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


Weekly Briefing Note for Founders

14th October 2021

This week on the startup to scaleup journey:
  • The rising appeal of 'passive' investors
  • Greasing the skids for your VC's investment memo
  • Building your narrative is a messy business
  • As deal count falls, how to capture investor attention?

1. Insights of the week

The rising appeal of 'passive' investors

Take one look at the investment market data for Q3 and it's clear once again that we are in uncharted waters. The landscape of VC is changing right before our eyes. This blockbuster funding year has seen $454B invested globally in the first three quarters, already way ahead of 2020's $332B. One data point really stands out: 64% of all capital raised was in rounds of $100M or more. These mega rounds have grown 97% year over year. It takes a particular kind of investor to write this size of cheque. As we have previously reported, giant growth funds are becoming more active in the VC space. Whilst primarily focussed on Later stage deals, they are gradually moving down into Early stage, threatening to displace established VC funds. As a result, VCs that previously viewed Series C as their entry point are now eyeing deals at Series A - the plan being to get a foothold on the cap table before the big growth funds arrive. Founders with strong investment propositions are having to quickly learn how to navigate these changing conditions. For some, there are big choices to be made: First, what kind of investor is going to be the right partner for the journey ahead: 'active' or 'passive'? Second, do we want investors who are stage specialists or multi-stage players?

VCs are by definition 'active' investors. They sit on boards and provide advice on company building. The new entrants with the big cheque books are mostly 'passive' investors - hedge funds, mutual funds, big family offices - often with a more public market history of investing, now coming into the private markets. The threat to the active investors is that passive investors have a proposition that founders are responding to. "Here's a cheque for $10M, call me when you need more." Part of the problem is that active investors have long oversold their value to founders. They claim to change outcomes, but then don't deliver. It's not often you hear a founder raving about the value-add that a VC brings to the business: The insights into resolving operational issues, guidance on strategic matters, connections to industry, a true sounding board they can trust. Top tier funds would perhaps dispute this broad characterisation, but there is much evidence that whilst founders would love to have more than money, they just don't get it. The passive investors see this opportunity and are increasingly emboldened to pursue founders who are looking for a 'no strings attached' type of offer. In the frothiness of the current market, it can sometimes only take one or two calls before a term sheet lands.

In the choice over stage specialists versus multi stage-players, there is a lot of debate occurring right now over who the right bedfellows are. This is a particularly hot topic at Seed. Those VCs that are 100% Seed focussed will claim what they bring to the table is much more relevant and practical than Series A fund managers that are trying to step down a level. There is something to be said for this. At Series A and beyond, commercial momentum is building and it's often about driving the unit economics hard. At Seed, none of these factors may yet be kicking in. The focus will heavily be on customer discovery or customer validation, i.e. finding product/market fit. This requires more nuanced thinking that isn't yet about scaling. Here, it is more likely founders will value the wisdom and insight of the specialists that bring deep understanding. But for multi-stage funds operating from Series A and all the way through the growth stages, this approach has huge appeal for founders. We are entering an era that with the right VC behind you, a founder can fund the entire journey through to exit with one primary shareholder. Some of the very biggest will remain shareholders even through the IPO and continue to buy shares in the public market. Heady times.

Greasing the skids for your VC's investment memo

When a VC loves your investment pitch and wants to progress to the next stage, this is a 'punch the air' moment for founders. But the journey is far from over. A VC partnership must build conviction before they issue a term sheet. In the current market, where competition for the hottest deals is intense and FOMO rules, some deals are being done in just a few weeks. But these are still exceptions. For the mainstream, the conviction building process can take several months. During this time, the partner 'sponsoring' your investment has a big internal selling job on their hands. To assist this process, the investment proposition is captured in an 'investment memo', written by this sponsor. Typically, a short form version is first presented at a Monday morning meeting to get initial resources allocated to start due diligence. Eventually, a long form version is then debated by the partnership before a term sheet is finally issued. 

Founders will never see these internal memos, for they reveal the true investment criteria and the investor's critical assessment. But founders can smooth the path for the creation of this document by helping the sponsoring partner access the information they need. Kai Cash is an investor at US VC, Primary Venture Partners. In a recent article he describes how he writes an investment memo. This explains the two primary ingredients of this pathfinding document. First, an assessment of the basic proposition. Unsurprisingly, this maps very closely to the main topics in any investor pitch: The market, competition, product, go to market plan, business model, team, and financial outlook. The second ingredient is the overall investment thesis. What is the fund's view on the potential return potential? What will boost this? What might hold it back? By having the company's key reference materials ready in the data room, the sponsoring partner's job can be made a lot easier. The latest market and competitive analysis, for example, can be of particular value. Having access to all the key charts and diagrams from the pitch, so they can easily dropped into the memo if required, can be an easy win.

Incorporated in the final investment memo will be a decision framework, often in the form of a scorecard that brings all these factors together, each with a rating. This will assess the elements that are under the company's control, as well as the bigger macro-market influences that are not. Pass a certain threshold on the scorecard and you will receive a term sheet. Fall below, and it's probably a 'no' or 'too early'. While each investment firm will have their own particular decision framework and scorecard, our insights from numerous transactions confirm that many have a great deal in common. To help founders look at their business from an investor's perspective, we have built a scorecard that is the aggregate view of these insights. This is used during Investment Analysis to provide a 'investor's eye view' of the proposition. By increasing their understanding of how VCs assess opportunities and develop investment memos, founders will better assist the conviction building process. Having a well stocked data room is a great place to start.

Building your narrative is a messy business

In the every early stages of creating a startup, experimentation loops provide essential feedback. You are testing ideas on people, using an MVP to solicit feedback from early adopters, engaging with different cohorts of users, and trying out different product features. Through a process of trial and error, sometimes many steps back for only a few steps forward, a repeatable formula emerges. A formula that enables a product to efficiently reach a market where there is clear demand and real opportunity to make money. This process may take years, but eventually you are ready to start early scaling. This is typically the moment of the Series A round. As you craft your investor pitch, you try hard to build a compelling narrative around the journey and where you are headed. But there is an issue. Some of the experiments that didn't work out so well have created a legacy that just doesn't align with this narrative. This may be customers you picked up along the way that don't really fit this future vision; early products that you would now like to kill, but need to support; revenues from these sources that bolster your top line but aren't representative of your future market opportunity. How do you factor all this into your story?

In VC Gil Gibner's latest blog, he talks about this 'messy reality' of the things that don't align. "My advice is to get out in front of these discrepancies. Own them. Wrap your narrative around them proactively."  The message is clear:  Don't make it sound as if everything has just fallen into place, as you will almost certainly get found out. Instead keep things straight and build a more realistic insight: “Our total ARR was technically $700K, but we’re really only counting $300K of true on-thesis ARR because $400K of it was really for a different use case from two big customers that don’t really represent where we are going.” Or even: “Our biggest customer is actually Acme Inc, but I really don’t like talking about them because I don’t think they represent our real business going forward. They found us, and we could easily meet their needs, but we are not pursuing customers with that profile.” Rather than confuse things, this openness helps an investor see how you have gradually built a single coherent story. You may be anxious that in stripping back these non-aligning items you may be left with little that does align! If that's the case, you are probably not ready to build an investment case.

Sometimes, even the best intentioned plans hit a roadblock. A pivot may be forced. Perhaps some form of financial restructuring may be necessary. If the bank balance is tumbling and fresh capital isn't in sight, 'clean' narrative building must be put on hold. Survival requires going where the money is - what can we sell and to whom? Live to fight another day. Even these off-piste moments become part of the story, and in some cases become an integral part of discovering where the true demand really is. As the narrative is then rebuilt, it will give shape and direction for the team. It will help set new priorities, organise and motivate people to find the Series A jumping off point once again. As Gibner adds: "As a company scales, the ability to control and shape a narrative only gets more important, not less. (If you doubt this, just read some IPO prospectuses.) Series A investors are not just judging the quality of a narrative — they are judging your ability to shape your narrative and communicate it effectively."

As deal count falls, how to capture investor attention?

We're in report season. Last week Crunchbase hit us with their global numbers for Q3 and this week CB Insights rolled out their State of Venture Report. Others will follow soon - and they all tell the same story. The unprecedented capital surge into global tech continues. The headlines for Q3 are eye-popping. Total global venture funding up 105% YoY at $158B. 409 deals over $100M. 127 new unicorns in the quarter, taking the total for the year so far to 848. The European figures are also remarkable: $72B invested in 2021 YTD, up 87% over the whole of 2020, even though the Q3 figures cooled to $24.2B from $27.8B in Q2. But while the absolute amounts are going off the charts, deal count is not keeping up. As a result the average global deal size across all stages is up at $25M (2021 YTD) versus $16M for 2020. Median deal sizes are now at $4M versus $3M a year ago. An astonishing fact is that the median valuation for late-stage deals in 2021 YTD is now at unicorn status, reaching $1.1B.

Startups that don't yet have the evidence of strong commercial traction may feel deflated. Watching Seed stage deal numbers fall, whilst later stage businesses vacuum up the lion's share of the bounty, just creates even more anxiety. Founders who are already straining every sinew to cross the chasm from 'experimentation' to 'company building' are having to fight ever harder to capture investor attention. The primary job of the CEO/founder has truly become that of 'chief persuader'. Having the initial insight, the product vision, the team building skills, the operational nous, is just not enough. Founders must now be master storytellers first and foremost. They must be able to weave a narrative where the opening gambit must be truly attention grabbing. And as we know, creating this narrative can be a messy business. But the end result must be utterly convincing. Every prop that accompanies this story (e.g. your pitch deck) must shine and look world class. These props are windows onto the professionalism of your approach, the standards that you set, and the culture you are building.

Only a few years ago, you may have been anxious about overhyping your story. In static or predictable businesses, modest projections have always been a wise move. But in today's environment, tech startups have licence to claim much loftier ambitions, especially on revenues. If they don't they may not catch the eye. Higher revenue multiples are already boosting valuations to record levels. At the Series A and B rounds, multiples of 100x or even 200-300x ARR have become regular occurrences. Whilst still rare overall, the spread in revenue multiples is widening. Companies with the same amount of revenue increasingly get wildly different valuations. This is the power of narrative, the ability to contextualise a snapshot of a company’s current performance and project real excitement about the future. Founders must master their stories and not be shy about painting a vivid and exciting picture for the future. Modesty will get you nowhere.

2. Other pieces really worth reading this week: 

The Playbook for Hiring the Right Marketer at the Right Time
In the First Round Review this week, some practical advice on the product marketing function by Maya Spivak. "With relatively few founders and CEOs coming from a marketing background, the org often remains a black box, particularly in the earliest days of a startup. There’s the hyper-focus on finding product/market fit, onboarding the first set of customers, and ironing out the kinks in the product to contend with — leaving marketing near the bottom of the to-do list. But plenty of startups then find that their launches are falling flat, there’s no way to get the word out without well-crafted content, and the initial website copy isn’t grabbing any eyeballs — potholes that a marketing hire can pave over."

Scaling to $100 Million
From the excellent Atlas blog of US VC Bessemer Venture Partners, a detailed playbook on scaling: "The definitive benchmarking report on how cloud companies grow operationally efficient businesses and scale to $100 million in ARR (and beyond)."

Schlep Blindness
A timeless essay from legendary VC, Paul Graham. "No one likes schleps, but hackers especially dislike them. Most hackers who start startups wish they could do it by just writing some clever software, putting it on a server somewhere, and watching the money roll in—without ever having to talk to users, or negotiate with other companies, or deal with other people's broken code. Maybe that's possible, but I haven't seen it."

Happy reading!

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