Duet Partners
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Weekly Briefing Note for Founders

25th March 2021

This week on the startup to scaleup journey:
  • Partnerships don't work
  • Beware the signalling risk of multi-stage funds
  • Customers must not hijack your product
  • Navigating the stock options maze in Europe

1. Insights of the week

Partnerships don't work

On the journey to product/market fit, startups must pay extreme attention to customer feedback. They know that it's not just about the product being great, but the whole experience of being a user. Attentiveness is essential to drive the feedback loop so the experience can be improved. Early-stage investors are therefore wary of sales or marketing partnerships in B2B settings because they can get in the way of such progress rather than enabling it. Channel partners in particular can become a filter on the information flow with end users. And unless the startup quickly becomes a rocket ship for revenue growth, the partner can potentially lose interest or worse, feign interest, whilst they focus on more lucrative opportunities.
Paul Graham is cofounder of influential US startup accelerator and seed capital VC, YCombinator. In one of his most insightful essays on the art of scaling he says: "Partnerships ... usually don't work. They don't work for startups in general, but they especially don't work as a way to get growth started. It's a common mistake among inexperienced founders to believe that a partnership with a big company will be their big break. Six months later they're all saying the same thing: that was way more work than we expected, and we ended up getting practically nothing out of it."
In some highly regulated markets, such as automotive, healthcare and financial services, it often seems that there is little choice but to work with partners; for example, supply chains are often controlled by established intermediaries, such as 'approved' suppliers, VARs, and systems integrators. But unless a startup can develop some form of direct relationship with the end user(s), it may almost be impossible to find true product/market fit. The bottom line is that investors will carefully scrutinise the rationale for any channel partnership prior to early scaling. Unless it is operating with great transparency and efficacy it will undermine the investment proposition.

Beware the signalling risk of multi-stage funds

The concept of multi-stage funds is not new. Big international VC firms like Accel, Sequoia, Bessemer and others have operated Venture stage (typically Series A and B) and Growth stage (typically Series C onwards) funds in parallel for many years. But the increasing number of multi-stage investors now dipping down into Seed rounds is unsettling the market. So far this has mainly been a US phenomenon, but is now starting to occur in Europe. The tactic is to invest a token amount, usually around $100k to $200k, that puts them on the cap table, securing an insider position for later rounds. This enables these investors to create 'optionality' on the next wave of high growth startups. And it's not just VCs that are making these land grab moves. For example, the big New York hedge fund Tiger Global Management has become a prolific global venture investor in recent years, leading 69 Series A and 10 Seed deals, according to Dealroom.

As a result, Seed stage funds have been calling foul, claiming that when big billion dollar funds put $100K cheques into seed rounds, it just adds signalling risk. The risk is that if these big incumbent VCs do not participate in the next round this will put off others who will think they have seen 'issues'. On the 20VC podcast this week, serial entrepreneur and K9 Ventures founder Manu Kumar commented, "If things don't go well that company is going to have an incredibly difficult time raising capital."  Keith Rabois, Partner at Khosla Ventures adds: “I’m not sure it’s going to turn out that well. Early stage is just a very different skill set...". And Seed VC, Amanda Robson goes further; "If they want to do your A [round] they can show value without being an investor."

It's understandable why early stage VCs may feel aggrieved. But founders often find the lure of big name money at Seed too much to refuse. Being eternal optimists at heart, the prospect of plans not materialising as hoped isn't the biggest concern when trying to get the business funded. Should things go well, having a growth fund already 'in the camp' could really accelerate things. In the US, preemptive offers from such investors seeking to aggressively double down on their investments, are now increasingly common. But the uncomfortable reality for many startups is that accepting such small cheques adds risk and unnecessary pressure. Founders who find themselves in this position must weigh their options carefully. If they can convince the bigger funds to write larger, more meaningful cheques right from the outset, this may well be worth the gamble.

Customers must not hijack your product

Revenues are evidence of commercial traction, the key care-about for early-stage investors. But not all revenue is equal. For any startup, engagements with early adopters that are not strongly representative of the particular problem focus will at best be a distraction. Worse case, they could pose an existential threat to the business before it even begins to scale. It won't take prospective investors long to figure this out in due diligence. Experienced founders know that by focusing on solving one problem really well, momentum can be developed by finding more customers with the same problem. We now accept that such 'cohort analysis' is critical in developing SaaS businesses, but it's just as important in other business models. 

Refining the exact qualification criteria for the initial target cohort can be a lengthy, iterative process. And every month, dwindling cash balances put founders under ever greater pressure to pursue potential revenue opportunities where the cohort fit may seem dubious. In business models that require deep engagement with each new customer, for example where technology or product integration is required, it may take months to confirm viability. Here the immediate qualification criteria must be willingness to pay, right from the outset: pay for the initial feasibility study, pay for the proof of concept, pay for any joint development, and so on. Customers that are not sympathetic to the enormous opportunity cost for a startup should not be allowed to hijack your product to solve their own unique problem.

Some founders, often those with limited sales background, can be nervous about seeking such early cash commitments. Worse, by initially trying to paint their startup as a more established business - for example, by adopting the behaviour patterns learnt from earlier experience in the corporate world - they can undermine their own pitch. In fact startups are uniquely positioned to leverage their often tenuous cash position to negotiate for early payments. And if you don't ask you certainly won't get. Where deep engagement is an essential, willingness to pay (early) is also a sign of intent. Accessing cash from operating budgets can take time, so the sooner you make your case the better.

Navigating the stock options maze in Europe

Stock options are one of the main levers startups use to recruit the talent they need. They reward employees for taking the risk of joining a young, unproven business, and give them a real stake in their company’s future success. Once the preserve of the Silicon Valley tech scene, stock options have become increasingly important in attracting employees to UK startups. But elsewhere in Europe the picture is more fragmented and varies widely from country to country. Research by Index Ventures has shown just how grant sizes must vary to provide the same level of incentive by assessing the amount of tax and social charges employees will pay on their stock options when they exercise and sell their shares. This excellent benchmark data is available here.
It’s clear that in many countries, current policies that govern employee ownership are ineffective and often punitive. Change is needed if Europe is going to compete for the best talent. Not Optional is a campaign launched 2 years ago, now backed by 700+ European founders, to lobby for stock option reform across Europe. An open letter to policymakers set out the issues that must be addressed and work by Index has shown how ‘stock option friendly’ each European country is. In January, France unveiled a series of small changes to rules on employee stock options to make it easier for French startups to compete with US rivals and big corporations in hiring staff. In the past week, the European Commission launched an initiative to pressure national governments to put in place more startup-friendly policies, the so called Startup Nations Standard.
Stock option harmonisation seems to be one issue where investors and founders are clearly aligned. The related issue of vesting periods for founder stock is still, though, a source of much debate. To avoid the trap of dead equity, VCs are pushing more and more for vesting periods to be extended. Whilst 4-year vesting is now increasingly common, investors are suggesting that founders double the vesting schedule to eight years. And VC Twitter is full of angst on the topic, some saying that they will simply ‘pass’ when 5%+ of the equity is held by a person(s) no longer in the business. In addition to longer vesting periods, VC recommendations include Founder Agreements that include clawback provisions, whereby the company can repurchase shares of departing founders at fair value. For aspiring founders, this is serious food for thought.

2. Other pieces really worth reading this week: 

Dissecting startup failure rates by stage
A sobering analysis by Sebastian Quintero, Founder, CEO and Chief Scientist at strategic research house, Invariant Studios: "Not surprisingly, the rate of failure to exit decreases as a startup progresses through financing stages. This is an intuitive result—you would expect a company that is further along in the sequence to be more mature and established, and hence more likely to exit. The rate of failure to raise the following round makes for a significantly more interesting analysis. Notice the considerable drop from Seed (79.4%) to Series A (50.0%), and directional reversal to Series B (55.8%)..."

How to Cultivate VC-Entrepreneur Relationship That Will Pay Dividends
An insightful article by early stage VC, Olga Maslikhova: "As VCs manage a wide portfolio of investments, we are generally less dependent on a particular founder and it can be easy for us to succumb to an illusion of power and slip into a boss/employee mode of communication — an uneven dynamic that can fast erode mutual trust and respect. Maintaining an open line of communication as peers and equals is essential to building strong, lasting funder-founder relationships..."

75% of VC in 2025 will use AI to make decisions
According to Gartner, by 2025 more than 75% of venture capital and early-stage investor executive reviews will be informed by AI and data analytics. In other words, AI might determine whether a company makes it to a human evaluation at all, de-emphasizing the importance of pitch decks and financials. 

Why remote work has eroded trust among colleagues
A series of thought-provoking articles by BBC Worklife. "After a year of remote work, we now trust our colleagues less than before. Here's what we can do to rebuild those bridges..."

Future Fund Data: What We Know So Far…
Launched back in May 2020, the Future Fund was a UK Government fund set up to support innovative, pre-profit companies affected by COVID-19, by matching funding from private investors. Beauhurst has explored which ambitious companies benefited from the scheme, plus its most prolific co-investors, and their thoughts on the scheme.

Happy reading!

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