Duet Partners
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Weekly Briefing Note for Founders

28th January 2021

This week on the startup to scaleup journey:
  • Golden era of VC: exits and new funds at record highs
  • Meeting investors in a remote world
  • How VC funds make money
  • Understanding VC psychology: FOMO and FOLS

1. Insights of the week

Golden era of VC: exits and new funds at record highs

2020 turned out to be a bumper year for VC in Europe, according to Pitchbook's 2020 Annual European Venture Report. After a slow start to 2020, exit value gathered momentum as the year progressed. Total European VC exit value rose 13.9% YoY in 2020 to €18.6B. Companies pushed ahead with announced plans, in some cases expediting exits given the strong performance of IPOs. Sectors such as biotech & pharma, cybersecurity, and e-commerce gained. Surprisingly, the software sector generated only €1.5B in liquidity, the weakest showing since 2014, indicating that these startups decided to maximise growth via extended VC funding, perhaps with an eye on 2021.

European VC fundraising achieved a record high in 2020 as Limited Partners (the investors in VC funds) across the continent shrugged off long-term concerns posed by COVID-19. VC funds raised a record high of €19.6B in 2020, representing an astonishing 35.2% YoY increase. €5.1B of this was raised across the UK and Ireland, despite the anxieties of Brexit. Across Europe, 172 new funds closed, reversing the decline of the last two years. Average fund sizes were up. In 2020, funds over €100 million represented 82.0% of the total capital raised in Europe, just below the peak of 83.8% set in 2019.

Between the bookends of raising new funds and exiting, the real story for founders remains the flow of capital into the startup ecosystem. Here the messages are far more nuanced and we have commented on these many times in recent months. Headline figures for capital outflows in 2020 were remarkable, with a new annual record set at €42.8B. However, a large slice of this, €26.5B, related to deals in excess of €25M. At the other end of the spectrum, first time financings hit new lows, having been in steady decline since 2014. Once founders make the jump from private to institutional financing, the world opens up, but this step has rarely been higher. 


Meeting investors in a remote world

Despite the record amounts of capital being invested across Europe, 46% of founders said in a recent study that access to capital was the biggest challenge they faced in 2020. Anecdotal feedback from founders suggest it has never been easier to arrange an initial meeting with an investor. The issue is that it has also never been easier for an investor to evaluate so many opportunities so efficiently. So whilst Zoom interactions are up, actual dealmaking is down. A recent article by SaaStock analysed some of the dynamics at play when interacting with investors online and is well worth a read.

One of the biggest differences in the remote relationship building experience is due diligence (DD). It's so much harder to build rapport with people you only meet online. Establishing trust is a core part of the process. It will certainly be harder for investors to get a feel for your team culture and morale without the face to face. As a result, investors have become even more thorough at checking out teams and companies during DD. For example, there's clearly an increased focus on referencing. Founders should give this greater forethought and line up suitable references well in advance.

In parallel, founders should ensure they are running further checks on potential investors. Speaking to a peer that took money from a prospective investor at a similar stage is particularly valuable. If possible, find one that has already exited as they may feel less beholden to that investor than if they were still sitting on their board. Given how challenging 2020 was, understanding how that investor behaved when the chips were down will provide invaluable insight. Find out how supportive they have truly been, for example stepping forward with bridge finance and drawing in support from the smaller investors to help management swiftly and efficiently close. DD cuts both ways.


How VC funds make money

For an insight into the basic maths, there are 2 elements to consider. First, the management fee:  Out of any fund a VC will take around 2% per year management fee (to pay operating expenses such as salaries, rent etc.). A typical VC fund will run for 10 years. Second, a performance fee: The VC will take around 20% of the profit on exits. These profits are referred to as carried interest (or just ‘carry’). The profit is usually the net gain after the initial investment in the fund is first returned to the investors (the ‘Limited Partners’ or LPs).
 
For example, consider a $200M Seed fund and assume it ultimately generates a healthy 4x return. The resultant $800M would be split as follows:
Management fee of 2% x 10 years x $200M = $40M
The Initial investment of $200M is returned to LPs, leaving a Gross Profit of:
$800M - $40M - $200M = $560M, of which 20% is taken by the VC as ‘carry’ = $112M
The balance (80%) goes to the LPs = $448M
 
To hit the 4x return target, and assuming an average 15% stakeholding at exit (following some dilution of their initial stake), total returns (the sum total of all exits) would need to be $800M/15% = $5.3B. A $200M fund may expect to make around 30 investments in total, but returns will vary hugely by portfolio company. A fund manager will expect 5 to 6 companies to have great outcomes, 12 to have modest returns, and the rest, 18, no return - they will either die or just fade away. This means that a $200M fund is going to be a unicorn hunter


Understanding VC psychology: FOMO and FOLS

Time is often the biggest enemy of the capital raising CEO, but it’s the VC’s friend. The more time a VC has to evaluate an opportunity, the more they will understand the true risk and opportunity profile, which is always their aim. But the closer they take you to your cliff edge on cash the more negotiating leverage they will have. Keeping up campaign momentum is therefore critical. You must close in the fastest possible amount of time, and to do this you have to understand the 2 key psychological drivers of VCs: The Fear of Missing Out (FOMO) and the Fear of Looking Stupid (FOLS).
 
FOMO: Given the huge number of opportunities VCs assess relative to the number of investments they make (typically less than 1%) VCs carry a certain degree of paranoia about missing something great. Every VC has their stories about the ones that got away, and the ones they ‘passed’ on that turned into big money spinners. These are the ‘losses’ that VCs rarely talk about but are the ones that prey on their minds. So, when a VC sees something that ticks all the boxes, they will usually move quickly to get the deal ‘off the table’.
 
FOLS: VCs look to carefully protect their reputations and will do everything to avoid looking stupid, especially amongst their peers. Investing in a company that looks like it’s late to market, or a company that is going up against huge incumbents, or where a competitor has been recently funded by another well-known VC fund, might end up looking like a dumb bet if things end up going south. Worse, it could impact their ability to raise the next fund. So, expect VCs to be particularly wary if your business has ANY such attributes. More on this topic in our latest blog, Understanding the VC mindset.



2. Other pieces really worth reading this week: 

Post-pandemic, the best place to start a company will be in the Cloud
An eye-opening blog post from Kim-Mai Cutler at US VC, Initialised Capital: "Pre-pandemic, the Bay Area was still the leading choice for our founders in terms of where to start a company. Post-pandemic is a different story. More than 40 percent of founders say that the best place to start a company will be in the cloud."

Will Rolling Funds Roll Over the Venture Capital Industry?
A perspective piece by Minal Hasan on the emergence of Rolling Funds and they impact they may have on the early stage funding landscape. A great primer if you have not come across this new phenomena.

VCs cutting out the Press to control their own PR
A revealing article in Business Insider lifting the lid on the PR strategy of the big VCs. "Andreessen Horowitz is not the only VC firm building its own in-house 'media machine', top VCs tell us."

Who Will Control the Software That Powers the Internet?
A thought-provoking piece from Andreessen Horowitz: "There is a growing movement — emerging from the blockchain and cryptocurrency world — to build new internet services that combine the power of modern, centralized services with the community-led ethos of the original internet. We should embrace it."

Our Stack at a $10M Fund
A surprisingly open and honest attempt by a small VC to create differentiation through transparency. Weekend Fund is a pre-Seed fund with a two-person distributed team, one in London, one in LA. Don't dwell on the fund size, look at how they organise deal flow management. 


Happy reading!

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