Duet Partners
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Weekly Briefing Note for Founders

30th March 2023

This week on the startup to scaleup journey:
  • 2023 could be a vintage year for VC
  • Founders must realign funding expectations
  • DeepTech funding in Europe is still wanting

2023 could be a vintage year for VC

Venture markets have tightened relentlessly over recent quarters following a slew of negative macro-market forces. Founders are anxiously peering into the gloom wondering whether investor sentiment will improve anytime soon. An analysis of investment market conditions in the US by Pitchbook indicates that at least some stability may be appearing on the horizon as inflation calms. As US market conditions usually provide advance signalling for the global venture scene, understanding the key trends here can be informative. The place to start is public markets. If they are stalled due to valuation anxiety - as they have been for months - then this has an impact that is felt all the way down the venture food chain. Pitchbook estimates that in the US alone, there are well over 200 VC-backed startups ready to go public but can't progress due to depressed market conditions. But once this log-jam starts to ease, these exits should quickly lead to higher distributions to LPs as GPs obtain liquidity. This would provide a critical shift in sentiment. Public markets are gradually clawing their way back from the lows of 2022, but it is still an uncertain road ahead.

In the meantime, we are navigating an imbalance in the supply and demand of capital, most notably at late stage. Here, Pitchbook estimates that startups currently need 2.8x more capital than is being supplied by investors. Even though the growth in startups’ need for capital has decelerated, the supply of capital has dropped more quickly, leaving late-stage Software the most starved (3.8x), followed by late-stage B2C (3.3x), and late-stage Healthcare Services and Systems (3.2x). Many big crossover funds, notably the nontraditional investors that really came to the fore in 2021, have already shifted their investment strategies towards early stage. This is because smaller, less mature companies are now likely to provide the best return to investors. 2023 could end up being one of the best-performing vintage years on record. Conversely, funds that invested through 2021 and 2022 could see some of the lowest return multiples ever recorded. Founders may be wondering why they haven't heard much from certain VCs that were all so excited to invest in their startups over the past 18 months. Many that spent heavily at the top of the market will now just become zombie funds. Those fund managers will have severe difficulty in convincing LPs to invest in any new funds, so the outlook for them is bleak. Some will simply not survive.

This change in emphasis from late stage to early stage is accompanied by two other significant and related trends. The first is that VCs are raising less money from LPs in new funding rounds. 2022 saw a record amount of new LP commitments closed by VC funds. However, we have witnessed a tepid fundraising environment so far in 2023, with a collapse in new fund count. This has disproportionately impacted emerging fund managers as the more established managers offer a 'safer pair of hands' in a very uncertain market. Realising that they will not be able to deploy capital at the rate anticipated, a second more unusual trend is underway. Some VCs are cancelling capital calls and even returning money to LPs. Most notably, Founders Fund has reduced the size of its $1.9 billion fund to $900 million in large part because its leader, Peter Thiel, believes the opportunities in VC are not as plentiful as when the vehicle was raised about a year ago. And a host of smaller funds, especially solo GP funds that were born out of some remarkable founder exits in 2021, are following suit according to TechCrunch. The big takeaway for founders seeking investment in 2023 is that to deliver the vintage year that so many expect, deals still need to be done. If you have a truly compelling proposition, this could be your moment to stand out from the crowd.

Founders must realign funding expectations

This is a tough time to be a founder, especially one that has to raise money in the coming months. Fundraising puts immense pressure on founders at the best of times. It's a full time job on top of your day job, and it takes months to see it through. In good market conditions it's a high intensity sprint. Now it feels more like a marathon. Over recent months this shift has been palpable. You can sense it in every founder (and investor) conversation. As a result, our role seems to have unconsciously morphed beyond that of advisor to that of coach. As a fund-raising advisor you are typically bringing a combination of market insight and best practice, as well as your network. This includes investor research, the sharpening of investment propositions, tools for efficient investment preparation, and proven methods for campaign execution. But that is not enough. Given the increasing uncertainties, you are not just advising in a 'practical' sense, you are also helping founders mentally prepare. Many will have never experienced a funding environment like this before. Getting them into a position where they are more able to help themselves is now a key part of the mission.

The less you feel in control of events, the more your anxiety heightens. In this sense, mental preparation means understanding what to expect and working out in advance how you will deal with it. When setting expectations for the funding journey ahead, we are asking founders to now factor in 3 new realities: 1. It's a full-time commitment. The campaign is going to demand every ounce of your creativity and focus, so don't expect to do the full day job on top. The fact that you will have to reach out to many more investors than you did for your last round will consume much more time. Response management will then demand your full attention until the close. To create this capacity, you will need hand over as many of your day-to-day responsibilities to others as you can. Your lieutenants will need to step up and backfill. 2. It's going to take longer. There will not just be more investors to manage through the funnel, but they will also want to undertake more due diligence. Their internal processes will also take longer. More will say 'no'. You'll need all your metal stamina to stay the course and keep positive. To help manage this extra complexity, diligently track feedback and don't rely on keeping everything only in your head. This is crucial for undertaking trend analysis before making any course adjustments (which are now increasingly required).

Finally, 3. Expect investors to be better briefed than ever before. Institutional investors are planning to know a lot more about you than you are about them, even before the first conversation. The research tools that investors have at their disposal these days are significantly more powerful than just a few years ago. They can quickly analyse your market, your entire peer group including competitors, and your company history down to a level of detail that often astonishes founders when they first see it. Some also use the very latest ML-driven analytics to predict your company's ROI ranking against peers, your chances of exit success, and even what kind of exit it is likely to be! If investors are interested it is now much more likely they will talk to their contacts in other funds and compare notes at a very early stage. This is a return to a 'safety in numbers' approach where more and more deals are going to be syndicated to reduce risk. This means you will need the highest level of preparation before you reach out and absolute consistency in approach when you engage. Founders that mentally prepare for a marathon may find the race is not as arduous as expected. Those who don't may find it very heavy going.

DeepTech funding in Europe is still wanting

Not so long ago, the technology startup landscape in Europe was sparsely populated, especially when compared with other tech-rich regions of the world. But in recent years, European universities and research centres have become more proficient at spinning out young companies, recent analysis by the Boston Consulting Group (BCG) shows. At the same time, the entrepreneurial bug has bitten a growing cohort of aspiring Tech founders. Between 2015 and 2020, the number of European startups soared from about 1,850 to almost 6,600, according to Statista. Likewise, European DeepTech investment has been growing at a rate of about 50% a year. BCG data shows that in 2016, European DeepTech startups raised one-eighth as much venture capital equity as their North American counterparts; by 2020, the difference had dropped by half. But today these same DeepTech startups face a different and daunting challenge: scaling up as they begin to demonstrate technology and market success.

Understanding this challenge has become critical in addressing scale-up needs. The elements are often intertwined and vary by country. BCG found that the top 4 challenges were: 1. Securing financing and, in particular, a lead investor; 2. Building and leveraging a strong and productive board of directors with independent members; 3. Developing a compelling business strategy and investment narrative, and 4. Navigating European institutional challenges. Closer to home, a report just published by Pragmatic Semiconductor asks the question: "How can the UK turbocharge its ambition to become a science and technology superpower?" The report makes 10 key recommendations aimed at making a practical contribution to the Government's work to turn scientific and technological ambition into reality. Perhaps unsurprisingly both reports echo common themes, especially around attracting and securing investment domestically, supported by funding from around the world, to ensure that the best homegrown ideas can be realised. These calls to action should be applauded as they highlight critical recommendations for policy makers.

There is no doubt that the DeepTech funding landscape across Europe lacks breadth and depth. There are only a handful of funds that regularly invest strategically in DeepTech and a few more opportunistic funds that explore advanced technologies from time to time. The specialist funds that only invest in DeepTech tend to be small and are rarely in a position to lead larger rounds. Smaller funding rounds often result in lower valuations, which can deter talent and, sometimes, other investors. And it's not just a function of size. European investors are often more risk averse than their counterparts in other regions. BCG's observation here is that: “While European investors typically ask, ‘How small can the investment be? How can we minimize the risk?’ US investors ask, ‘How big can the investment be? Would the impact double if we doubled the investment?’” And if you are a founder with a failed business in your past, then good luck raising capital in Europe. US investors, on the other hand, will more likely see this as invaluable experience worth backing. Even if initiatives to open new sources of European funding succeed, will they ever manage to change the culture?

Happy reading!

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