Duet Partners
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Weekly Briefing Note for Founders

28th July 2022

This week on the startup to scaleup journey:
  • Europe shows resilience as VC investments decline
  • VC fundraising defies market conditions
  • Customer Development versus Product Development

Europe shows resilience as VC investments decline

European startups raised €54.4 billion in 1H22 showing real resilience in the face of macro-market pressures. In Q2, €25.7 billion of investment was recorded, representing a modest decline of 10.6% over the first quarter of 2022, according to Pitchbook. This compares very favourably to an overall global decline of 26% for the same period. European companies received over €100 billion in VC funding in 2021 and if the current rate of investment continues in 2022, we could see that watermark beaten for the second consecutive year.  The U.K. remained the undisputed regional leader in terms of VC deal value in 1H22, and together with Ireland cemented their positions as the leading VC hubs in Europe. The countries secured combined investments of €17.9 billion in deal value in 1H22, representing 32.8% of the aggregate total across the region.

European late-stage deals consumed €36.1 billion in 1H22, representing 66.3% of total investment. They also increased their share of the overall deal count, which was flat compared to 2021, squeezing early-stage and seed stage deal counts moderately down. Nontraditional investor participation in the form of corporate VC (CVC) arms, private equity (PE) firms, sovereign wealth funds, investment banks, hedge funds, and pension funds, hit €42.4 billion, primarily supporting this late-stage activity. This is in sharp contrast to the US where so-called 'crossover' investors (notably big PE firms and hedge funds) have pulled back from late-stage investing during 1H22 as the publicly traded elements of their portfolios have seen valuations slashed. Although corporations have been dealing with their own challenges in a bear market, VC-backed startups still seem to be a priority for their growth strategies. Both corporate M&A and CVC investment have remained relatively strong in 2022. Nontraditional backers can bring real value-add to startups. CVCs in particular can offer synergies and lucrative strategic partnerships.

European exit value hit €25.8 billion in 1H22, a far cry from the headiness of 2021 where the annual figure reached €136.5 billion. Remember though that 2021 was a truly exceptional year for exits, driven by some outsize public listings. 1H22 performance is already ahead of the full-year figures for 2019 and 2020, representing a reversion to the mean, not a catastrophe. Exits, now skewed heavily to M&A, are continuing to take place at a healthy rate. Nevertheless, the short to medium-term outlook continues to present uncertainty, according to Pitchbook: "VC is heavily linked to technological development and the availability of capital due to record low interest rates has helped capital flow into VC. H1 2022 has marked a shift towards more bearish policy from central banks to combat inflation, and tech stocks have struggled in 2022. As a result, we could see exit activity dry up as we move deeper into 2022." Despite these increasing pressures, European VC investment momentum continues to show great resilience.

VC fundraising defies market conditions

Amidst the current doom and gloom around startup funding, something doesn't seem to add up. We've all seen the drop-off in VC investment levels through 2Q22 and the strong downward pressure on valuations. The impression is that the VC funding world is in a protracted and painful slowdown. But one key indicator provides hope that this may not be the huge crisis that some predicted: Capital raised by VC funds continues to break records through the first half of 2022. As we said back in June, LP money supply is a metric we all now care about. That metric is on the up. According to Pitchbook, global VC fundraising in 1H22 hit $180B and seems well on track to beat the record $256B raised in the whole of 2021. A big chunk of this is attributed to US VCs, where $120B has been raised in 2022 to date and looks set to smash the $138.9B raised for the whole of 2021 (which itself blew away the $85.4B raised in 2020).

Across Europe there is similar hope for optimism. €12.3B was raised in 1H22 by 98 VC funds. This is a comparable rate to the total €24.8B raised over the whole of 2021. But the number of new funds is markedly down compared to the 264 vehicles closed the year before. This could be the lowest number of new funds closed since 2013. As a consequence, median fund sizes continue on a strong upward trend to €84.5M in 1H22. The momentum seems to be behind established fund managers with proven track records. Emerging managers setting out to close their first or second funds are having a much tougher time and some may not survive. Even so, the overall amount of dry powder in the market is still increasing, which is great news for founders. Pitchbook says: "..strong historical return profiles and long-term investment horizons associated with VC have enticed LPs to commit. VC is relatively insulated from near-term shocks as funds can have a lifespan of 8 to 12 years. LPs could view VC funds as a viable option in the long-term as volatile asset prices persist and inflation erodes returns."

Despite this strong momentum in LP allocations, the deployment rate of capital has clearly slowed through 1H22 as investors take stock. No-one really wants to commit beyond the urgent needs of their current portfolio until they think the market has bottomed. There are murmurings from some VCs that through Q2 and the early part of Q3, they have simply been in ‘wait and see‘ mode. September could see some initial resurgence as markets, together with the overall macroeconomic picture, will have hopefully stabilised. Once there is an uptick in optimism, VCs with significant funds to spend will we be looking to increase their rate of cheque writing. Nothing is certain but the fact that the underlying performance of most startups continues to be positive and the appetite of LPs for the VC asset class seems as strong as ever, should create pressure on VCs to deploy capital at faster rates than we have seen so far in 2022.

Customer Development versus Product 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 larger 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 or even fatal. The challenge for many founders, especially those coming from the corporate world, is that several aspects of the process - such as 'Customer Discovery' - can seem highly counterintuitive. These deserve careful study as they are pivotal in securing early-stage funding.

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 an initial market for the product as currently specified. They don't just abandon the vision of the startup 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 will drive 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 initial market can then deliver early traction is vital to then finding product/market fit. From this landing point the startup can begin to scale and expand. When the business becomes established, the transition to a Product Development philosophy can begin.

Happy reading!

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