Weekly Briefing Note for Founders

17th February 2022

This week on the startup to scaleup journey:
  • Follow-on rounds less certain as VCs increase diligence
  • Moats that deliver long-term advantage for the startup
  • How to trigger the emotional buying decision

1. Insights of the week

Follow-on rounds less certain as VCs increase diligence

In each new round of funding, founders put most of their focus into securing new investors. Bringing fresh sources of capital to the table to drive growth and expansion is crucial. But existing investors can also have a vital role to play in ensuring a round comes together. Their involvement and enthusiasm sends a strong signal to the newcomers. Founders must therefore have a clear strategy for fostering maximum participation from existing investors. This requires that they not only have good relationships with those already on the cap table, but a realistic understanding of the ability of these existing funds to 'follow-on'. In an investment market where round sizes have been breaking all records, forcing many investors to reduce the number of companies they support though subsequent funding stages, ongoing participation cannot be taken for granted.

Founders that develop a keener awareness of the capital allocation strategies of their most influential investors will avoid unwelcome surprises. These strategies will vary greatly depending on the type and target stage of each investor. For example, a VC fund will operate under much more restrictive conditions than a Corporate Venture Capital (CVC) investor or a Family Office (FO). Whilst many CVC and FO funds are essentially 'evergreen', VC funds will have a fixed amount of capital to deploy over the typical 10-year life of the fund. During the initial investing period, usually the first 2-3 years, a portfolio of investments is constructed. For a seed stage VC, typically 30% of the overall fund is initially deployed to buy a seat at the table. At this point no-one has any real idea of the future fortunes of any portfolio company. This is high risk territory and many will not perform as expected. VCs will then limit the number of portfolio companies that can access the so-called 'reserve allocation' (the remaining 70%) in later rounds. Current market conditions are forcing some of these reductions to be dramatic.

As VCs allocate a larger proportion of their capital into a more concentrated cohort of emerging 'winners', deciding where not to double-down is now a bigger challenge. This means they are increasingly approaching follow-on deals with the mindset of a first-time investor. This requires deeper levels of diligence to build conviction the second or third time around. The result is that investment processes are becoming more arduous and are taking longer. Smart founders are therefore starting these internal 'campaigns' at a much earlier point. Socialising the latest story with all the main protagonists, before the more formal Investment Committee pitch, is key. Building this support takes time. Gone are the days when deals would have been waved through an IC meeting without the founder in attendance. And as we head back to in-person meetings rather than the more efficient (though far less personal) zoom calls, the pure logistics of all this also takes its toll. But with this internal investor support secured, founders will have a solid platform on which to build their new round.

Moats that deliver long-term advantage for the startup

Virtually every company is built on some kind of advantage: an entrepreneur uncovers an inefficiency in the market and then exploits it. But lasting companies are built on moats — on structural advantages that make it difficult for other companies to come in and repeat that same original discovery. This positioning is a core element of any investment proposition that promises long term defensibility and strong returns. Warren Buffett helped popularise the concept, saying a company’s moat (or lack thereof) means everything when deciding to invest in it: “The key… is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.” Interestingly, the moats of today mirror many of the foundational 'corporate' moats from the past, such as size and scale. But while the likes of Amazon and Google harness similar advantages as older generation businesses like General Electric and IBM, they have achieved it in a totally different way, right from the startup phase.

In the latest CB Insights report: "25 Business Moats That Helped Shaped The World's Most Massive Companies", we find many powerful examples of long term defensibility. These fit into one of 4 categories: Cost, Cultural, Resource, and Network Effects. Cost advantages are traditionally associated with economies of scale, but switching costs and sunk costs are also critical when trying to unseat products that have become deeply embedded in the customer's solution. A cultural moat is usually associated with intangible factors like brand and tradition, where customers are buying on factors other than price. Resource can be a key factor even for startups, especially in DeepTech hardware. Companies can leverage their pioneering internal expertise, patents, and/or legal protections to forge ahead unhindered, at least for a period of time. A product has a network effect when its value to its users increases in proportion to its use and the number of users using it. This is why investors seem to love network effects businesses above all others, due to this self perpetuating growth motion.

The unique feature of a network effect - unlike other defensibilities - is that it's native to the digital environment. These days a highly capital efficient software startup with a handful of employees can leverage network effects to dramatically scale its business. But network effects are not just cheaper to create and easier to harness than other defensibilities, they also improve retention. As new users join, they add more value to other users, increasing the overall rate of return to everyone else. For example, they have powered the growth of social networks, which are extremely sticky if all of your friends are on them — and useless if they’re not. Many different kinds of network effect exist, such as 'marketplace' (e.g. Amazon), 'data' (e.g. Google), and 'platform' (e.g. Apple iPhone - the OS and the ecosystem around it). And the better any product with network effects can optimise its cost of user acquisition, capitalise on high switching costs, and increase engagement, the more able it will be to maintain its user base and fend off competitors over the long haul.

How to trigger the emotional buying decision

When positioning your business to investors, customers, and even new hires, we know it's important to clearly convey WHAT the business does. We believe that if we don't quickly set out what we do, the audience might lose interest, get confused, or worse, become irritated that we aren't getting to the point. This desire to quickly paint a picture of where we fit is ingrained. If someone doesn't understand what we do, how could they possibly want to do business with us? But we also know that any rational buying decision is preceded by an emotional buying decision. We interpret this as people quickly falling in love with WHAT we do. But this is a fallacy. People don't initially buy WHAT you do, they buy WHY you do it. That provides the real inspiration for action. Investors consistently say they need this context and framing to "get excited". This is not just because they need to convince themselves – they also have to sell the founder's vision to their colleagues. They want them to feel the emotional connection too.

VCs say that one of the first questions they ask themselves in a pitch meeting is, "Why does this organisation exist?"  Founders sometimes confuse the WHY with the ultimate financial outcome they are striving for. But this particular WHY doesn't relate to generating revenues or making a profit. That's just the result. This WHY underpins the founder's motivation to act in the first place. In other words, the purpose, the cause, the belief. And this is the most powerful way a founder can convey their special insight. This is eloquently captured in Simon Sinek's excellent TED Talk where he says: "The goal is not to do business with everybody who needs what you have. The goal is to do business with people who believe what you believe." That's why great leaders start with the WHY, not the WHAT. The WHY is also the most powerful call to action - people are more likely to buy into your cause. Importantly though, they don't do it for you, they do it for themselves. As Sinke says, "That's why Martin Luther King gave the 'I have a dream' speech, not the 'I have a plan' speech."

This concept also applies to early customers. Startups looking to create or disrupt markets know that only certain types of users will be willing to adopt the first release of the product. The Diffusion of Innovation Theory calls these the 'innovators' and the 'early adopters'. They are unlike the 'early majority' or the 'late majority' as they are more willing to share the founder's belief. They don't need to see broad market acceptance of the product. They are going to decide based on instinctive gut feel. Similarly for key hires: Experienced founders know that those who are driven by money alone are risky bets. If a key exec doesn't fully share in the founder's vision, they will likely come loose during crunch times. The WHY provides a call to action again, this time the spur for a well-matched candidate to join the team. These emotional responses (to take action) come from deep within the limbic system of the brain, uniquely associated with our core behaviours and decision-making. By focusing on the WHY first we are more likely to trigger an emotional buying decision. In the aftermath of such decisions, people may not remember exactly what you said but they will remember how it made them feel: Great.

2. Other pieces really worth reading this week: 

Minsky Moments in Venture Capital
There has been endless analysis of boom and bust cycles that characterise public financial markets. But there’s been far less examination — in fact, there's almost none — of how such dynamics apply to private markets. In his latest essay, Abraham Thomas, former hedge fund manager and now Angel investor, provides an intriguing perspective on how the increasing velocity of VC deals has created an illusion of lower risk and why (at least for now) this is good news for all.

Lessons Learned from SOSV’s 400 DeepTech Investments
SOSV has backed over 400 DeepTech startups, out of the 1000+ companies in their portfolio. Founder and Managing Partner, Sean O’Sullivan, recently shared some of the lessons learned in an extended fireside side and Q&A session in Paris during the Hello Tomorrow deep tech conference in Paris. Some great insights here for DeepTech founders.

Collaborations between corporates and startups
Misconceptions abound about what corporations and start-ups should expect from their partnerships on innovation projects. Yet these collaborations are growing in importance as companies of all sizes try to rapidly respond to shifts in the marketplace. In this episode of McKinsey's Inside the Strategy Room podcast, leaders from McKinsey's Innovation Practice discuss ways to improve the odds of success of such partnerships.

Happy reading!

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