1. News & Insights

2Q 2020 European investment data shows risk appetite slowly returning

The latest Dealroom report into investing activity across Europe is out. The headlines are:

For the first 6 months of 2020, European startups raised €15.8 billion, down 21% versus the same period last year. Surprisingly, the number of rounds is almost the same as last year. 

The quarterly data is the most revealing. Venture capital investment in Europe reached €8.1 billion in Q2 2020. This is up 5% compared to the previous quarter although down 27% from Q2 2019. In 2Q20, the UK was down almost 31% to €2.7B compared to 2Q19 (€3.9B) as Covid started to bite.

Across Europe, the biggest sectors in 2Q20 were Health Tech, Fintech and Enterprise Software (SaaS) taking a combined €4.7B out of the total €8.1B.

The most eye-catching insight relates to the new European VC funds raised in 1H20, which hit an all time record in terms of capital raised at €9.2B. This means there’s more dry powder than ever ready to be deployed into European startups in the rest of 2020 and beyond. This is now a buyers' market more than ever, with a tightening of terms as we highlight below.

All the charts are in the Dealroom blog.

 

Europe VCs are active again - but a great deal has changed

In a recent survey of 107 European investors by Chausson Finance, activity levels are resuming after a torrid March and April. Whilst we still need to be careful about taking any data points from VCs at face value, the overall sentiment is improving. However, the bar has definitely been raised:

At the first founder/investor meeting, 51% of investors have changed their way to assess required qualities of founders. The key attributes most tested are now resilience and agility.

There is an increasing focus on revenue momentum and 40% agreed that 2 consecutive months of restored growth is enough, even after some setback months.

During early due diligence, 49% have changed the way they assess unit economics, with a major emphasis now on earlier profitability and more controlled cash burn. Growth (at all costs) has been demoted as we have been observing in recent weeks (see next topic).

At the point of offer, 50% have changed their term sheet standards during the crisis and there is a trend towards milestone based tranched equity rounds, an increasing use of convertible notes (CLNs), and then other sticky terms such as more punitive ratchets and liquidation preferences.

As Rob Niaz commented in his Forbes article on the subject of tranched rounds: "This has perverse effects on companies as even when a round is closed, founders still must worry about hitting milestones to actually receive the full capital, which can then create a downwards spiral of making suboptimal short term choices at the expense of longer term value-generating investment. For example, founders may choose to cut burn by deferring key leadership hires that over time would produce outsided value to the company. This is unfortunate and certainly a negative trend to see in Europe compared to the U.S. where tranched rounds are far less common in most fundraisings."

 

No longer 'Growth at all costs' - what does this mean for SaaS businesses?

SaaS investors are rethinking many of the key metrics used to assess prospective investments - especially in enterprise software. Finally, some would say, we are back to measuring the real efficiencies in the underlying business rather than the fluff.

This week we had an insight into the thinking of Notion Capital, one of the most prolific early stage (late Seed/Series A) SaaS VCs in the UK. They have developed a simple dashboard to link INPUTS to OUTPUTS - what goes 'into' a business (Funding, Customers, People, Product...) and what comes 'out' (Revenues/ARR, Runway, Payback, Margins..). General Partner Jos White has penned a useful article in their blog to describe this revised approach and this is required reading for any SaaS founder.

To hear an early stage VC talk so passionately about profitability is refreshing. "Looking at the EBITDA margin, most venture-backed SaaS companies will be loss making but there’s much more focus now on when the company plans to be EBITDA positive. Investors will no longer be comfortable seeing this projected in several years time like a dot on the horizon. The rule of 40 does a good job of tethering your growth to profitability. It is calculated by adding your growth to your EBITDA margin which should come out to in the region of 40. So if you’re growing by 100% a year your EBITDA margin should be no less than -60% for the business model to make sense in terms of balance and sustainability."

 

What do Limited Partners (LPs) look for in VCs?

As we know VCs need to raise money too. They don't talk about this aspect of their business much and guard their insights carefully. How they do it - or more importantly how they are assessed by their own investors or LPs - can give a real insight into the VC mindset. Just as VCs will 'scorecard' a startup, so LPs will do the same for VCs. So if we were a fly on the wall, what would we see on the LP scorecard?

Ha Duong, Principal at Cambrial Capital in Berlin, has provided a fascinating insight through his 3-part series of recent articles that look at the money behind the money. He looks at understanding the concept of 'edge' in venture capital - the difference that makes a fund deliver above-average returns, known in the trade as 'alpha'.

Part one, Informational Edge, discusses the importance of insight. It starts with preferential deal flow and how VCs really develop 'signalling' strategies for sector and stage positioning. Proprietary insights gained from being on the 'inside' of a market through their portfolio companies is also crucial. This leads to a 'virtuous information cycle' that delivers premium deal flow. A further study worth treading from Yale on VC firms confirms “that the success rates of top firms flow from access to the best startups that is not available to newer or less prestigious firms.”Part one in full is here.

Part two, Analytical And Behavioral Edge, discusses how VCs find real insight. Analytical edge can be defined as the ability to extract better or more insights from information by processing it differently or better.  A VC with an analytical edge is able to define the right hypotheses for an investment, identify the relevant risks and determine the related milestones to mitigate those risks until the next financing round. This is part of an evidence based approach that depends on Stage and Sector. This links closely with Duet's own Investment Analysis methodology. Part two is here.

Part three, Structural Edge, suggests that besides having superior information, analyses and rational decision-making ability, VCs can also have a structural or strategic edge that puts them in a better position relative to their peers. Key considerations are size of the fund (how big their expenses bill can be) and how this can be leveraged to provide additional services, not just cash. Just as important is securing a high-quality LP base that deeply understands venture and the longevity of this asset class. This is something we struggle with in Europe outside the big funds, where the pressure for returns is driven by short-termism. Part three in full is here.


 

2. Other pieces that are really worth reading this week, all on the future role of the office: 

Startups are drifting away from offices, post Covid-19
Early-stage startups are confident of re-opening their offices in the wake of the COVID-19 within the next six months. But there will be changes according to TechCrunch.An exclusive survey compiled by Founders Forum with TechCrunch, found 63% of those surveyed said they would only re-open in either 1-3 months or 3-6 months — even if the government advises that it is safe to do so before then. A minority have re-opened their offices, while 10% have closed their office permanently. The full survey results can be found here.

How Remote Work Could Destroy Silicon Valley (& other Tech hubs)
A piece by Steve LeVine in Medium offering a glimpse into how the Valley has been impacted by Covid-19. The tech industry is built on serendipity, but chance encounters are no longer happening.
 

Reimagining the office and work life after COVID-19
An article by McKinsey that assesses changing attitudes on the role of the office and 4 steps to reimagine work and workplaces. The pandemic has forced the adoption of new ways of working. Organizations must reimagine their work and the role of offices in creating safe, productive, and enjoyable jobs and lives for employees.
 

How to Keep Your Team Motivated, Remotely
An excellent piece of research by HBR: How do you motivate people who work from home? Though the academic research on remote productivity is mixed, with some saying it declines while others promise it increases, our research suggests that your success will depend on how you do it.
 

How to do remote work right, from the teams that know it best
A review of remote office best practice in Extra Crunch, based on a series of in-depth interviews with the founders of GitLab, Doist, Zapier, Mattermost, FlexJobs and YouNeedABudget. 

Happy reading!