1. Insights of the week
Using a financial model to build investor confidence
As average deal sizes have risen over recent years, so too the expected maturity level of companies across all investment stages. There was a time when you could wing a Seed round on a cash flow forecast and a basic P&L spreadsheet, but that time has long passed. A financial model is now just as essential for a Seed stage deal as it is for Series A. Whilst your pitch is designed to convey excitement, your financial model is a confidence building tool. Not just to demonstrate that you are running a professional operation, but that you fully appreciate that the whole purpose is about value creation. That is what investors ultimately care about. The model is not intended to be an accurate prediction of the future - neither will investors expect it to be. Instead it is a tool that allows investors to understand the key levers of growth in the business, the core assumptions that the founder has made, and whether the company has the potential to hit the fund return targets. i.e. Could this startup become a multi $B valuation business? To do this a VC will use the core assumptions, such as unit pricing, to undertake a very simple 'bottom-up' analysis.
VCs operate on the basis that every deal they do should have the potential to 'return the fund'. For example, if a $200M fund anticipates holding 20% equity at exit, their return would be $200M on a $1B exit, matching the fund size. To hit this $1B valuation threshold, VCs will often model a simple 10x revenue multiple, although this will vary by market and stage. So the question a VC asks when studying the financial model is: Can this business get to $100M in revenues and, if so, how quickly? By looking at customer growth, average unit pricing, and other data points, a quick bottom-up analysis can provide a ballpark answer. The next question is whether $100M of revenues would be feasible based on a very modest market share - usually in the 5-10% range. The timeline here could extend out perhaps 5-7 years, well outside the normal threshold of the model, so this is a pure judgement call and investors can be guided. If this all looks plausible, then other key considerations will come into play: Have the necessary KPIs been identified and are they starting to track? Will the new funding provide a solid 18 month runway before the next funding event starts? In other words, a clear 24 months in total, so there is time to deliver the next big milestone.
Collaborating with a VC on this future value calculation is a great way to keep the dialogue progressing in the early stages of due diligence. Some founders love getting on the front foot here and even offer to 'present the model' in a follow-up meeting. The founder can then drive the model, showing how it works, highlighting how different scenarios play out by changing certain sensitivities. This can give the VC the opportunity to really tune in on the founder's assumptions. This is where a founder can head off one of the pressing anxieties a VC will have, and that is making it to the next round with an even stronger proposition for the new lead investor. Here the founder can elaborate on the use of funds and how this drives the key KPIs, especially on commercial traction. Highlighting contingency is also vital. This is done by demonstrating the degree of cash resilience baked into the model during the sensitivity analysis. By using the financial model in this way, founders can build confidence in the mind of the investor that they are shrewd operators, not just visionaries.
Investment won't come if you can't attract talent
Access to capital is a key enabler for developing any new business. For a high growth startup it is the rocket fuel that makes everything possible. Well, almost. Access to talent sits in the same boat. One without the other is just not going to take you anywhere. They are truly interdependent: VC's won't give you investment if they can't see your team growing. Equally, world class operators will be reticent if they can't see the business being funded. It falls to the founder to square this circle. As VC Hunter Walk says, "In my mind there’s no greater indicator of success than the quality and characteristics of the [first 20] individuals you’re able to bring on board. Success is a signal of two meaningful truths: you have the talent you need to execute your roadmap and A+ people have decided that you are worth working for."
No matter how much capital a founder might raise in the early stages, if they can't recruit and retain great talent, they are powerless. Scaling requires people. And with the surge in highly capitalised startups growing the world over, the competition for the very best people is intense. Investors have significantly elevated this topic in due diligence as a result. They know that hiring enough world class people is now the biggest bottleneck. The emphasis here really is on the words 'world class'. The funding marketplace is becoming more globalised, and thus smaller, every day. Cross-border investments are now the norm. The rise of entrepreneurship over traditional career paths means that the best people will find their ways to the best companies wherever they are. But astute founders know they have a secret weapon. If the business can execute, the final outcome is going to create a life changing event not just for them but for all the key team members. That is the very special prize.
In a sense, the story that founders paint for investors is almost identical to that painted for prospective hires. "Join us and be part of something huge." But it's not just the power to attract, it's the ability to retain. Of course, people will always leave great companies and startups are no different. But if this becomes a pattern, it then becomes a problem. The movement of talent, who's in who's out, is being tracked - even if you are blissfully unaware. VCs will have access to key people stats for any young business, even before the first pitch. Founders who think they can hide this will come unstuck. Successful entrepreneurs have always known that hiring and empowering highly driven individuals is a top priority, but market conditions mean that it is harder than ever. Whilst the 'search' method is still viable, a better (and cheaper) process is for the individuals to find you. VCs are now keener than ever to understand your hiring strategy - how you attract and then convert the very best there is to drive the business forward. VCs can help fill the funnel here too, but it will be your vision that gets candidates over the line.
The least expected investor question
In preparing for investment, founders try hard to predict the big questions that investors will ask. The structure and flow of the classic investor presentation anticipates the most common questions. As a result, there is a broad consensus around what investors want to see in your pitch deck. Experienced founders know that it's also good practice to create a list of questions that they would least like to be asked by an investor. By writing down the answers in advance they can rehearse their responses. Some even create a set of Q&A slides that can be immediately drawn upon in the pitch meeting itself, should the need arise. Feeling that you have all the answers on tap boosts confidence. But there is one simple question that shrewd investors pop that sometimes catches out even the best prepared founder: "What don't you know yet?"
Josh Kopelman is the founder of First Round Capital, one of the most prolific seed and early stage VCs with over 900 investments globally. In a recent interview, he says that founders mistakenly think they have to have all the answers. Instead, he says, one of the key things that he looks for in a founder is the ability to understand - and clearly articulate - what they don't know. He links this to the fundamental principle that the job of a startup is to learn and the job of a company is to grow. In the startup phase the job is to maximise the learning for every dollar spent - to learn as fast as you can and as cheaply as you can. Kopelman adds:"The best founders have a real grasp of what they know and what they don't know. They are able to intelligently talk about the unknowns and their path to figuring them out. If a founder gets stumped by asking "What don't you know?", that's a warning sign."
In the 'use of funds' analysis, founders know they must set out what they will spend the next round of investment on; product development, headcount, marketing, and so on. But this tells only half the story. Early stage investors want to know why you are doing each of these things - i.e what questions you are trying to answer. If the use of funds is directed at 'company building' and not 'question answering', these investors will get very anxious. Company building comes later, when product/market fit is clear and the business is starting to scale. At each successive stage of development, the cost of answering the fundamental questions rises. In addition, the more that variable costs rather than fixed costs (especially people, facilities and equipment) can be used to prove the founding assumptions, the more interested those early investors will be.
Europe Q3 investment numbers slip back
Even though Q3 investment amounts reduced 24% from Q2, European funding was up 138% year over year, according to Crunchbase. Europe has also increased its proportion of global funding to 19% in 2021, up from 13% in 2020. 17 European cities have received venture funding above $1 billion so far this year, compared with just five cities in 2020. The UK leads with $9.6B invested in the quarter, down from its $10.7B peak in Q2. Germany claimed $4.4B and France $3.9B. Out of the $28B invested across Europe in Q3, late-stage and tech growth rounds (Series C onwards by VCs + PE fund participation in venture deals) accounted for a whopping $18.9B (68%) across a mere 160 companies, 60 of which exceeded $100M. Early stage (typically Series A and B) held flat at $7.5B ($7.8M Q2) but Seed dropped to $1.5B ($2.2B Q2) - although there is often a lag in Seed deal reporting.
As we pointed out last week, the most challenging aspect of these figures for founders is the volume of deals at Seed and Early stage in Q3. Seed deal count was down at 943 deals versus 1,297 in Q2 and 1,290 a year ago. Early stage slipped to 384 deals versus 464 in Q2 and 406 a year ago. These numbers will increase a little as more deals eventually get reported. At the other end of the market, four of the top public market listings from Europe went public in the US via SPAC deals, including used car marketplace Cazoo, electric aircraft developer Lilium, diagnostic health care company LumiraDX, and encryption platform developer Arqit. NASDAQ clearly still has major appeal for European founders, although the biggest IPO of the quarter ($11B) was money transfer company, Wise, with a direct listing on the LSE.
Europe's private unicorn herd grew stronger in Q3 by 19 companies. This takes the total for 2021 to 61 and 131 in total. The flood of capital into Late stage companies is not only enabling them to stay private longer, but is creating M&A war chests. Acquisitions as a means to accelerate growth is now just as much a tactic of private companies as it is for their public counterparts. The most active acquirer for European headquartered companies was Sweden-based buy now, pay later provider Klarna, which acquired U.K.-based e-commerce shopping platform HERO, Germany-based mobile wallet Stocard, and Sweden-based influencer marketing company Apprl—all in the third quarter and for big sums (>$100M). Even though Q3 cooled off a little overall, 2021 still looks like it will break all records.
2. Other pieces really worth reading this week:
VC Funds 101
For a highly informative insight into how VC funds operate this detailed article by Ahmad Takatkah provides all the gory details, from fund structure and team compensation to fund metrics and LP reporting.
Market Sizing Guide
This useful guide from Pear VC provides tips on how to estimate your startup’s market size and explains various market sizing definitions.
3 Critical Hires Most Startups Make Too Late
From the pen of one of our favourite founders, Mathilde Collin, Co-founder & CEO of Front (frontapp.com), this article identifies some of the unsung startup roles. Mathilde sets out: What they do; Why people hesitate to make the hire; and, Why it’s worth it. Great advice from a seasoned operator.