Duet Partners
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Weekly Briefing Note for Founders

26th August 2021

This week on the startup to scaleup journey:
  • FOMO is good for investors too
  • Founders must understand the impact of their 'strategic play'
  • What is Customer Development?
  • How to ensure VC/Startup fit

1. Insights of the week

FOMO is good for investors too

The 'fear of missing out' on the next billion-dollar opportunity is a constant worry for investors. FOMO is powerful for founders because it is a major accelerant to the funding process. In the US, where there is currently huge competition for deals, founders are stoking FOMO to drive fast closes on amazing terms. In January, Dan Primack tweeted a stat from Josh Kopelman of First Round Capital: “We can look at every company we’ve ever funded, and learned that the time from first email/contact to term sheet has shrunk from 90 days in 2004 to just 9 today.”  Speed is also becoming an increasingly important factor across Europe. William McQuillan, Partner at Frontline Ventures (Dublin & London) recently wrote about what he had learned when looking through all the data of the companies he had said NO to since he became an investor, 6 years ago. "While there were a number of important learnings from it, one really stood out to me. The companies that I said no to because I didn’t have time to complete due diligence (i.e. I was not fast enough) had performed substantially better than my portfolio. To put that in context, if I had never done a single piece of due diligence and only had invested in the companies whose rounds were closing fast, then my new hypothetical fast-moving portfolio would have raised more capital than my current one has." 

VCs realise that FOMO is not only the most powerful lever a founder has to drive a deal forward, but also that it can be good for dealmaking. Johan Brenner, General Partner at Creandum said recently in Forbes, “FOMO fosters the investor to get to conviction quickly and increases the performance of VCs. If you truly believe not only in the founder(s) but also in the company, embrace the fear and turn it into an accelerator of your motivation to win the deal. There are two types of FOMO: the fear of saying ‘no’ to the deal, and the fear of not even seeing the deal. Investors will say latter is probably the bigger worry because at least they have had the opportunity to make the call, rather than being left out of the loop entirely. As a result, VCs frequently talk to each other, comparing notes on what deals are in the market. This back scratching and the trading of market intelligence is an attempt to ensure they are invited into the best deals. Founders frequently underestimate the degree to which this happens. Investors are also regularly researching emerging companies to try and keep ahead of the game, often reaching out at an early stage to try and develop a dialogue.

One of the questions we ask founders during funding preparation is whether they have had any inbound approaches from VCs. If the answer is no, this is likely due to one of two reasons. The first is the company is in a sector that isn't regarded as 'hot'. This is usually because the overall returns investors are forecasting are not anticipated to be upper quartile. The second reason is that the company just hasn't made it onto the investor radar. Both reasons are worrying, although the former is much harder to address than the latter. Being able to paint the potential for outlier returns in a generally low performing sector requires creative thought and positioning. But if the calls aren't coming in due to lack of visibility then this can immediately be addressed. This often stems from the founder not providing sufficient news flow into the market to capture investor attention. And this flow of positive news must continue right through the investing process. This helps fan the FOMO flames and keep the deal on the front burner until closed.

Founders must understand the impact of their 'strategic play'

The success of any startup will depend on several key factors. Some of these will evolve over time, like the team, the product, and commercial traction. But other factors are more baked into the business from the outset. These are so foundational that they can only change as a result of a fundamental pivot. The most significant of these is the business model strategy, or as McKinsey calls it, the 'strategic play'. There are 4 basic 'plays' that enable a business to scale effectively. They are: 1. Network (users make the platform more valuable to other users - think marketplaces or social media). 2. Scale (rapid early growth is necessary to reach critical size and economies of scale - think ecommerce and consumer). 3. Product (the product experience itself accelerates sales - think much of B2B SaaS), and 4. DeepTech (heavy R&D prior to commercialisation - think hardware, AI/ML, biotech). McKinsey's research into the top 1,000 European Tech startups unveils the factors that typically drive success for each 'play'. These impact the amount of capital and timescales required for positive outcomes so are vital for founders, as well as investors, to appreciate.

The McKinsey analysis suggests a range of five such critical factors are at work. For Network players, it’s crucial to win local markets one by one and not try to grow globally in one fell swoop. Scale plays need to over-index on building strong commercial capabilities. Both Network and Scale players [eventually] benefit from M&A. Product-play companies need to prioritise a compelling product and narrow use case initially, while for DeepTech plays, attracting the best research and development talent is most important. Intriguingly, but maybe not surprisingly, a key insight is that valuations in DeepTech are linked to the amount of talent they hire from Europe's top 100 research universities. In terms of traction, the median revenue required to reach unicorn status is the lowest for DeepTech at €8M, versus €52M for Product, €88M for Network and €194M for Scale. An unexpected insight here is that Network and DeepTech players tend to reach unicorn status early, while significant shares of Scale players (24%) and Product players (31%) take more than ten years.

In the analysis, these 'plays' also had different funding requirements to reach unicorn status. Network and DeepTech required the highest amount of funding at approximately €200M. Scale and Product players required much lower funding amounts at around €80M and €160M respectively. These different characteristics, especially the time and investment levels required, not only influence what kinds of investors will be attracted to these plays but also help founders to identify the quickest and most reliable route to success. i.e what scaling activities to prioritise. For DeepTech founders this research provides confirmation that the even though the road to success may be the most capital intensive, revenue expectations to hit unicorn status are actually the lowest. This means that revenue multiples can be an order of magnitude higher than other categories, reflecting the huge promise of future revenue potential.

What is Customer Development?

Over the past decade, lean startup principles have fundamentally changed how we think about innovation and entrepreneurship. The lean startup movement developed around the visionary work of Eric Ries, encapsulated in his treatise, The Lean Startup, and later developments by Steve Blank in The Four steps to the Epiphany. The breakthrough notion that startups search for business models while established companies execute them was utterly profound at the time, even though it seems so obvious now. This insight, that startups are not smaller versions of large companies, radically changed how new businesses are created, funded and grown. Blank's four-step Customer Development Process has reshaped how founders proactively uncover flaws in product and business plans and correct them before they become costly. But the first step in the process, 'Customer Discovery', is often not fully appreciated by first-time founders, especially those with corporate backgrounds.

When established companies create new solutions for the market, they employ a 'Product Development' process. A market requirements document or MRD is usually the first step. This is the sum of all possible customer feature requests captured from various departments – sales, marketing, product development, customer support, etc. The roadmap from idea to product launch is clear. The market is known, the customers are known, and their needs are known. A product specification is then developed, and engineering builds the product. Under the fanfare of a marketing blitz the product is released into the mainstream market. Customer feedback then enables constant product refinement. But startups can’t compete with this lengthy, resource intensive process - and nor should they. The lean startup model, based upon the Customer Development process, leverages the concept of a minimum viable product or MVP. This is used to systematically sniff out the ideal customer profile for early adoption - 'Customer Discovery' - and then exploits this initial market or ‘beachhead’. Crucially, it is not the product that is changed to find the market fit, but the customer.

The MVP captures the founder's vision and incorporates the minimum feature set needed to acquire early customers. The customer development team then works hard to find a market, any market, for the product as currently specified. They don't just abandon the vision of the company at every turn. Instead, they do everything possible to validate the founders' belief. That means searching to find the market sector and the customer type that resonates strongly with the MVP and drives initial growth. Conversely, developing and then refining the product to find the widest audience is the behaviour of the established company. Emulating this approach can be the kiss of death for a startup that has limited means. Instead, successful startups undertake customer discovery until they find their beachhead. Validating that this beachhead can then deliver early traction is vital to then finding product/market fit. From this landing point the startup expands, fuelled by eager investors who have seen this pattern before - and love it.

How to ensure VC/Startup fit

Transitioning the cap table from private to institutional investors is a pivotal moment in the development strategy for any high-growth startup. Big choices need to be made. Over 500 VC funds have been active in the UK over the past 5 years. This is a very diverse investor class and a real mixed bag of capabilities, value-add, and aspiration. However, all VCs are out to learn, so will often be happy for you to educate them about your tech and/or space without any intention of investing. Carefully selecting those to approach is therefore crucial to avoid wasting time. Experienced founders use two primary criteria: relevance and relationshipRelevance means they are a good fit for your type of business - your interests will be well matched. Relationship is all about the individual VC Partner that will likely sit on your board for many years. This is someone you will need to get along with - someone you will be able to trust and respect.

During the funding preparation phase, founders should first look at relevance. The easiest elements to assess are sector and stage focus. Many VCs take a strongly thematic approach to investing so will focus on a particular sector or sectors to the exclusion of all others. The deep vertical knowledge acquired enables them to make informed investment decisions and add value post investment. VCs will also have strong stage preferences, e.g., Pre-Seed to Seed, Seed to Series A, Series A only, Growth. This particular stage-specific knowledge is critical in their risk/opportunity assessment. With sector and stage sorted, you are halfway there. Experienced founders then assess the size of the fund and the age of the fund. This information is often harder to dig out, but is vital. Founders must really do their homework here as these factors can trump all others.

The size of the fund must align with your expectations of future valuation, which will be linked to market potential. As we described in our blog, Understanding the VC mindset, VCs make their big returns by investing in potential outliers. For example, a $200M fund is going to be a unicorn hunter, searching out businesses that one day could be valued at over $1B. If your Total Addressable Market is going to be $1B or less, then this won’t be for you. You will need to be targeting smaller funds. New funds also have an ‘initial investment period’ - often no more than 2 to 3 years - during which time they are looking to invest a portion of the fund in new opportunities. The balance, their 'reserve allocation', is going to be exclusively earmarked for portfolio follow-on investments. Targeting a fund that is outside their initial investment period is probably a waste of time. Many will be happy to take the meeting, but will have no capacity to invest in anything new. [This item is an updated version of our post from March 18th]

2. Other pieces really worth reading this week: 

The Chief People Officer as PM: Rethinking The Systems & Tools That Run the Company
As a startup begins to scale, CEOs tend to find themselves spending the bulk of their time and mindshare on people-related challenges. Whether it’s bringing the right people onto the team and managing others off, developing a cadre of leaders, or crafting culture and compensation, it all quickly becomes more difficult. In the First Round Review this week, Colleen McCreary discusses the role of the CPO as "the product manager of the systems and tools that run the company."  

The Class That Changed The Way Entrepreneurship Is Taught
"Revolutions start by overturning the status quo. By the end of the 20th century, case studies and business plans had reached an evolutionary dead-end for entrepreneurs. Here’s why and what we did about it."  From one of the founding fathers of 'lean startup' movement, Steve Blank, on how this new approach has become embedded in modern entrepreneurial practice.

VC Investor Relations
Have you been invited to present your business at your lead investor's LP meeting? Are you even aware of this forum? An informative blog post from legendary VC Fred Wilson of USV (Union Square Ventures) on how VCs manage their own investor relations.

B2B VC: Why everyone’s talking about product led growth (PLG)
Taking the lead from our 'strategic play' item above, a reminder of why product led growth has become an increasingly important factor in VC decision making. An article by Joseph Pizzolato of Felix Capital.

Happy reading!

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