Duet Partners
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Weekly Briefing Note for Founders

1st June 2023

This week on the startup to scaleup journey:
  • VC fundraising down 72% in 1Q23
  • De-risking the journey to Product/Market fit
  • The essential capabilities of a founder

VC fundraising down 72% in 1Q23

The amount of capital being raised by VC funds is always a key indicator of market health for startups. The more money going into the system from LPs, the more can be deployed by GPs - at least in theory. From the 4th quarter of 2020 to the 3rd quarter of 2022 this was headed only one way - up. But in 4Q22, the trailing 12-month fundraising figure (a key metric for VCs) took an abrupt turn backwards and was nearly as low as 2018 levels. New fund count dropped back even more dramatically, looking more like 2014. The extremely slow exit environment has blocked off the cash returns required by LPs to fund future commitments. This has all been the result of a valuations slide that has impacted public and private markets alike. In 1Q23, according to Pitchbook, only $29.5B was raised by VCs globally, representing a 72% drop from the first quarter of the previous year. Those LPs that did commit, exercised great caution in capital allocation, favouring familiar GPs with long-term and consistent track records over emerging managers by a ratio of 2:1.

There are several stark insights from Pitchbook's analysis of these 1Q23 figures. Firstly, geographic: Venture funds in Asia raised over half of all capital committed globally - more than double the 2022 share of 24.0%. Among the 10 largest funds closed in 1Q23, three were located in China and were all related to regional governments or state-owned enterprises. The massive size of those three Chinese funds constituted 68.2% of all funds closed in Asia during the quarter. In tandem, North America secured 37% of total capital raised, whilst Europe stood at 8.2% - the lowest share since 2018. In terms of new fund count, North America showed the greatest diversity, with 53% of the global total, with Asia on 30% and Europe on 10.9%. In terms of industry dry powder, this still stands at almost record levels. The 'cumulative overhang' - the term that describes the total amount of dry powder in the system - hit $548B in 2022, up from $482B in the prior year. The slower pace of investing by VCs into startups has thus improved another key VC metric, which is 'years cash on hand'. From a healthy 2.7 in 2019, this dropped to 2.0 in 2020 and then a worryingly low 1.3 in 2021, as VCs splashed the cash in a FOMO frenzy right at the top of the market. In 2022, profligate spending was curtailed, bringing this metric back to a more sustainable 2.9 years.

The big question of course is, what happens next? Pitchbook believes that many funds will continue to slow the pace of deployment and push back the timing of their next fundraise until markets improve. But others will see a unique moment to invest in the next crop of big winners. With a 'fortune favours the brave' mindset, some established, top-tier investors are out raising more fresh capital despite market headwinds. For example, US VC, Craft Ventures, has just raised an eye-watering $1.6B across  3 new funds: a $712M venture fund, a $749M growth fund, and a $165M feeder fund. These new funds are considerably larger than predecessor vehicles, reflecting the fact that for certain General Partners with solid track records, the markets are still very much open. For the rest of the market, fund managers - especially the smaller and emerging managers - will have to carefully regulate capital outflows so they can continue to support existing portfolio companies without running dry. Founders need to be increasingly aware of 'zombie funds' that are happy to take meetings but have absolutely no capacity to invest in new startups. Sadly, we are seeing a real increase in these, so founders must do their homework to avoid wasting precious time.

De-risking the journey to Product/Market fit

The journey to product/market fit defines the early-stage mission of a startup. The wayposts on this journey are the steps that a startup team navigates to build a product that customers love. The MVP or first product, quickly becomes the central focus. But arriving there too quickly can sow the seeds of future failure - not finding genuine product/market fit before scaling. Our experience in working closely with dozens of Seed-stage businesses over the past decade reveals that Idea Validation is the waypost that is most often underestimated by founders. Where does this sit in the journey and what are the mistakes that can lead to the illusion of fit? The wayposts (for a software business) are typically: Problem Identification, Idea Generation, Idea Validation, Iteration and Refinement (of the proposed solution), and Product Development. These steps are rarely linear, and the process often involves iterating and revisiting previous stages based on new information and insights. The Idea Validation phase is about assessing market potential and typically includes market research, surveys and customer interviews, MVP creation, prototyping, and competitive analysis. But it is the approach to Idea Validation that Seed investors increasingly dig into when undertaking early due diligence. These are the potential weaknesses they are looking to spot:

Confirmation Bias: Founders may fall into the trap of seeking validation for their ideas rather than genuine feedback. They may selectively listen to positive opinions and overlook critical feedback that challenges their assumptions. Lack of Market Research: Insufficient research can lead to overlooking key trends, competitors, and market dynamics, although this can be offset if the founders have direct industry experience. Insufficient Customer Engagement: Sometimes, founders rely too heavily on their own assumptions and fail to engage directly or early enough with potential customers. Misinterpretation of Early Feedback: Early feedback from potential customers may be limited or contradictory. Caution is vital when interpreting this feedback, especially with small sample sizes. Patterns and trends are more valuable than individual opinions. Overemphasis on Features, Not Problems: Founders sometimes focus excessively on building specific features without deeply understanding the underlying problem they are solving. The 'solution' is always bigger than the product. Lack of Iteration and Adaptation: It's rare to get everything right on the first attempt. Being adaptable and willing to make changes based on new information is critical. Premature Scaling: Founders may start investing significant resources into product development or scaling their operations before thoroughly validating the idea. This can lead to Premature Scaling, which is still the biggest startup killer.

Founders seeking inspiration for the journey to product/market fit will often research the topic online. There is a vast amount of material out there on this subject. But this presents a new challenge as quantity quickly obscures quality. One of the best sources is the First Round Review, which provides some excellent founder-written case studies and methodologies. How Superhuman Built an Engine to Find Product Market Fit is a great place to start. The insights into building a measurable methodology and the misinterpretation of early feedback are gems.This underlines that the essence of the early-stage mission (for a software business) is finding the customer cohort that loves your product, rather than developing a product to suit the needs of an entire market. This is often a much more challenging route for a hardware business, where early customer engagement is far more difficult, the cost of each iteration much higher, and the technical risk much greater. Here, Idea Validation often depends more on the founder's own direct industry experience. In developing the pathway to product/market fit, founders must establish their own approach to Idea Validation that will bear rigorous investor scrutiny. This is the biggest insurance policy against premature scaling and gives investors confidence that their money will be wisely spent.

The essential capabilities of a founder

Assessing the quality of the founder before making an investment is a critical consideration for VCs. The earlier the stage of the business, the more VCs must rely on the founder's raw capabilities. Veteran VC Vinod Khosla of top-tier firm, Khosla Ventures, echoed the sentiment of many others when he said, "We invest more in people than a plan, because plans often change." So what are these capabilities? Peter Fenton of global VC, Benchmark Capital, says they always assess 3 key factors: 1) Deep motivation. This is the fuel for relentless execution: VCs understand that a brilliant idea alone is not sufficient for success. They look for founders who possess a deep, innate motivation to execute on their vision. A strong sense of purpose and determination can be indicative of a founder's ability to overcome challenges and drive the startup forward. To convey this attribute, the key here is for founders to talk first about WHY they are doing what they are doing rather than WHAT they are doing. The cue for the 'why' is often the founder's special insight, and the mission must run much deeper than the potential just to 'make money'. If you have any doubt about starting with the 'why', just listen to Simon Sinek.

The second key factor is 2) Ability to learn. Startups operate in dynamic environments that require constant learning and adaptation. VCs seek founders who are open to learning, willing to iterate on their ideas, and adaptable to changing market conditions. Fenton observes that: good judgment comes from experience, which comes from bad judgment. The key here is for founders to talk about how they have created a learning culture and how this seeks to FOSTER new insight and then ACT on this feedback. Examples, dotted throughout the investor pitch, help to drive this home. Lastly, 3) Team building. The ability to attract and retain great people is an essential founder skill. Dan Levitan, of VC firm Maveron, says that successful VCs and founders are obsessively focused in finding great people to work with. They spend far more time recruiting than most would imagine since they realise how critical a strong team is to success. This is often a differentiator between serial founders and first-time founders as we highlighted last week. The key here is for founders to talk about their own method for inspiring, motivating and assembling a talented team, and the key hires they have recruited as a result.

First impressions also count heavily. The assessment of the 3 capabilities only happens after an investor has decided to invest the time to look deeper. Jim Goetz of Sequoia Capital says: "Tell good stories before good spreadsheets; speak from the heart not the mind....We’re looking for clarity and focus; 1 in 15 entrepreneurs can present their company in 5 minutes time. Be concise and compelling." This clarity of vision, delivered with passion and authenticity creates an attraction. The VC can immediately 'feel' the potential, not just for the idea but for the person. It is said that prolific investor Paul Graham, co-founder of Y Combinator, made 2/3 of his returns from just 2 companies; Dropbox (2nd) and Airbnb (1st). Even though Graham had uncertainties about the opportunity for Airbnb, he loved the founders from the off and could sense their amazing potential. His email exchange with legendary investor Fred Wilson of Union Square Ventures - where he tries to convince Wilson to co-invest - provides rare insight into these usually private interchanges between VCs. This revealing thread demonstrates how ardently a VC will go into bat for founders they believe in, when bringing together a syndicate.

Happy reading!

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