Duet Partners
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Weekly Briefing Note for Founders

27th April 2023

This week on the startup to scaleup journey:
  • European funding back to 2019 levels
  • Understanding the DeepTech investor playbook
  • How European startups succeed

European funding back to 2019 levels

New insights this week into 1Q23 European VC funding, this time from Pitchbook. The decline in investment levels confirms our earlier reports: Deal value was down 65% YoY (v. 1Q22) and 32% QoQ (v. 4Q22). Deal count was down 46% YoY and down 19% QoQ. In short, this is a return to 2019 levels of funding, which at the time was celebrated as a new record! How the extreme highs of 2021 quickly made us forget all that. As we head further into 2023, VCs are clearly applying tougher investment criteria, where capital efficiency and robust paths to profitability are now the priority. This strongly favours startups able to demonstrate convincing early growth in the face of heavy downward macro-market pressures. Some sectors are clearly more in favour than others: For example, Financial services is battling major headwinds whereas the Climate Tech sector is seeing resurgence. We are currently witnessing a greater polarisation between really hot sectors (where VCs are chasing founders) and all other sectors (where founders are chasing VCs). Startups that find themselves in sectors where current macro forces are providing such tailwinds - in particular, anything AI - are seeing elevated levels of inbound investor interest, despite the wider market gloom.

One of the keys to more positive investor sentiment will be increasing liquidity returning from exits. In 1Q23, European VC exit activity deteriorated, with only €1.6B in exit value - representing just over 1% of the total exit value realised during 2021, when exits peaked. This reflects a 70% QoQ decline to the lowest figure since 1Q20 and even lower than 1Q19 at €2.9B. The largest VC exits have historically been driven by IPOs but public markets are essentially off the table right now - at least until inflation cools across major economies, interest rate hikes cease, and business confidence re-emerges. Four of the five biggest exits in Q1 were M&A deals and this looks set to be the most likely exit route for several more quarters. Large corporates seeking efficiencies in innovation will be increasingly well-matched with startups seeking liquidity. As we highlighted before, there are now 100's of tech companies in holding patterns waiting to be 'given clearance to land' their IPOs.  As Pitchbook predicts, when markets rebound, public listing activity could accelerate rapidly, as it did in late 2020, after pandemic lockdowns highlighted high-growth areas such as e-commerce and cloud-based businesses. This time there will be a new line up of hot sectors.

In the meantime, muted exit returns will make it harder for VCs to raise new funds. European VC funds collectively raised over €20B in each of the past four years, but only €3.4B was raised in 1Q23, indicating this could be the lowest annual figure since 2015. In 2021 and 2022, the difference between capital deployed into startups and capital raised by VC funds swelled to €84.2B and €74.6B, respectively, reducing dry powder levels. And with exits drying up, GPs could begin to struggle to generate returns back to LPs and satisfy funding requirements of their ageing portfolios. As more vehicles extend beyond their typical 10-year lifespan, so-called 'zombie funds' could begin to reappear. These will be holding assets past their expected holding period with no way of liquidating them or raising a successor fund, effectively imprisoning capital in a non-performing fund. Some VCs will therefore be looking to the secondaries market to provide their current LPs with an exit route. Partial share sales in individual portfolio companies (to other shareholders or new investors) are another option for cashing out. Either way, it's likely that the 'ultimate ownership' of many startups will change hands quietly during the course of 2023.

Understanding the DeepTech investor playbook

Many VCs are currently nursing huge paper losses as valuations have fallen dramatically from the highs of 2021. The software investing playbook, the typical model of mainstream VC, has not been able to mitigate this downward spiral. Software investment is based on the premise of only taking market risk. This is the inverse of the DeepTech playbook where investors are predominantly taking technical risk (and little market risk - if they're doing it right). To be fair, investing in software businesses is enticing for many reasons and generated incredible returns for a huge number of investors in 2021. Over the years, VCs have become highly adept at assessing the growth prospects for software startups: As early revenues appear, growth largely becomes a function of capital. Equity raises essentially fund CAC where revenues become highly predictive and are less prone to surprises. But when macroeconomic forces tank valuations across entire markets, even the most exciting software startups get hit - just look at Klarna, Stripe, Affirm and PayPal through 2022. Investors eyeing more (valuation) resilient DeepTech plays such as ClimateTech, might now be tempted to shift thesis. But unless they are able to fundamentally change their entire investing mindset, they will fail.

Champ Suthipongchai is a co-founder and general partner at Creative Ventures, a method-driven DeepTech VC firm investing in startups that address the impact of increasing labour shortages, rising healthcare costs and the climate crisis. In his recent TechCrunch article, he says there are three things software investors must relearn before investing in DeepTech: 1. The market is king. Your founder has no power here. What Suthipongchai is driving at is that it is virtually impossible for DeepTech companies to do a hard pivot. They need to get the market right from day one. They have to preempt product-market fit now. For this they need the deepest insights, often driven by a technical mind, that will likely originate from first-hand experience in the sector. 2. IP means nothing. Business lock-in means everything. "Sure, IP buys you time, but it’s hardly a means of defending a company’s long-term advantage." Implementing DeepTech is an audacious process that requires countless proof-of-concepts and pilots, not to mention an even more audacious rollout plan. It takes a really long time. Moreover, DeepTech does not usually work well at first, and scaling a solution right away can be costly from both an implementation and maintenance standpoint. The upside, however, is that once a customer is committed, they’re usually there to stay.

Perhaps the most controversial playbook difference is the very different approach needed for successful portfolio construction. Compared to software companies, DeepTech exits don’t take nearly as long. They also tend to be smaller and usually happen through M&A with incumbents with deep pockets and a distribution channel. For the acquirer, DeepTech companies are successfully commercialised R&D. Once a company has proven that its product works in the market (at some reasonable scale), they’re likely to be scooped up by companies that can leverage their existing sales channels to push the products out. Suthipongchai says that counting on one or two companies to return the entire fund (as is done in software) is not only foolish, it’s a good indication of an investment team that shouldn’t be investing in DeepTech. A good number of companies within the portfolio must perform well, and follow-on investments must be much more diversified. The upside here is that if you bet on plays where there is little or no market risk, then growth can look more like a step function than a smooth curve. Valuations will then shoot up in response, creating returns that - in aggregate - are just as compelling as software.

How European startups succeed

One of the most significant factors in the success of European startups over the past decade has been the choice of 'strategic play'. Research by McKinsey into the top 1,000 European Tech startups founded between 2000 and mid 2021 across 33 countries, has shown 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 - where the big risks are technical risks not market risks, as we highlight above). McKinsey's research 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 research identifies that different strategic plays require different success factors. 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 comparing DeepTech companies with similar funding, those with a higher share of top-tier researchers achieve 43% higher valuations than others. In terms of commercial 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 even though the road to success may be the most capital intensive (if they indeed need to reach unicorn status before being acquired), revenue expectations are actually the lowest. This means that revenue multiples can be an order of magnitude higher than other categories, reflecting the true power of the core technology breakthrough and the huge promise of future revenue and profit potential.

Happy reading!

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