Weekly Briefing Note for Founders

2nd March 2023

This week on the startup to scaleup journey:
  • Founders must be aware of VC groupthink
  • Venture Debt is fine until things go wrong
  • The science of storytelling

Founders must be aware of VC groupthink

Last week we highlighted why VCs are under pressure. The investors in VC funds, the Limited Partners (LPs), are not happy. And VCs desperately need their LPs to be happy if they want to raise new funds and retain their lucrative jobs. To do so, VCs need to demonstrate two big things in their track record: 1. They invested in hot startups in hot spaces, and 2. The failures they had weren’t bad investments, even if they didn’t work out. If a VC is making great returns then they'll be forgiven their failures. But as investor, DC Palter, highlights in his blog, there’s a little problem known as the J-curve: Failures come quickly, but successes take a long time to generate a return. Unlike stocks or real estate funds, it’s hard to tell how an investment in a VC fund is doing until 7–10 years later. This forces a horrible conformism that pushes VCs to never invest in anything that makes them look stupid if it fails. And they have to assume that every investment will fail. That's why experienced founders know that If you’re in a hot sector, VCs will fight over you for the chance to invest. If you’re in a space that isn’t sexy, it can be hard to find any traction with investors.

When a VC sends out their quarterly report to LPs, they are always anxious about explaining the failures. Since most investments fail, there is nearly always some bad news to deliver. As Palter says: If the failed investment was in say, SaaS, the fund can claim it had been a good investment, but the industry hit unexpected headwinds from the slowing economy and unfortunately, it didn’t work out. No big egg on face here. But what if the failed startup was developing something more radical, let’s say…teleportation. If it succeeded, it would’ve changed the world. The founders were brilliant physicists. The fund hired respected scientists to double-check the theory. Sure, it was a long shot, but if it worked… it would’ve been the greatest investment ever, easily worth trillions. But it didn’t work. And now the fund needs to report to their LPs that the teleportation startup in their portfolio failed. The reaction this time is likely to be very different: WTF??? Teleportation??? What the hell were you idiots investing my money in? No way I’m ever giving you another cent.

Founders seeking funding must acquaint themselves with what VCs are looking for. If you're slap bang in the centre of a hot sector, great. If not, is there some way you can position your startup as part of one of those sectors? For example, hot verticals that are propelling change in established industries right now include ClimateTech, FemTech, HealthTech, and Supply Chain Tech, just to name a few. Palter's advice is that If you’re in an unpopular, unsexy category and there’s no way to spin it differently, don’t waste your time on the funds that play 'follow the leader'. Look for investors that will truly 'get' your pitch. These could be smaller thesis-based VC funds; CVCs where there is clear mission-fit; strategic partners who look at your success as an opportunity for their business instead of simply a financial investment; and even angel investors who don’t need to justify their investments to anyone except themselves. Experienced founders know that researching investor alignment is a critical step in any successful funding campaign. Figure out who your audience is first, then create an investor deck with those exact targets in mind.

Venture Debt is fine until things go wrong

Startups that took on venture debt in recent years are facing uncertain times. When markets are growing, credit-based financing can be an attractive non-dilutive option compared to equity financing. But when commercial momentum slows and cash gets tight, founders can suddenly find they are being overtaken by events. A key 'feature' of venture debt is that the main collateral is cash. For early stage businesses that are not yet cash-generative, that cash comes from the company's equity investors. If they aren't forthcoming with fresh capital when cash gets low (as we witnessed numerous times through 2022 when valuations reverted to pre-pandemic norms), the venture debt lenders have a right to get paid out. A low-cash situation can quickly turn into a no-cash situation. As veteran VC, Paul Graham, once put it: "Even the best startups often go through near-death experiences. The problem with venture-debt is that it tends to turn near-death experiences into death experiences. Avoid it if you can." Easier said than done, for some.

Software startups can more easily rely on equity financing alone. But for those also developing hardware, venture debt is often a key part of the financing strategy. This is a form of debt specifically structured for startups by specialist lenders, which reduces the capital demand via the equity channel. It thus lowers the capital intensity for VCs who would rather defer big commitments until the company's growth prospects become much clearer. Even in times of a cash squeeze, provided the equity investors remain supportive, venture debt providers are usually happy to renegotiate terms. But once the equity providers start stepping back, the writing is on the wall. This is not to say that all forms of credit product carry the same downside exposure as those using cash as collateral. As VC, Shaun Abrahamson, discussed in his blog recently, revenue-based financing, equipment financing, and inventory financing can all offer other ways to ensure that lenders don’t lose their investment. For example, they can take back equipment and sell or re-lease it or they can cut available credit if company revenue declines.

There are many other sources of 'capital' that are applicable to startups, including government grants, supply chain financing, and impact capital. UK companies are well served with grant funding via Innovate UK. Supply-chain financing, however, is often under-explored. This could include component suppliers or contract manufacturers offering flexible payment terms (how Apple started) or customers providing advance payments for products (how ARM started) or governments providing tax credits/rebates (how Tesla started). It can even include equity financing by strategic supply-chain partners (Tesla, again). Impact capital comes in many forms but is usually designed to accept low or no financial returns to increase the possibility that startups in certain emerging verticals (e.g. Climate Tech) can secure capital from other investors. Founders should always explore avenues of non-equity financing before deciding on an equity round. But if the only option is taking on debt, even 'startup-friendly' venture debt, founders should think very carefully about the possible downside impact and where that could leave them if markets turn.

The science of storytelling

The power of storytelling as a means of securing audience engagement is widely recognised. It's vital in capital raising. In the words of Don Valentine, founder of Sequoia and one of the first investors in Apple, Atari, Cisco, Oracle, and EA: “Learning to tell a story is critically important because that’s how the money works. The money flows as a function of the story.” 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. 

Happy reading!

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