Duet Partners
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Weekly Briefing Note for Founders

1st December 2022

This week on the startup to scaleup journey:
  • European valuations show resilience
  • Low drama bridge rounds
  • What's your North Star metric?

European valuations show resilience

European 3Q22 valuation data is in and there is some room for cautious optimism. Whilst the global picture for VC is still all gloom and doom, with the US market particularly depressed, Pitchbook reveals that Europe is showing real resilience. The median valuation of companies at all financing stages - Angel, Seed, Early stage, and Late stage - is tracking higher on a year to date basis than the 2021 full-year figures. Angel and Seed valuations showed particular strength through Q3. With valuations coming in above expectations, the drop off in public market valuations has not filtered into this part of the European VC ecosystem - at least for now. Median Angel pre-money was €2.9M (with a median deal size of €0.5M) and median Seed pre-money was €5.9M (with a median deal size of €1.8M), both above the record 2021 figures. These formative stages remain well shielded from volatility in public markets compared to the later funding stages.

At Early Stage (typically Series A and Series B financings within the first 5 years of a company's founding date) the median valuation was tracking at €8.0 million through Q3 2022, up from €6.0 million in 2021. Again, there seems to be strong buffering from public market anxieties. But as we reported 3 weeks ago, there has been a noticeable decline in deal count through Q3 compared to 2021, even though deal sizes and valuations have remained elevated. Through Q3 2022, the median early-stage deal size topped €2.1 million, well above €1.7 million registered in 2021. It seems clear that as investors become increasingly selective they are happy to back companies that are commanding valuation premiums. Meanwhile at late stage, all figures are trending down due to their public market proximity. The median late-stage valuation declined for the second consecutive quarter from its peak of €19.7 million in Q1 2022 to €11.9 million in Q3. As round sizes tumble alongside these sliding valuations, late-stage businesses are fighting hard to adjust. Companies that grew strongly during the pandemic lockdowns are now focusing on capital efficiency rather than growth at all costs.

In terms of exits, this is a mixed bag depending on the exit route. Overall, European VC exits in 2022 have fared well, with a median exit size of €39.8 million, an increase of 2.8% YoY and more than double the 2020 figure. On the IPO front, only 39 IPOs have been recorded YTD in Europe. Median public listing exit valuation YTD is at its lowest figure in a decade at €20.8 million versus an average of €41.1 million in the past 10 years. In sharp contrast to public listings, acquisition exit valuations continue to trend higher. Even though the exit count of acquisitions is below 2021 levels, the median exit is at all-time high of €40.9 million, up 47.2% YoY. As Tech valuations have plunged at late-stage - especially for software businesses - larger and better capitalised companies have been snapping up bargains. M&A will likely dominate the exit market for the foreseeable future. With the IPO market stalled and exit count down overall, companies are staying private longer thus delaying exit returns to funds and LPs. Eventually this will slow the redeployment of capital, although that seems some way off for now.

Low drama bridge rounds

Bridge rounds have been big business since the pandemic and look set to reach new heights in 2023. They have always been a feature of the funding journey, with just about every startup needing one at some point. So, what is a bridge round? It's extra investment from existing investors to enable the company to achieve a key milestone. This is seen as a critical enabler to a subsequent capital raise with new investors. Despite their importance, the big problem with bridge rounds is that no one really wants to do them. Current investors would much rather see a new investor coming in to lead an exciting 'up round'. But life is rarely so smooth. Every startup eventually hits a rough patch and needs unplanned financial support to protect and develop the value already created, often in the face of unforeseen conditions. The pandemic unleashed a tidal wave of bridge rounds that were necessary to shore up potential portfolio winners that were being battered by that unique event. But the continued macro-market uncertainty and the decline in externally led rounds means that the incidence of bridge rounds will likely increase through 2023. Founders need to think ahead and ensure they are preparing the ground carefully to deliver the most stress-free experience for all stakeholders.

The most crucial aspect of any bridge round is making sure current investors are ready, willing and able to support it. The first step is readiness: Investors need as much notice as possible to get all their ducks in a row. Be aware that a partner at a VC firm will nearly always have to burn some significant political capital to push through a bridge round. This is particularly true if they led the last round as they will be in the driving seat for the bridge. They will need time to warm up their partnership and explain why this is really necessary and not a 'bridge to nowhere'. Then they will need to be willing: If your lead investor isn't supportive of the bridge then other investors will almost certainly be of the same mind. This can spell big trouble. And if the partner has left the VC firm since the last round, you will be what is known as an 'orphaned' investment. Without your internal champion, everything will be significantly harder. The final question is the ability to support the round and this is often the biggest hurdle. The major VC funds carry 'reserves' for this very moment, but if the last round was a party round - perhaps a group of angels or small VC funds working in concert - it's highly unlikely that they will have set aside such reserves. This means that finding a 'lead' amongst them will be very hard and even if one emerges, the terms will likely be punitive.

The pressure on VCs to ensure they have reserves available to 'protect' current investments has become intense. Those that are successfully raising new funds in the current market are looking to increase their reserve allocations. But as we explained in our recent article, 'VCs are raising even more money', capital flows from LPs are being concentrated into fewer, bigger funds. Many small to medium size fund managers are struggling and are either already tapped out or closely guarding their limited remaining capital. As we help startups prepare for 2023 campaigns it is worrying to see in the research how many VCs have either dramatically slowed or entirely stopped investing during the course of 2022. Founders that are contemplating bridge rounds over the coming months need to start early. They must ensure the current investors are on board by presenting a credible plan and keeping all stakeholders regularly appraised of the cash-out date. Ideally, you are just buying a little more time to deliver the next 'up round'. If so, a convertible note with a modest discount to that round should provide the right incentive. The overall approach is to minimise the drama and create an environment where all parties work collaboratively to preserve company value for the better times ahead.

What's your North Star metric?

Metrics are the key indicators of progress on the startup to scaleup journey. Every company has them and every investor wants to talk about them. But how should a founder decide which metrics really matter? Above all, which metric will provide the ultimate focus for priority-setting - the so-called 'North Star Metric' or NSM? The primary metrics to choose from are typically: Revenue (e.g. ARR, GMV), Customer Growth (e.g. paid users, marketshare), Consumption Growth (e.g. messages sent, bookings made), Engagement Growth (e.g. MAU, DAU), Growth Efficiency (e.g. LTV/CAC, margins), and User experience (e.g. NPS). Just about every early growth story, such as Airbnb, Netflix and Uber, can be traced to a single, crucial NSM. These NSMs also evolved over time: What made sense in the run-up to product/market fit (PMF) needed to be replaced in early growth. What worked in early growth then had to change to drive further expansion.

Angel investor, Lenny Rachitsky, says that the most important determinant of the NSM is the underlying business model: For example, in Marketplace businesses it is likely to be Consumption Growth as they make money from usage. For paid-growth driven businesses the hot metric will be Growth Efficiency - where there is a physical product the focus will be margins, and for purely digital businesses it will be LTV/CAC. Some products win or lose based purely on their user experience — how delightful, easy, and useful customers find the product. Thus, these types of companies include a quality-oriented NSM, such as the net promoter score or NPS - how likely a user will recommend their product to another is crucial for growth. For certain businesses, Rachitsky observes that using a specialist metric often becomes essential: Duolingo, for example, uses a metric called 'learning competency' from the Common European Framework of Reference for Languages (CEFR), which is the international standard for measuring language ability.

North Star Metrics by their very nature describe a result - the consequence of taking earlier actions. When investors interrogate a company's metrics they aren't just going to look at these 'outputs' they will also drill into the key drivers or 'inputs', especially around the NSM. Rachitsky describes from his time at Airbnb that the NSM was simply 'nights booked'.  The input metrics that fed into this higher-level metric included the number of Airbnb homes, the number of visitors to the site, and the guest conversion rate. But of course these are primarily growth-stage metrics. In the pre-PMF phase, metrics should revolve around one simple question: Am I building something people want? Cohort retention would be a great example here. With such granular and actionable input metrics, founders can come up with concrete ideas that align teams around these key objectives. Whatever phase you are in the NSM defines your core strategy at the time. It's what keeps your team focused, motivated, and building toward the ultimate vision. What's your current North Star Metric?

Happy reading!

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