Duet Partners
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Weekly Briefing Note for Founders

13th May 2021

This week on the startup to scaleup journey:
  • April - another blockbuster month for VC
  • Making sense of record-breaking VC investment levels
  • Do early-stage VCs care about financial models?
  • The importance of market analysis

1. Insights of the week

April - another blockbuster month for VC

As we reported in our April 15th newsletter, 1Q 2021 VC investments broke all records. April followed suit. Venture capital and growth investors invested $48B globally last month, according to Crunchbase data, marking the second-highest month for investments in private companies following $54B invested in March. All funding stages saw an increase compared with a year ago: Late-stage funding more than doubled year over year; Seed-stage funding grew by a third; and Early-stage by 50%. On average, two new unicorns were created every working day in April, with half of these in the US. Big 'growth investors' including certain PE and Hedge funds continue to move down into VC territory to fuel super high growth companies.

New York hedge fund Tiger Global Management led 7 Series A & B deals in 1Q 2021, out of its total crop of 93 global investments. The firm was also the most active investor in April, investing in 32 companies. Over the past 4 months the fund has already exceeded its 2020 investment count. The global investment frenzy has been most marked with late-stage companies and then continues across into public markets. Three companies went public at valuations above $10 billion in April. San Francisco-based Coinbase, a cryptocurrency exchange, went public via a direct listing and was valued at $86 billion at the end of the closing day, making it one of the most highly valued venture-backed listings. New York-based robotic process automation company UiPath — founded in Bucharest, Romania — valued at $35.6 billion; and Palo Alto-based AppLovin, a mobile app company, which was valued at $28 billion. So far, 11 companies have debuted above $10 billion this year, compared to 13 companies for the whole of 2020.

Alongside record amounts of capital being deployed, investors are claiming that deal flow has increased both in quantity and quality: The pandemic accelerated the digital transition for industries in Europe, such as telemedicine, fitness and wellness, education, online shopping, events and many others. Founders are having to work harder to stand out from the crowd. Investment propositions must be thoroughly tested first, then targeted at well qualified investors to increase the chances of 'fit'. Every detail counts, including pitch decks that must look visually stunning as well as compelling. This is a fight for attention, with investors spending less time than ever scanning incoming proposals. Those founders who have invested time developing relationships with key investors well ahead of launching formal funding campaigns will have the edge, especially at the most challenging step, Series A. Those planning their first scale-up round for 2022 should be fostering relationships now and establishing a drum beat of positive news flow to create anticipation and mindshare.

Making sense of record-breaking VC investment levels

The momentum of VC, almost unshaken by the events of 2020 and now breaking all records in 2021, is a remarkable growth story. Hardly a day goes by without some startup crashing through the $1B valuation barrier. Often, companies are hitting $1B+ without any sign of profitability (think Clubhouse) and in some cases with barely any revenues (think Retool, a low code software platform, on only $10M of revenue). Over the past decade, Seed stage valuations are up 2.1x, Early Stage valuations up 3.7x, and Late Stage up by an incredible 5.3x, according to a recent analysis by Kenn So of US VC, Shasta Ventures. The VC community is not known for driving up valuations, as the bigger the valuation the greater the ticket size to hit their shareholding target. Then the additional risk that a fund may end up with too highly a concentrated portfolio increases. The answer - simply raise bigger funds so there is plenty to go around. This is exactly what is happening.

But what's behind this relentless surge in valuations? There's a mix of two compounding elements: scarcity and projected returns. Scarcity is all about demand exceeding supply. For example, in the US, the number of new businesses created has grown by 40% (810,000) since 2010. In the same period, the amount of capital available for startups has risen by 380%, hence a huge imbalance. On the returns side, the average IPO a decade ago was under $500M, today it's over $2B. By comparison M&A exits have doubled from $150M to $300M; still a 2x increase. The upshot is that 'cash on cash' (CoC) returns, the key measure of venture success, have boomed. On the M&A side, the chances of being acquired have reduced a little since 2010 but this has almost been made up by higher CoC returns when this happens. On the IPO side, whilst the changes of a successful IPO are much lower than an M&A event (1.5% versus 13.5%), the CoC return over the past decade has shot up from 100x to 240x according to So's analysis.

One of the key underlying factors in public market valuations, is the perception that software businesses of today are inherently lower risk than those businesses of 2010. They can scale much faster and achieve global reach with much lower cost structures. Bessemer's EMCLOUD index, which is composed of 61 of the best cloud software companies, is a good proxy of the software industry. Since mid-2013, the index grew by 1,000% versus just 274% for NASDAQ and 140% for S&P 500. In the same period, EMCLOUD revenue multiples quadrupled from 5x to over 20x. Because of these incredible metrics, the software phenomenon has gripped VC attention, especially at early stage. Hardware companies still have a voice, but now must have truly game-changing potential in huge global markets.

Do early-stage VCs care about financial models?

Just about all VCs will say they take financial forecasts with a pinch of salt. Founders misinterpret this as meaning that financial forecasts don't really matter. As a result, many startups don't put the effort into creating a proper financial model, or if they do, it's done as box-ticking exercise rather than a serious piece of investment preparation. The consequences can be severe. At Series A, not having a proper model will almost certainly be a showstopper. Even at Seed, you will likely get heavily marked down. So, what's going on here? Why are investors so keen on evaluating your model if they don't think your forecasts will ever materialise? In short, the financial model is hugely insightful to investors as it reveals how the founders think.

Creating a financial model requires the founders to translate their business model into numbers. That means all the key assumptions around revenues, costs and cash must be quantified. The important relationships and sensitivities between the P&L, balance sheet and cash flow forecast then become clear. This reveals key insights that investors care deeply about. These are typically macro-level issues to start, such as: Capital intensity; How much cash is needed before the businesses is self-sustaining? Economies of scale; Do margins increase healthily over time? Capital efficiency; Do revenues cost less to generate as the business grows? Cash burn; How quickly will the business run out of cash if you miss the revenue forecast by x%, y%, z%?  And most tellingly, what has to happen for this business to reach $100M in revenues? In other words, can this potentially be a $1B valuation business in say 5-7 years?

The act of gathering all these financial assumptions in a proper financial model also says a great deal about the rigour with which the founders approach the business - the attention to detail and the operational discipline that imbues investor confidence. This is not about being held to a specific number but about having a vision for a business that is economically viable and has real scaling potential. It also shows you are not trying to hide the past. Any good model will have at least 2 years of history so trends can be easily identified. The investment in time to create the model then pays dividends all the way down the line. It instils important habits for planning the business as it evolves, as well being a powerful fundraising tool. One that will be used many times over.

The importance of market analysis 

One of the most common gripes VCs have about assessing startups is the lack of proper market analysis. Too often, founders brush over this topic thinking that a well developed problem statement and estimate of market size will suffice, before majoring on the solution or product they are developing. Lack of good accessible data is often sighted as the reason or perhaps the founder hasn't worked in that industry before, so has limited first-hand knowledge. Neither of these are excuses. Contrary to popular belief, we now know that most founders don't have any directly relevant work experience in the industry they are disrupting. Founders must demonstrate resourcefulness in the ability to research, assess, quantify and segment the market they are addressing.

Calculating the Total Available Market (TAM) opportunity is critical as VCs will not invest in startups where there is not a sizeable market to go after. VCs will only fund companies that they believe have the potential to 'return the entire fund'. This is a very high bar to reach. In today's market, nearly all the major funds are on the hunt for unicorns - businesses that could be valued at $1B or more on exit. For a detailed walk through of investor return expectations see our recent blog on this topic. With this threshold met, the real work is then in the segmentation. There is no hard and fast method but the objective is to first identify your beachhead market - a segment that has the highest probability for you to demonstrate early traction and gain investor confidence based on hard evidence of demand.

The selection of the beachhead can be one of the hardest priority calls a founder has to make. Those that try and dodge this moment by hedging across multiple sectors may struggle to find the true beachhead before they run out of cash. In addition, investors will be incredibly wary if this choice is simply based on instinct, inbound traffic, or what large enterprises may say they want. Instead a methodical and iterative approach to winnow through different user or customer cohorts is seen as the most reliable. Initial factors such as customer size, location, sales cycle time, acquisition cost, and ability to pay, will all be key. There are no absolutes here and the criteria startups work with will vary and will certainly change over time. Thus begins the journey to product/market fit.  

2. Other pieces really worth reading this week: 

The future of marketplaces 2021
Marketplaces are outpacing Tech overall, according to a new report by Dealroom. The combined value of marketplace unicorns has climbed 70% since January 2020, outpacing the Nasdaq – which grew 50% during the same period. During the first three months of 2021, global VC investments in marketplaces reached an all-time high of $28bn. At the current pace, 2021 investment into marketplaces would more than double to $132B.

Building resilience as a hardware startup
Powerful insights in this article from Nils Mattisson, formerly at Apple, now CEO and Co-founder of Minut. "Looking back on our startup journey at Minut, I remember several moments when we could have died. However, surviving several near misses we learnt to tackle these challenges and have become more resilient over time. While there will never be one, fully exhaustive, answer, here are some of the lessons we learnt over the years..."

We don't interview Product Managers anymore
A great article by Brad Dunn, Chief Product Officer at Whispir: "Job interviews are mostly nonsense. According to Ron Friedman, a psychologist and author of “The Best places to work”, 80% of people lie during their interviews — so if that's the case, the information you’re hearing is likely fiction, or at best, inspired by real-world events. Instead, we audition product managers (and Designers too for that matter) in the same way actors are auditioned for a movie."

Startup learnings from great founders
Pages of inspiration in this classic book written back in 2009 but still potent today. The book studies the early days of some of the most celebrated founders with in-depth interviews. The sister book, European Founders at Work, was published 3 years later. Many of the founders interviewed are now well known VCs such as James Currier, Paul Graham, Tim Brady, Brent Hoberman, Jos White, and Saul Klein.

Happy reading!

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