Duet Partners
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Weekly Briefing Note for Founders

20th May 2021

This week on the startup to scaleup journey:
  • The 'herding in' mentality of VCs
  • Stop talking and let the investor ask questions
  • Stealth mode and the dreaded NDA
  • Why LPs pass on VC proposals

1. Insights of the week

The 'herding in' mentality of VCs

A key aspect of investment planning for any business is predicting investor appetite. This is partly going to be associated with a startup's investment proposition and partly with the sector it operates in. Your startup may have the most compelling proposition, but if the sector is out of favour with VC, you might have an uphill struggle getting funded. This is not because you won't be able to impress certain investors with your story, but because early stage investors may be concerned that later stage investors won't be there to fund the business through to exit. This transition will likely occur before the company is cash flow positive and thus be essential to the survival and growth of the business. The so called 'herd mentality' of VC is the notion that there must be sufficient buzz around a sector for investors to crowd in and find safety in numbers though all the funding stages. Few VCs have the means - or inclination - to fund a startup all the way on their own.

The result of this 'herding in' is that certain sectors will wax whilst others will wane. Momentum builds behind those in favour to the point that individual funds, and even fund managers, start specialising in certain markets to the exclusion of others. A rush of new funds will develop, Fintech being a case in point over recent years, where Limited Partners place their bets on a certain sector. But in doing so they may be depriving other sectors of capital. In investment preparation, such sector trends are important to identify and can be crucial in the positioning of a business to prospective investors. A key analysis that should be undertaken is an assessment of company foundations and cessations within a particular sector over recent times. In any emerging market the number of foundations will increase to begin with before cessations then kick in a few years later. Inevitably, some who start will fail. The difference between the two plotted over time - on a cumulative basis - will reveal the number of active companies in the market at any given moment.

In thriving markets, where early stage VCs are herding in, the number of active companies will be increasing. As the growth in the number of active companies slows, VCs move on to new pastures. The investment baton is passed onto late stage investors or even public markets. As sectors become established, the leaders then dig their moats to secure long term defensibility. Over time, market forces - perhaps enabled by new technology - will break through these defences causing market fragmentation. New veins of opportunity will open up. If these disruptions are big enough, the herd that moved away may then return, but enough must do so to create safety in numbers once again. Founders that are formulating funding strategies for their early stage businesses must first find out where the herd is.

Stop talking and let the investor ask questions

Just as the startups transition through funding stages (Seed, Series A , B..) so too the funding process in each stage is a series of steps. The purpose of each step is solely to open the door to the next, until the investment is done. Initial preparation leads to the investor approach, which leads to the pitch, then in-depth discussions, then Term Sheet, then due diligence etc. The biggest determinants of success through the initial funding stages are 1. that you are pitching the idea to well qualified investors, and 2. that you have done everything humanly possible to develop a stand out proposition. The investment proposition is then gradually unveiled. As each step is 'pass/fail' the temptation is to tell the entire story in all its glory as early as possible. This is a mistake. The pitch is only part of the unveiling process. It is there to excite, not educate. There will be time to educate later on, but for now the goal is to create anticipation, to draw the investor in, and to trigger the emotional buying decision.

How do you know if this is happening? The biggest tell tale sign is the number of questions the investor asks. Albert Wenger is a partner at Union Square Ventures (USV), a New York-based early stage VC. In his latest blog he says "..your goal is to get from push mode into pull mode as quickly as possibly. What do I mean by that? You want to stop talking and let the investors ask questions. A bad pitch is one where you do all the talking. A good one is where the investors are tripping over themselves to ask questions. So what does this imply? Keep your pitch geared towards being intriguing rather than trying to answer every question upfront." If the technique is to elicit questions, then being prepared for the hardest questions is crucial. Founders should create a FAQ in the preparation stage so they are ready. Answers with numbers in them are the most memorable and credible. And the more succinct the answer the better. Numbers really help with this.

Wenger says, "The crucial art of giving an answer is to deliver it firmly and then shut up. Nine times out of ten that’s it and the conversation will move on to a different question." But if the investor wants to go deep, you have to go deep too.  Don't try and skirt the question, as this is a test. In your backup slides you will have solid reference material on the potentially contentious points. You may never use it but having it there will give you extra confidence. That confidence will radiate. And in the debates that will (hopefully) ensue, engage fully, but don't forget to tie this into to your headline messages: the key customer benefits; why you will succeed; and what's in it for investors. Make these bold, simple statements. Create initial engagement on what you will do and why you will do it. The how can be the reason for the next meeting.

Stealth mode and the dreaded NDA

'Stealth mode' is a term used by startups to describe a period a secrecy prior to launch. Often the idea is to keep potential competitors in the dark to gain the advantage of surprise. The company works away quietly developing the product and executes NDAs with any 3rd parties necessary for essential collaboration. During this time the IP will be developed, patents will often be filed, and copyrights secured. Every week that passes gives the startup a potentially bigger first-mover advantage at launch. And so with few external distractions, all efforts can be focused on the core development. This approach can work for a while, but unless the company is 'internally' funded (by founders, friends and family) through the initial product, the need to raise external capital will likely dent these stealth ambitions. And for good reason.

A funding campaign usually requires a company to get out and shake the bushes. Startups create a buzz in the funding market, pumping up investor excitement and driving FOMO. For companies in stealth mode, fundraising has to be done discreetly and this makes an already difficult process 10x harder. For serial founders that may have already developed a roster of relevant investor contacts, stealth funding may be possible. But two major factors will conspire to undermine such a plan. First, the concept of 'launch' is now regarded as something that only established companies do. They already understand the needs of the market and their customers. Startups don't have such relationships and must pursue an iterative process of early customer feedback to eventually arrive at product/market fit. Going to market blindly with no sense of product/market fit could be a suicide mission that investors will simply not fund.

The second factor is the belief that the NDA can also be used with investors. This might be possible for certain DeepTech companies in the technical due diligence phase, but for 99% of funding rounds, an NDA is a no-no. Very few VCs will entertain the idea of signing an NDA for a whole host of reasons, not least the practicalities of ensuring confidentiality on the dozens of insights they are exposed to every week. They simply aren't going to expose their funds to such risk, at least not through the initial meetings. Even asking for an NDA will appear naive and be a mark down. Corporate investors will be more willing to entertain an NDA, especially if they want to dig deep on the tech. The challenge then is often the delay in executing the agreement itself, as corporate legal departments will want to demonstrate their 'added-value'. This may be a bridge worth crossing if there is a clear prize in sight and the runway permits.

Why LPs pass on VC proposals

Understanding how LPs select which VCs to invest in can tell founders a great deal about the VC mindset. LPs, or 'Limited Partners', apply stage, sector, and other important criteria in deciding which fund managers ('General Partners' or GPs) to invest in just in the same way that VCs do with startups. One is a mirror of the other. And VCs pitch for this investment just as founders pitch to VCs. Everyone is in the capital raising game. A VC fund is heavily influenced by its LPs who expect outlier performance, as we described in our recent blog. LPs will carefully assess each VC's investment strategy. A key part of this is being confident that the VC has both clear focus (stage & sector) as well as access to high quality or differentiated deal flow and a real edge that will enable them to execute on this focus area. Above all though, they are most interested in a VC's track record, as reported in a recent survey. Sound familiar?

LPs are not particularly visible in the public sphere, so when one takes to Twitter to set out the reasons why they 'pass' on VC proposals, it's worth taking note. Sam Ettelaie is Senior Investment Manager at the British Business Bank, the largest UK based LP investing in UK VC. His latest musings are notable as they refer to the Enterprise Capital Funds (ECF) programme, a major initiative to support emerging fund managers in the UK. There is particular focus on managers looking to operate in parts of the market where startups are finding it difficult to access the capital they need. For example, those with underrepresented founders (e.g. Ada Ventures), or University spinouts in certain areas of life sciences (e.g. Epidarex Capital). In total, 31 funds are now heavily supported by the ECF programme. What makes Ettelaie's missive so interesting is that track record cannot feature highly in the list of criteria, as emerging managers may well be first-time fund managers.

The top 3 reasons why the ECF programme does not progress with certain VC proposals are Team, Value-Add, and Investment Strategy. Teams that are under-resourced, don't have a relevant history of working together or too much key person risk (e.g. solo GPs) will get a 'pass'. The words on Value-Add are even more revealing: "Every prospective Manager says they have it, but only a few can articulate & demonstrate how their value proposition to founders is differentiated. Why would a founder take capital from you over others? Just stating that a network can be leveraged is not enough." Hence we can see why GPs make much of their so called value-add in their marketing to founders - LPs place great store by it. But as we have discussed many times before in this column, founders often feel duped with investor value-add. It's good to know that LPs have founder's interests so much at heart.

2. Other pieces really worth reading this week: 

Fierce Nerds
From the blog of legendary VC investor Paul Graham. "There has never been a better time to be a nerd. In the past century we've seen a continuous transfer of power from dealmakers to technicians — from the charismatic to the competent — and I don't see anything on the horizon that will end it....As the world progresses, the number of things you can win at by getting the right answer increases. Recently getting rich became one of them: 7 of the 8 richest people in America are now fierce nerds."

Growth Firms, Not VCs, Are The Most Active Investors In New Unicorns This Year
Crunchbase reports on the continued incursion of big growth funds - Private Equity and Hedge funds in particular - into the VC space. An unprecedented number of companies have joined Crunchbase’s private company unicorn board already this year: Less than halfway into 2021 there are 166 new companies, compared to 163 for the whole of 2020. PE firm Tiger Global now has twice as many unicorns in its portfolio as the next-biggest unicorn investor: Silicon Valley-based Sequoia Capital.

Detail of VC Distributions: Who Gets the Money in a Startup Investment?
ACV is an international Corporate Venture Capital (CVC) fund investing globally in startups & VC funds. Here they publish a very useful primer on the different ways investors take their ultimate returns. 

US investment into Europe’s startups hits an all time high
Interest from US VCs in European tech companies has accelerated over the past two years, reaching an all time high last month. As reported by Sifted, less than halfway through the year, American investors have already put €10.1bn into Europe’s startups in 2021, according to Dealroom; easily surpassing the €9.3bn invested in all of 2020.

Happy reading!

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