Duet Partners
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Weekly Briefing Note for Founders

27th May 2021

This week on the startup to scaleup journey:
  • Exit values exploded in 1Q21
  • The trap of the oversized investment round
  • Non-founder CEOs have more to prove
  • What to look for in a lead investor

1. Insights of the week

Exit values exploded in 1Q21

All the talk this year has been about record VC investment levels. But if you're a VC the most exciting topic is what's happening to VC returns. According to Pitchbook, in Q1 2021 alone, exit value generated in the UK & Ireland reached a record £10.9 billion - far surpassing 2020’s annual total of £6.2 billion and beating 2018’s record £10.3 billion. With pent up investor demand from 2020, rising public equity valuations and pandemic-induced growth for tech-based businesses, many startups have been capitalising on market conditions. IPOs have so far generated the vast percentage of returns (think Deliveroo at £5.7B pre-money), which is the opposite of 2020 where M&A dominated.

But looking at the numbers of exit events by type reveals where the most likely exit routes lie for startups. Over the past 10 years, acquisitions dominated in the UK & Ireland. 2020 mirrored prior trends: Out of 155 exits, there were 125 acquisitions, 5 IPOs and 25 buyouts. In 1Q 2021, acquisitions are running just ahead of buyouts, with IPOs far behind in number - even though they are generating the biggest returns. The attraction of VC continues to fuel the creation of more new funds on home turf. Despite very uncertain market conditions in 2020, 49 new funds were launched in UK & Ireland (59 in 2019) with £3.9B raised (£5.9B in 2019). And 2021 is off to a solid start, with 9 new funds in 1Q raising over £0.7B. These levels are expected to pick up even more strongly as the year progresses.

The trend seems to be towards increasingly specialist funds that focus on hot sectors like Fintech and Healthcare. The biggest new fund to close in the UK & Ireland was London-based Abingworth Bioventures VIII at £340.9 million. This transatlantic fund will back life sciences startups across Europe and the US that create therapeutics to enhance healthcare solutions. The pandemic has surfaced many opportunities to build a better future through data utilisation. As Pitchbook comments, "By raising capital and investing in data technology that will likely be ingrained in the UK healthcare sector moving forward, VC GPs could be the vanguard of this movement."

The trap of the oversized investment round

For the hottest deals, VCs are willing to pump in way more capital than is being sought. Whilst late stage deals are grabbing the headlines, Seed stage deals are not immune. In some cases founders seeking £2M to £3M are being offered - and taking - twice that and sometimes a lot more. This is reminiscent of what's been happening in the frothy US market over the past 12 months. But surely that's a good thing? It's not unusual to hear investors saying, "Raise as much as you can when you can - you never know when the next round might come along", or something similar. But this sets a potential trap. Assuming the valuation will support the new capital without diluting founders and other investors too much, then taking way over what is needed to navigate the path to Series A can create a false sense of security. Some founders that have been in this position will admit it has led to their downfall.

As one founder recently said, "Taking on lots of capital at big valuations puts so much pressure on yourself & raises expectations for everyone involved in your company. It forces you to hire faster, spend more on S&M, build more product features etc." If this is happening before you have validated that your early customers love your product so scaling can begin, you could be driving up expenditures well before the revenues start to flow. Such premature scaling is one of the biggest startup killers. It seems counterintuitive, but constraints are one of the main advantages a startup has. This forces the greatest creativity, spurs the hustle culture and keeps maximum pressure on finding true product/market fit. 'False' product/market fit, where you allow the size of the funding round to lure you into thinking that the investor has seen something you haven't, is often fool's gold.

The fact is that you know your business better that anyone else. You know the stage you are at and what it should take to get to the next. Of course you want to have some decent contingency baked into your 'ask', but if that contingency is looking like 18 months or more of runway, you may be inviting new problems. The crucial thing is just to be aware that this trap exists and to be frugal in how you spend this cash whilst you are still figuring out the scaling formula. Set clear expectations with investors right from the outset. Describe this in your use of funds plan. Don't get bullied into ramping up the team before you are ready, as this is the hardest cost line to moderate when things aren't working out. Stick to lean startup principles and take advantage of the many hard lessons that other founders have learnt before you.

Non-founder CEOs have more to prove

Not all founder/CEOs survive the startup to scaleup journey. Whether through their own choosing or as a result of board or investor pressure, the founder/CEO may step aside to make way for the hired gun. Whatever the motivations, little is known about the fortunes of startups that are fully founder-led compared to those where the CEO is (eventually) hired-in. At least until now. In Ali Tamaseb's new book, Super Founders: What data Reveals about Billion-Dollar Startups, we find some real insights. Tamaseb spent the last four years conducting one of the largest data-driven studies into startups, trying to understand what was different between the startups that became billion-dollar successes versus those that did not. Overall, the data shows that in an ideal world, founder/CEOs deliver the best outcomes.

Among all the unicorns founded in the past 15 years, 65% still have the original founder as the CEO. Of those that were acquired or had an IPO that valued them at over $1 billion, 73% were founder-led at the time of the acquisition or IPO. Measuring the same metric among failed unicorns (those that had achieved a billion-dollar valuation, but later failed, or their valuation fell below $1B): 47% were founder-led and 53% had a 'professional' CEO. As Tamaseb says, it might be easy to make the conclusion here that “hired” CEOs led to failure, but that’s probably not an accurate take. It’s often the case that when a company is troubled and things are not working, the board of directors gets influenced to bring in a professional CEO, hence why the failed unicorns were more likely not to have the founder as the CEO anymore.

The most interesting insight is that founder-led startups ultimately create greater value. The average valuation of founder-led unicorns was 10.8% higher than those with a hired CEO and among those that had an IPO or were acquired for over $1B, the average valuation of founder-led ones was 18.5% higher than those with a professional CEO. Tamaseb points out that we don’t know what would have happened to a specific company had it not replaced the founding CEO. Hence it’s not a straightforward conclusion that founding CEOs are always better than hired CEOs. There are always nuances and special cases for each company. Our own observations from working closely with over 50 startups in recent years is that investors are significantly more wary about non-founder CEOs prior to sustained revenue growth, usually associated with Series B or C. Before then any hired-in CEO is going to have a lot more to prove.

What to look for in a lead investor

Lead investors play a crucial role in funding. As rounds are often syndicated with multiple investors, the lead investor brings efficiency to the process by doing two important things: 1. Writing the term sheet and negotiating the final deal with the CEO/founder, and 2. Putting the most money into the deal. The Term Sheet provides the main commercial terms of the offer and the lead investor will coordinate with the other new investors on the terms to be proposed. This includes the valuation, or price. It is generally expected that the lead will also put in around 50% of the round, but this can vary considerably and depends on the number of syndicate members. Given the importance of the role, founders must give great thought to who the lead investor could be as they undertake the funding campaign. Picking right can make things run very smoothly. Picking wrong can create a nightmare.

The lead investor should be well practiced in deal making. The obvious part is having the gravitas and experience in bringing multiple parties together and converging quickly on terms. The less obvious part is understanding how to navigate from the Term Sheet to the Investment Agreement. To do this efficiently requires a grasp of legal matters and the ability to manage the lawyers who will be doing the drafting. In deals where some syndicate members may be based outside the UK, having a lead investor that has an established working relationship with a good UK law firm can be a huge benefit. Negotiating final agreements with overseas law firms or with a hastily appointed UK firm that may not be familiar with venture deals can, at the very least, create huge frustration. In too many cases, it can severely delay a closure - or even derail it.

Lead investors accrue an authority that comes with being the 'dealmaker', extending beyond that of a key shareholder and (most likely) director. This combination provides a certain soft power that can be leveraged post-deal. Whilst all investors are owed the same duty, it's likely that the executives will be most responsive to those that have the greatest leverage. Some VCs will regularly try to position themselves as the lead and, provided they have a solid track record in this role, founders should make the most of this capability. In the right hands, lead investors can really smooth the process of dealmaking and make a founder's life a lot easier. When building target investor lists, founders should therefore ensure that potential lead investors are clearly identified and given priority treatment.

2. Other pieces really worth reading this week: 

A Guide To Subscriptions For Hardware Startups
Some great insights for hardware startups by Nils Mattisson Formerly at Apple, now CEO and Co-founder of Minut. "Experienced founders will tell you that having a subscription model is the best way to ensure that your hardware startup can be sustainable in the long term. The financial markets reflect this as well. It’s notoriously difficult to raise funding if you can’t show a path to recurring revenue, and market valuation multiples are typically much higher for companies that benefit from service revenue in addition to sales."

Common mistakes that founders make around compensation
In a recent article, Dominic Jacquesson, VP of Insight & Talent at Index Ventures shares some key observations about compensation. "Another issue that tends to happen with solo founders is they want to bring on an experienced entrepreneur with specific complementary skills. It’s too late to offer equity (versus stock options), or to be considered a co-founder. If you’re in this position, it might drive you to offer them a very large option grant (draining your employee stock ownership plan, or ESOP) and paying higher cash compensation than you can afford."

Playing the Long Game in Venture Capital
Musings of highly respected VC, Mark Suster, in Both Sides of the Table. "While the VC community realized 5ish years ago that short-termism in venture capital didn’t make sense and has capitalized on the scale advantages of letting companies go long, the LP community by and large hasn’t totally grokked this."

Will startups return to offices after Covid?
A survey of Index Ventures portfolio provides insights into the changes some companies will adopt. "Surprisingly few startups are shifting to fully-remote models, primarily out of concern for impacting collaboration and culture, which are both so critical in the early life of companies."

Happy reading!

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