1. Insights of the week

VC fundraising momentum drives buoyant dealmaking in Q1

Despite a very uncertain economic environment, VC dealmaking remained buoyant in Q1, according to Pitchbook. European VC deal value reached €27.5 billion in the quarter, and investment levels remained elevated after a record 2021. "Over €100 billion was invested into Europe-based companies in 2021 and, at the current rate in 2022, we could see that figure repeated for the second consecutive year." 1Q22 funding was down 18% compared to 4Q21, mirroring figures at the global level. But compared to the same quarter a year ago (1Q21: €17.6B), funding in Europe was up an astonishing 56%. However, as the economic effects of the pandemic emerge and the cost of living surges across Europe - and as the invasion of Ukraine continues to cause uncertainty - 2022 could be a challenging year for companies across Europe. 

Late-stage VC continued to dominate with €19.7 billion in investment, equivalent to 71.6% of the aggregate total. Impressively, late stage deal count also gained overall share, squeezing Seed and Early Stage yet again on a downward trend line that began back in 2014. This reflects a maturing ecosystem, with increasing non-traditional (i.e. non-VC) investor participation and companies staying private longer. These non-traditional backers have targeted high-growth companies operating in industries with wide long-term economic moats. Cutting-edge VC-backed companies have the potential to deliver outsized returns to portfolios that may have been affected by lower returns from asset allocations geared towards bonds or public equities. Consequently, nascent VC-backed companies tackling new challenges emerging from recent regulatory changes, technological development, or brand-new markets often form part of a forward-looking investment strategy. 

On the other side of the funding coin, European VC fundraising got off to a solid start in 2022, with 54 funds closing on a total €7.4 billion in Q1. Whilst capital raised in the quarter was in line with the pace set in recent yearly figures, fund count dropped significantly. Average fund sizes hit a record high of €144M. If the rate of new funds closing continues, it could result in the lowest VC fund count since 2013 by year-end. A significant positive trend is the emergence of funds looking to help startups grow inorganically through acquisitions, supporting so-called 'buy and build' strategies - previously the domain of big PE firms. "As company formation processes become more efficient across Europe and capital availability expands, new companies are constantly emerging in fast-moving sectors. Therefore, VC-backed companies and investors that have thought about and equipped themselves with the resources to quickly acquire competitors could be well-positioned to grow their market share in the long run."

Why you must build a monopoly

Founders know that competitive leadership requires clear differentiation on two fronts: First, a clear USP that will open up the market to drive early growth, and second, the creation of a long-term defensible position - a 'moat'. The USP can be a key product capability or feature that secures early sales. Over the long haul, it becomes harder to gain leverage from what was a unique capability at the start. A moat provides this long-term protection and may incorporate elements of proprietary technology, brand, economies of scale and network effects, as we described in our earlier article. Investors love companies that are able to build deep moats as they are essential for the creation of monopoly businesses. Why is this important? To paraphrase Peter Thiel: "Whereas a competitive firm must sell at the market price, a monopoly owns its market, so it can set its own prices. Since it has no competition, it produces at the quantity and price combination that maximizes its profits."

This belief in the ability to maximise profits at some future point is fundamental to early stage investing. This is another way of describing the ability to generate future cash flows. And as the value of a business today is the sum of all the money it will make in the future, companies that can make this promise will command huge valuation premiums. Technology companies, in particular, must make this pledge to investors. They will likely lose money for many years until finding maximum value perhaps 10 to 15 years down the line. The moat provides durability for the long haul, securing the monopoly and protecting future cash flows. In turn, this security provides a powerful incentive to innovate. Monopolies can make the long-term plans and have the confidence to finance the ambitious research projects that firms locked in competition can’t dream of.

But founders naturally steer way from using the 'M' word. They know that governments, usually via regulators, frown on monopolies, believing that competition is always best for society. Thiel draws a distinction between 'static monopolies' that occupy a world where nothing changes - the "rent collectors"  that will corner a market and jack up the price - and the 'creative monopolies' that "give customers more choices by adding entirely new categories of abundance."  This is the mantra of the tech world. Investors know that every business is successful exactly to the extent that it does something others cannot. The phrase 'category leader' nicely captures the spirit of a creative monopoly, so we can use this term instead.

The science behind storytelling

When preparing investor pitches, founders seek to create the most compelling story: The power of storytelling as a means of securing audience engagement is now widely recognised. But what is the evidence? Research has shown that audiences are more likely to engage with and adopt messages that make them feel personally involved by triggering an emotional response. Noah Zandan, author of Insights into Influence, has studied the science behind ‘influence’ and his work reveals that stories make us use our brains differently. Referring to research by Ohio State University on cognitive processes that occur when becoming immersed in a story: “They call that feeling - of being so lost in a narrative that we hardly notice the world around us - ‘transportation’. And they discovered that when we’re transported by a narrative - whether it’s true or imagined - we tend to view the protagonist more favourably and embrace the beliefs and worldviews the story presents. Most importantly, though, we tend to believe the story more readily than we would believe a non-narrative account."

Paul Zak is the founding director of the Centre for Neuroeconomic Studies at Claremont Graduate University in the USA. He discovered that a neurochemical called oxytocin is a key “it’s safe to approach others” signal in the brain. Oxytocin is produced when we are trusted or shown a kindness, and it motivates cooperation with others. It does this by enhancing the sense of empathy, our ability to experience others’ emotions. In his article ‘Why your brain loves good storytelling’, he describes how his team wondered if they could “hack” the oxytocin system to motivate people to engage in cooperative behaviours. He found that character-driven stories consistently cause oxytocin synthesis. Zak advises businesspeople to begin every presentation with a compelling, human-scale story. “Why should [your audience] care about the project you are proposing? How does it change the world or improve lives? How will people feel when it is complete? These are the components that make information persuasive and memorable.”

Investors often say that the greatest pitch meetings have also been the most memorable: The story felt 'real', it 'came alive', and they 'felt moved'. Great storytellers use a structure for this called the narrative arc. When used skilfully this technique can transport an audience to a place where they feel fully engaged. The slides become almost incidental. Exponents are able to create powerful images very quickly, often using an analogy, an anecdote, a revealing insight or other technique to help visualise a scene. They use these mental images to frame their thesis, to stir curiosity, to challenge received wisdom, and to set out an alternative vision. The most powerful presentations are also open and honest. Great exponents don't just talk about their mission, they talk about their journey, their sacrifice, and their failures. They explain what it means to them and, critically, what they have learned. If you can create a human context and get some oxytocin pumping, this will make the story highly relatable. By doing so you will create a connection. This will make you and your story more credible and alluring. 

2. Other pieces really worth reading this week: 

The state of the Series A: how has it changed?
In Sifted this week, a range of expert perspectives on the changing dynamics of early stage rounds: "Series A funding has skyrocketed — the average global Series A round increasing from less than $6m to more than $18m over the past decade. These chunky cheques naturally follow the ever-ballooning seed rounds and come with a whole new set of requirements from founders and leadership teams."

The shifting sands of capital
Phil Morle is a Partner at DeepTech VC, Main Sequence Ventures. This is his thought-provoking speech on The Shifting Sands of Capital at the Equities Forum (Centre for Institutional Investors) in April 2022. "Today, I am going to talk about $4 trillion moving somewhere else — how global forces are requiring humanity to innovate and how technology might profoundly change industries we have taken for granted as enduring. It might be shocking. And I might be wrong. But I might be right..."

Pulling off the acquihire
Great advice in this article from VC Sammy Abdullah, co-founder at Blossom Street Ventures. "We just watched a company go through a very intense, distressed M&A process that fell apart in the final hour. It was an acqui-hire which has its own nuances relative to traditional M&A. Below are some tips to pulling off your own acqui-hire should it come to that."

Happy reading!