Duet Partners
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Newsletter

Weekly Briefing Note for Founders

1st April 2021

This week on the startup to scaleup journey:
  • The rise of the pre-emptive funding offer
  • How to drive a higher valuation
  • ‘Cash flow positive’ is not a term VCs want to hear
  • In the M&A world, an ‘approach’ is rarely what it seems

1. Insights of the week

The rise of the pre-emptive funding offer

More and more high profile startups are closing sequential funding rounds in quick succession. Hopin, one of the most remarkable examples, closed a £5M Seed round in February 2020, a Series A of £32M in June 2020, a £95M million Series B round in November 2020, and recently announced a $400M Series C. This frantic timeline seems to dispel the accepted norm that the typical time between funding rounds is around 18 months and that each round takes between 6 and 9 months to close. But what we are seeing here is the rise of the ‘pre-emptive round’, a phenomenon that has already become a big feature of the US venture funding scene. In such a round, investors that have become particularly excited at the emerging prospects of a business, proactively offer investment outside of the normal funding cycle.
 
Highly respected VC investor Elad Gil sets out the drivers for this trend in his blog. These include the remarkable growth being experienced in some emerging sectors; bigger funds looking to deploy larger cheques; and, where an incumbent investor(s) is making the play, a determination to keep their competition off the cap table (i.e., greed!). This is all underpinned by a slowdown in the number of new startups entering the VC ecosystem. Funds are chasing fewer 'high quality' investment opportunities. For founders of such startups the upside can be huge, not least because they don't need to actively fundraise and can keep focussed on building the business. But there are dangers too. Unprepared founders can get trapped by the dynamics of a pre-emptive offer and forced into suboptimal outcomes. Without any real competitive comparison how can a founder be sure that such an unsolicited Term Sheet is the best offer achievable at the time?
 
Research by US fund YCombinator has shown that if founders can use the pre-emptive Term Sheet to initiate an accelerated process (i.e., quickly talk to multiple funds) the more likely they are to secure better terms. This necessitates an abbreviated process with a handful of select investors. Speed is everything as the offer on the table must not be jeopardised. “The way to do this is for founders to make sure they are cultivating relationships with a subset of investors they think would be good partners for their company far in advance of their actual raise. This allows them to ensure that in the case of pre-emption, they have other partners who could keep up with an accelerated process.” If those relationships don't already exist, then the opportunity for comparison will be lost. Ironically, it's often from this very group that pre-emptive offers emerge.


How to drive a higher valuation

It's long been argued that 'discounted cash flow' (DCF) should be the true measure of equity value. But this is a complex equation that relies on a huge number of disparate future variables. In the startup world many of these are simply not yet known. Investors and companies may be tempted to use shortcuts such as Price/Earnings (P/E) ratio or Price/Revenue multiple as a guide, but in a world of rapidly evolving business models, such simple metrics can vary radically. They certainly don't explain the wildly different valuations that supposedly similar companies carry. Our own exposure to the approaches used by some VCs at early stage tells us two things: The biggest determinant of valuation during an investment round is how competitive the round is. If several big VCs are fighting over you (FOMO), then you are going to drive a premium valuation. But in the mainstream, where most of us live, the answer depends heavily on revenue quality.
 
Whilst the proprietary valuation models that VCs build as a proxy for DCF will vary considerably, they will nearly all incorporate this key ingredient. Founders should therefore focus on the factors that determine revenue quality. The greater the revenue quality the higher the valuation.  VC Twitter comments regularly on this subject and many, such as legendary VC, Bill Gurley have written commanding essays on the topic. What we learn is that some of these 'revenue quality' factors are significantly more important than others. ‘Sustainable competitive advantage’ ranks most highly. As Gurley says, “If an investor fears that a company’s competitive position (which allows them to create excess cash flow) is tenuous and will deteriorate, then the value of the enterprise may be worth the cash flows only from the next several years.”
 
Revenue growth can also be a huge driver, but it depends on the ultimate cost of that growth. For instance, are there strong network effects (e.g., 'customers recruiting customers')? Is there high organic demand (lower marketing spend)? Is there low capital intensity? Other factors are: Good revenue predictability and visibility (e.g., SaaS/subscription wins big here); increasing marginal profitability (easy scaling with improving margins); low customer concentration (few eggs in one basket); and low partner dependency (as we highlighted last week). All of these elements play a part and the more you can check off, the higher your valuation will be. If you have them all working in your favour – and an increasing number of startups do – then FOMO should really kick in. Then the challenge will be keeping a lid on excessive valuation upswings that may undermine your future chances of funding!


‘Cash flow positive’ is not a term VCs want to hear

There is a misconception that early-stage investors universally see the pursuit of profitability as a key objective for their investee companies. For some types of investor, particularly those that seek early returns - dividends, interest on loans, or even a quick-turn trade sale - this may well be true. Such investors want a high degree of certainty and predictability around the ROI. They want to invest in businesses that will transition to stable, organic growth and even exit in a few short years. But for ‘venture’ investors such as VCs, most CVCs, and other private investment vehicles, the quest for outsize returns requires that they invest in businesses that are capable of significant growth once they reach the point of scaling. Such business will likely require sustained investment over a number of years to drive this level of (inorganic) growth – to create and capture new and exciting markets.
 
Founders that proclaim their ambition to reach cash flow positive is short order will likely turn off venture investors from the very first interaction. Running high levels of cash through the P&L to drive growth is heavily at odds with the aim of short-term profitability. This highlights one of the key challenges that founders face in the early stages, especially as they transition from private capital to institutional capital. Different types of investor will have their own priorities and, if these are not aligned, it often leads to trouble. According to Beauhurst, there are at least 20 different types of early-stage investor, and not all are driven by the same motivation. Of course everyone wants the business to be successful, but success means different things to different people.
 
Second-time founders often say that the importance of investor alignment was something they really underestimated the first time around. It is one of those key topics they wish they had better understood and had been better prepared for. For some, the lessons were brutal. They struggled to attract the right venture investors as the business was starting to gain traction simply because of who was already on their cap table. Their reputations unfortunately preceded them. The VCs had no appetite for getting into a never-ending squabble with the incumbent investors over strategy. VCs will study the cap table at an early point in the investment evaluation process. If they see investors that they believe will use their positions to dictate a more 'conservative' approach to growth, they might not even engage. Founders that grasp these risks early on will focus on recruiting investors that are more likely to share the same growth outlook, right from the start.


In the M&A world, an ‘approach’ is rarely what it seems

Startups that are building something compelling are often approached by companies that may be interested in buying them. It’s usually only a question of time. If you’re making the right noises in the market, you will light up someone’s radar before long. Big companies have entire departments focussed on M&A – often euphemistically called ‘Corporate Development’, or just ‘Corp Dev’. For founders taking one of these calls for the first time, it can create a real buzz. It’s flattering to talk to someone who wants to buy your business. The urge is to be super responsive, drop everything and dig deeper to find out more. Could this be the big exit looming? Is this the moment we have all been waiting for? But as I (in a prior life) and many other founders have discovered on countless occasions, this is rarely what it seems.
 
As VC Paul Graham says in his blog, “It's usually a mistake to talk to corp dev unless (a) you want to sell your company right now and (b) you're sufficiently likely to get an offer at an acceptable price. In practice that means startups should only talk to corp dev when they're either doing really well or really badly. If you're doing really badly, meaning the company is about to die, you may as well talk to them, because you have nothing to lose. And if you're doing really well, you can safely talk to them, because you both know the price will have to be high, and if they show the slightest sign of wasting your time, you'll be confident enough to tell them to get lost. The danger is to companies in the middle. Particularly to young companies that are growing fast but haven't been doing it for long enough to have grown big yet.”
 
The danger in question is the huge distraction that wasted M&A cycles can have on a business. If you think fundraising can be a time sink, M&A can be an order of magnitude greater. If they want to email you an immediate offer, then fine, nothing to lose. But this isn’t how it usually goes. If you get an offer at all, it will be at the end of a long and unbelievably distracting process. If you are tempted just to find out WHY they might be interested, don’t bother – they will almost never reveal the real reason. On some occasions the approach will come from a corporate who is already a customer or a business partner, someone who already knows the company well. Such 'warm' approaches deserve greater respect and attention, but exactly the same risks apply. Unless they are able to get to the bottom line very quickly, don't get sucked in unless it fits with your immediate priorities.


2. Other pieces really worth reading this week: 

Cazoo will list via a SPAC - shuns UK float
As reported in the FT,  Cazoo, the UK-based online retailer of used cars, is set to go public in the US at an $8.1B valuation, in the latest blank-cheque deal targeting high-growth companies. “We explored all of our options including a potential UK IPO,” said Chesterman. “The UK is an amazing place to build a business. But the IPO process in the UK is challenging for companies that are investing in high growth. Those companies are better understood by US investors.”

The danger of venture capital ‘foie gras’
A great perspective by Check Warner and Tom Wilson in Sifted this week that discusses the risks of 'too much funding'. "Capital foie gras describes the situation of being force fed, or stuffed, with too much money until you, and the company, choke. With interest rates at an all time low, SPACs everywhere and tech being one of the only areas in the global economy that is growing with global lockdowns, there is arguably more money than ever in the market."

Giving VCs feedback on their performance
10 non-obvious rules for founders and VCs in this excellent analysis by SafeGraph CEO, Auren Hoffman. Note, this reflects current US market conditions but is still a very salient piece about the founder/VC dynamic and how it needs to improve during the fundraise. "During the SafeGraph Series B process, I sent over a dozen break-up emails to VCs letting them know that we were not going to take the step with them.  The break-up may have been because (1) they were not the right stage for us; (2) they were not going to add enough value; (3) we thought there was a conflict with one of their other investments; or (4) the VCs missed a deadline and were not moving fast enough."

“Why Startups Fail” by Tom Eisenmann
A great new book from Harvard Business School professor, Tom Eisenmann. In this excerpt he writes a letter to a founder. "As a first-time founder, you’ve probably heard lots of conventional wisdom about what makes for a great entrepreneur. While this advice is mostly sound, following it blindly might actually boost your odds of failing. If you read books and blogs that offer encouragement to first-time founders like you, you’ll see six points emphasized repeatedly..."

B2B networks are the next big software tool for SMBs
An insightful article in Sifted on 'B2B Marketplaces'. "When the SaaS model emerged two decades ago, it allowed smaller companies to buy and use software over the internet, triggering a massive wave of digital transformation in the business world. Over this time, SaaS has become the dominant business model in B2B. But now there’s a new B2B playbook that could deliver a similar wave of transformation and returns. Say hello to the ‘B2B marketplaces’: social networks in a B2B environment."


Happy reading!

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