Duet Partners
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Weekly Briefing Note for Founders

19th May 2022

This week on the startup to scaleup journey:
  • The funding outlook is changing for startups
  • European VC valuations stay resilient - for now
  • Founders battling changes in macro-market conditions

The funding outlook is changing for startups

Last week we highlighted how investment momentum in Europe is slowing. In the light of recent public market valuation corrections, a reset in private markets was inevitable. We have characterised the slowdown thus far as a 'dip' rather than a huge drop, but it confirms that the market has firmly shifted away from the record-setting peaks of 2021 when global funding doubled compared to 2020. Unsurprisingly, slowing April investment activity and depressed global valuations have raised anxiety levels amongst founders, especially those looking to undertake funding rounds over the coming months. Investors too are trying to take stock as a period of tech exuberance sees a reversion to the mean. VCs are in 'portfolio triage' mode. Many firms over-deployed (too much capital, too quickly, at too high prices) and now says one respected US VC "they’re scrambling to monitor portfolio companies’ replanning efforts, determining where reserves will be needed, and pushing some companies for a sale."

Many late-stage companies will need to execute perfectly and conserve cash in hopes of having a chance to raise a “back to reality round”, which will be significantly down or flat, at best. Many of the big international growth stage investors (Series B, C, ..) have hit the pause button for now as they try to find the new normal for pricing. We are currently seeing late-stage valuations take a real hit in the US as we reported last week and there are cracks appearing in Europe as we highlight below. For those having to close deals right now, "..perfection is critical. Have your metrics and story in order, don’t miss a quarterly sales target mid-VC conversation, and be realistic about what public market multiples have done to valuations." At early stage, many companies may be "broken with too much money", too high a valuation, and a roadmap where 'normal' funding stage expectations are now far out of alignment with reality. This is where we are seeing the most rapid shift back to robust diligence by investors on a more conventional range of investment criteria, especially for early scale-up rounds.

The Seed to Series A transition is under particular scrutiny following a period of heavily FOMO-driven rounds. VC Jonathan Lehr, summed it up this week when referring to Seed stage companies that raised hefty Series A amounts at inflated valuations: "you can’t buy product market fit and those that didn’t properly define it from the start will struggle".  So too those that didn't have their go to market strategy or business model fleshed out - neither of which can be fully cemented until the true pull of early demand can be felt. The return to such solid fundamentals is even more profound for founders than the Series A valuation 'correction', which in the US during 1Q22 was 25%. As Seed stage rounds are the least impacted at present, many founders are evaluating whether a further 'interim' Seed round could be a smart move, providing additional time to improve the chances of a more successful Series A round a little later down the line. The next 12-24 months will be a testing time for even the best companies. Those startups that are now adjusting their expectations to align with a more constrained funding environment in 2022/3 will be best placed to stay the course.

European VC valuations stay resilient - for now

In the face of an increasingly turbulent macro-economic outlook, European valuations remained remarkably resilient in 1Q22, according to Pitchbook. Overall, valuations maintained their upward trajectory from a record 2021. The median Angel & Seed pre-money valuation reached €4.4M and €5.5M, both exceeding the records set in 2021. The median Angel deal size was €0.7M, 33.6% higher than 2021’s figure. Meanwhile, the median deal size at Seed was €1.8M, 39.4% above 2021 data. Early-stage VC valuations for 1Q22 were also above 2021’s figures, with the median reaching €9.4M. Early-stage deal sizes were also bigger in Q1 2022, with the median hitting €2.9M, 43.2% higher than 2021. The median Late-stage valuation increased 6.5% and reached €19.4M through 1Q22, with the median deal size reaching €7.2M, 43.3% larger than the figure in 2021. Overall, only 14.9% of rounds were completed with a cut in valuation, slightly below last year's figure of 15%.

These figures stand in very sharp contrast to the US market, where valuations at all stages have taken a real haircut in 1Q22 as we reported last week. Even in the UK, which could be argued has the greatest affiliation with the US market, valuations have stayed resilient - at least through the first quarter. At €4.7M the median Angel & Seed valuation trended above the records set in 2021. So too at Early-stage with a median valuation of €7.8M, 28.7% higher than 2021 with a median deal size of €2.1M, slightly above €1.9M for the prior year. But the median Late-stage valuation dropped to €14.8M, down from €16.1M in 2021 and perhaps this is the first indication of downward pressures looming. In the round, recent interest rate hikes by the Bank of England did not deter capital flows in 1Q22. However, the full effects of an increase in the cost of capital, combined with the rising cost of living, and increasing business expenses, could result in less appetite for high risk, high-reward strategies such as VC.

Despite a major decline in the number of exit transactions across Europe, the median post-money valuation upon exit moved upwards from €42.7M in 2021 to €60.0M in Q1 2022. However, for the biggest deals, post-money exit valuation in the top quartile was €133.1M, down 21.6% from 2021’s full-year figure. If macro-economic concerns persist, the exit market will likely remain very muted in the coming quarters. Companies may therefore be staying private longer; however, a prolonged period of curtailed exit activity will raise questions about companies remaining in the VC ecosystem. During the past decade, according to Pitchbook, the median time from founding until exit has remained relatively flat. The median number of years between founding and a buyout or acquisition was between 7.8 and 11.1 years and 7.2 and 8.1 years, respectively. For public listings the median time was between 7.7 and 11.9 years. "As we move deeper into 2022, time periods may lengthen, and we could see greater numbers of late-stage companies seeking VC funding rounds instead of risking an exit that could harm valuations or potential returns."

Founders battling changes in macro-market conditions

In the daily cut and thrust of building a startup, minds tend to focus on the operational challenges: Bringing the key components of the business model together - product development, customer engagement, hiring, go to market tactics, and so on. These are the factors that the business feels it either has direct control over, or those it can - or must - strongly impact. These are the 'internal' factors. The 'external' factors, such as macro-market trends, which would have been examined at the genesis of the project, typically don't get much attention when the team is in the trenches, fighting to gain traction and prove out the model. This approach feels instinctively right - spend the majority of your time on the things you can directly impact. Investors on the other hand have an inverse view of the world. In the early meetings - especially in the current rapidly-changing climate - they will become preoccupied by the things you can't control. If they believe your market timing is now off - either too late or too early - this will probably be enough for a 'no', irrespective of how compelling the rest of your investment proposition is.

It is often not until investment preparation begins in earnest that the question of market timing is re-examined. Founders know the 'Why now?' question is bound to come up. But if external market factors - technology, economic, political, social, etc. - are no longer acting as a tailwind, it might simply be too late to adjust the story before you need to pitch. The impact of this can be profound: If investors feel market timing anxiety, a founder may struggle to pull a round together. This hiatus can be avoided if a timely assessment of market conditions is undertaken. It sounds easy and obvious, but unless formalised in some way, this checkpoint often doesn't happen. Time slips by. That's why during Investment Analysis (an assessment we undertake for clients 9 to 12 months before capital is required) market trends are a core part of the research. If the market is still nascent, or perhaps has already peaked, there is still time to recalibrate the business strategy, make necessary adjustments and rethink the funding plan. Immediate tell-tales signs are; no competitors on the horizon, or a slew of competitors that are now funding ahead of you.

As 2022 unfolds, we are witnessing a dramatic reset of macro-market conditions. The US has felt the effect of these headwinds first and we can now feel the breeze in Europe too. The tech exuberance of the pandemic era is rapidly fading. International investors are talking of a great period of uncertainty. Founders are trying to rapidly incorporate this sentiment into their strategies. As John Luttig explains in his latest excellent analysis, "Tech massively over-earned in 2021 – generating growth and profits at a temporarily high rate – driven by substitute demand from the pre-COVID economy. Companies with accelerated temporary growth got credit for a permanent acceleration." The tech 'exponentialism' we saw during the pandemic was not only driven by a demand spike – it was exacerbated by low interest rates and money printing. But many tech category tailwinds are flipping to headwinds as we revert to the mean – "when you’re growing sub-30% and inflation is heading towards 10%, inflation becomes a far more consequential growth headwind." As we enter an era of tech stagflation, startups will need to demonstrate exceptional growth and efficiency to overcome these inflationary pressures.

Happy reading!

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