digest 2022 global funding reset

Venture and Growth investment in private companies dropped significantly in 2022, Crunchbase data confirms this week. Global venture funding in 2022 reached $445 billion, marking a 35% decline year over year from the $681 billion invested in 2021. As we reported last month, after a solid first half, the second half of 2022 ushered in a tighter funding environment and this hit deal volumes and valuations in equal measure. Funding in the fourth quarter was marginally below the third quarter, which had already declined significantly, particularly with late-stage financings. Fourth-quarter funding totalled $77 billion — down 6% quarter over quarter and 59% year over year — making it the lowest since the first quarter of 2020, when $70 billion was invested. Funding in North America was especially badly hit - down a whopping 63% - mostly due to the collapse at late stage.  But even with this much slower funding environment in 2022, investors spent $100 billion more last year than the $342 billion invested in 2020, and more than in any prior year.

As we alluded above, not every stage was impacted equally: Seed funding proved the most resilient. At $7 billion in Q4, it was down 15% from Q3 and down 35% year over year. At Early stage (typically Series A and B), funding totalled $31 billion in Q4, down 10% from Q3 and down 54% year over year. It is worth noting that Series B fundings were down by a greater percentage than Series A fundings through the second half of 2022. Late stage started to see significant pullback during the second quarter of 2022 and this continued through the year. For 4Q22, Late stage and Growth funding was $40 billion, down an eye-watering 64% year over year, due to public market proximity where tech stocks have taken a hammering through 2022. With a stalled IPO market, many startups are preferring to - or have little option but to - stay private longer even though capital flows and valuations into late-stage businesses have been badly hit. Those that raised in the heights of 2021 and may have skipped 2022 are almost certainly now looking at down rounds in 2023. That is the price of raising at the very top of a long bull market.

What does all this mean for founders looking out into 2023? The most obvious change is that proportionally more capital will find its way into Seed and Early stage as even the biggest investors shun Late-stage bets. VCs will use this move 'down market' to de-risk their portfolios because they don't know when the IPO market will open up. The silver lining is that this will help prop up valuations for those earlier stage businesses that are now coming to market. Deal count will continue to fall alongside a slower pace of investing as VCs take longer over due diligence. This feels like a return to pre-pandemic times when funding campaigns would typically take between 6 and 9 months to complete. The combination of fewer transactions will also drive larger deal sizes at early stage as VCs seek to deploy record amounts of dry powder, which grew yet again in the past quarter. This means a continued elevation in investment criteria especially at Seed and Series A. Founders looking to raise capital later in 2023 must now carefully evaluate their state of investment readiness as the competition for capital looks set to intensify further.

Due Diligence is back

Founders whose first capital-raising experience was in 2021 might wonder what due diligence (DD) really is. In those heady days of wild, FOMO-driven investment decisions, traditional DD simply became an obstacle for investors wanting to quickly jump onto the latest deal. Any thought of even a half-decent due diligence process could be enough to blow them out of a syndicate. As a result, even some of the biggest rounds barely included any meaningful dialogue between investor and founder. Each of the five funding rounds software startup Rippling closed on its way to an $11 billion valuation was conducted primarily through texting, says cofounder and CEO Parker Conrad, in a Forbes article. In other cases, some investors that were offering terms during the first (and only) CEO phone call, such as Tiger Global, may have at least undertaken some cursory due diligence in advance of this initial contact. But in terms of traditional, investor-led due diligence, this just seemed to evaporate.

But now everything has changed. Not just as a result of a venture market that has undergone a big reset, but from some calamitous investment decisions made by certain big VC firms on a string of fraudulent propositions such as FTX and Headspin (who raised $100M off fictitious financial statements). VCs are moving back swiftly to the playbooks they used in more 'normal' pre-pandemic times: Commercial, technical, financial and legal due diligence checklists have been dusted off. VCs now want to unpack the entire story and understand how the business model really operates. They want all the founder's key claims about the business to be evidenced. And why not? You want your key investors to have the full picture before they commit. If it takes until the third board meeting after the close for them to truly discover that all is not quite as it seemed pre-deal then, at the very least, all the trust is then shot. And in a 10-year relationship that you can't get out of, that's not what anyone wants right at the outset.

And there is another side to the DD coin. This is the DD that founders must undertake when they assess investors. Just as certain founders may be guilty of touting a very 'selective' picture of the investment proposition, so too will certain investors spin up their own pitch. One danger zone is in the micro funds arena, just above the individual high net worth investors but below the more recognized Seed funds. This could be a first-time fund manager looking to muscle in pre-emptively on a deal, maybe before they have even closed their own vehicle. Other red flag moments are investors trying to write cheques too quickly, perhaps shortcutting the most basic due diligence on your startup. If you can't find an investment track record or other founders that will take a reference-check call from you then be extra cautious. As investor Kyle Harrison says in his article, The Diligence That's Due,"If you're looking for ways to obscure details, and tell the best picture, then you're going to get an investor who gravitates towards obscured details, and rosy pictures." Not really a recipe for a long-term partnership.

Value creation: Not all revenue is equal

It's long been argued that 'discounted cash flow' (DCF) should be the true measure of equity value. But this is a complex equation that relies on a huge number of disparate future variables. In startup land many of these are simply not yet known. Investors and companies may be tempted to use shortcuts such as Price/Earnings (P/E) ratio or Price/Revenue multiple as a guide. But in a world of rapidly evolving business models, such simple metrics can vary radically. They certainly don't explain the wildly different valuations that supposedly similar companies carry. Our own exposure to the approaches used by some VCs at early stage tells us two things: The biggest determinant of valuation during an investment round is how competitive the round is. If several big VCs are fighting over you (FOMO), then you are going to drive a premium valuation. But in the mainstream, where most startups live, the answer depends heavily on revenue quality.

Whilst the proprietary valuation models that VCs build as a proxy for DCF will vary considerably, they will nearly all incorporate this key ingredient. Founders should therefore focus on the factors that determine revenue quality. The greater the revenue quality the higher the valuation. Legendary VC, Bill Gurley, wrote one of the most commanding essays on this topic a few years back. What we learn from Gurley's analysis is that some of these 'revenue quality' factors are significantly more important than others. ‘Sustainable competitive advantage’ (Warren Buffet's 'Moat') ranks most highly and this is why strong network effects (e.g., 'customers recruiting customers') are so prized. Other desirable attributes are high organic demand (lower marketing spend), low capital intensity, good revenue predictability and visibility (e.g., SaaS/subscription wins big here); increasing marginal profitability (easy scaling with improving margins); low customer concentration (few eggs in one basket); and low partner dependency (as we highlighted in Partnerships don't work).

David Peterson at Angular Ventures recently added a further perspective to Gurley's analysis. He says that the 'value' of revenue changes as the startup progresses. He recommends that founders think about the early stage of their company as having two distinct phases: finding product-market fit and finding go-to-market fit. During the first phase, the goal is to build a sticky product that solves a real problem. "Charge enough to learn what you need to learn (e.g. will people pay for your product), but don’t try to maximize your value capture." In other words don't focus on revenue growth per se before you know you have product-market fit. This is a classic premature scaling mistake. Only in the second phase should the the goal shift to iterating on the go-to-market motion and proving that the business can grow. Then you can scale with all haste.

Happy reading!

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