Duet Partners
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Weekly Briefing Note for Founders

13th April 2023

This week on the startup to scaleup journey:
  • European VC funding down 66% in Q1
  • Peer group analysis now vital to investment preparation
  • Sell the 'problem' before the 'solution'

European VC funding down 66% in Q1

European startups raised $10.6B in funding in Q1, down a whopping 66% year over year and 18% quarter over quarter, according to the latest Crunchbase data. This is a bleaker picture than the overall global figure, down 53% YoY and flat QoQ. European deal volumes also took a severe hit, down 44% YoY and down 22% QoQ, reaching their lowest level for the past 3 years. By comparison, global deal volumes were down 45% YoY and 15% QoQ. These reductions also reveal a dramatic and unexpected reduction of 25% by value at Seed stage as well as a marked pullback in cross-border investments by US funds. These are seismic changes demonstrating that tech industry is still reeling from 2022’s high interest rates and broader economic uncertainty. Founders are having to rethink their capital-raising plans with many now incubating strategies to put themselves in the U.S. market.

Late-stage funding has taken quite the beating these last few quarters. Funding in Q1 amounted to $4.3B, down 77% YoY and 26% QoQ. For those that raised big rounds at the peak in 2021, it’s still too hard to tell how much many of these companies are actually worth. That, coupled with fears of conducting a down round, has put funding in this space at a standstill. But it wasn't just late stage that suffered in Q1. The deep impact of the funding pullback has finally managed to ripple down to Seed-stage startups, which saw the biggest quarter-over-quarter hit. Funding dropped 43% YoY and 25% QoQ through Q1. Deal count also declined 28% from 4Q22. The Seed-stage drop could be read as a sign of worsening investor confidence, with venture firms prioritising portfolio companies that may need new funding down the line over new investments (however small they may be).

Early-stage funding was down 53% YoY but showed the most resilience through Q1, with only a 7% drop QoQ. Remarkably, more money was invested at Early stage in Q1 ($4.7B) than at Late stage ($4.3B). That’s a good indication that VCs are heavily prioritising investment in existing companies that are showing real promise as they move through Series A and B, even if they are not appreciably growing revenues yet. But as they grow, many are mindful that they’re likely to encounter some of the problems late-stage startups are now seeing in private market funding. As a result, European founders are looking to develop their networks and accelerate go-to-market strategies in the U.S., where venture funding is generally more abundant.

Peer group analysis now vital to investment preparation

With a slowing global economy, rising inflation, and geopolitical uncertainty, early-stage companies are pursuing a new type of growth. Not the 'growth at all costs' variety of recent years, but capital-efficient growth. This signals a rare alignment between private and public markets, where growth that delivers profits as well as maximising shareholder value is sought. In an unusual turn of events, private companies can suddenly learn much more from their public counterparts. McKinsey's recent study of the growth patterns and performance of the world’s 5,000 largest public companies over the past 15 years provides some unexpected insights for founders. Perhaps unsurprisingly, the research reaffirmed that revenue growth is a critical driver of corporate performance. An extra five percentage points of revenue per year correlates with an additional three to four percentage points of total shareholder returns (TSR) - the equivalent of increasing market capitalisation by 33 to 45 percent over a decade. More interestingly for startup founders, the findings identified ten imperatives or rules that should guide organisations seeking to outgrow and out-earn their peers.

In a more recent paper, McKinsey then demonstrated how each rule’s impact on performance varies considerably. “Don’t be a laggard” is the rule that emerged at the top of the ranking. Winning market share away from competitors is a sign of a superior business model, which investors tend to reward. As a result, such companies are 1.7 times more likely to generate peer-beating returns than those lagging behind their industries. McKinsey noted: "While faster growth typically correlates with better returns, we were surprised that outgrowing your peers matters so much more than simply being in a fast-growing market." Another related rule in the top half of the rankings - “put competitive advantage first” - confirms that having a clear source of competitive advantage is a prerequisite for profitable growth. "Companies with low returns need to transform their business models before investing in growth - otherwise, they might struggle to attract and deploy growth capital. Mastering this rule makes companies 1.3 times more likely to outperform their industries on shareholder returns."

Startups, as well as established businesses, are increasingly using business model innovation to create new categories in their quest for long term competitive advantage. Here the emphasis is on creating the first high-functioning 'flywheel', which is the combination of 1) a radical product/service innovation, plus 2) a breakthrough and repeatable business model, assisted by, 3) big data insights about future category demand. This is evidenced by an analysis of the Fortune 100 fastest-growing companies over the last decade. Of the roughly 600 unique companies across the 10 years analysed, companies with such a flywheel effect accounted for only 22% of the companies, but drove 52% of the revenue growth and 72% of the market cap growth. Like their public market counterparts, private investors are elevating the importance of a peer-group analysis when evaluating the business models of prospective investments. Forward-thinking founders are undertaking this for themselves during investment preparation to identify areas of potential weakness well in advance of the first investor meeting.

Sell the 'problem' before 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 to explain the very reason for the mission. Without deep customer insight and a true understanding of the problem we are solving, investors will rarely be convinced. Painting a picture of how much better the world will be when the business is successful then becomes the critical hook for further engagement. Without this emotional connection to the problem, 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 full problem/solution thesis - how our unique insights have helped us shape our solution and how we will deliver this to customers.

In our blog, The power of storytelling in the investor pitch, we describe the story arc: After you have set the scene, the next step -  known to film makers and novel writers as the 'Rising Action' - sets the story in motion. This is where the problems and challenges that must be overcome are described. Founder coach, Dave Bailey, calls this phase 'The Struggle'. He says: "If you race through the setup and struggle to get to the solution as quickly as possible, you’re making a mistake. It’s the struggle that really engages the audience, far more than the solution." This is easier said than done, so Bailey's tips on how to drive engagement are really useful: 1. Make the problem seem familiar: Just like comparing the characters to familiar people, you can compare the problem to something your audience is familiar with. This is why you have to do your homework on your investors — so you can use the information to relate to them. 2. Replace ‘I’ and ‘we’ with ‘you’: When you talk about your business, there’s a tendency to overuse the word ‘I’. A powerful technique is to replace ‘I’ with ‘you’. For example, compare the following sentences: ‘I saw this all the time.’ versus ‘You see this all the time.’ This makes your claim seem more credible.

Creating a sense of urgency also fosters engagement. 3. Use dialogue in the present tense: this makes people seem real - and people like to hear about other people. For example: ‘I knew I had to do something.’ versus ‘My board member looked straight at me and said, “Dave, you have to do something!”’ 4. Use specific details to bring your story - and the problem - to life. Compare ‘Customers take on average 2–3 hours to . . .’ versus  ‘James actually sat down with a stopwatch and measured how much time it took to . . . and it took him - an expert - 2 hours and 48 minutes.’ Specific metrics like this provide the strongest form of evidence. Numbers are also far more memorable than words. But even with these aids, founders sometimes shy away from describing the problem because they think it's obvious to the audience. But never make this assumption. Too often, founders get into the heart of their pitch only for the investor to then ask a really basic 'problem' question. Inexperienced founders will say of the investor afterwards, "They just didn't 'get it'." But the truth is that often the founder just didn't 'deliver it'.

Happy reading!

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