Duet Partners
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Newsletter

Weekly Briefing Note for Founders

3rd June 2021

This week on the startup to scaleup journey:
  • Investors are starting due diligence even before you pitch
  • Why are fewer first-time funds being created?
  • Domain knowledge is critical in DeepTech
  • Chinese investors are quietly becoming more active

1. Insights of the week

Investors are starting due diligence even before you pitch

It used to be that investors would begin due diligence work during the fundraising process, shortly after the initial pitch meeting. But with fewer deals being done (especially 'first financings') and competition for the 'best' deals increasing, investors are trying to get ahead of the game. We have been witnessing this in the US for some time. Here, speed to term sheet is being seen as a competitive advantage and investors have inverted the sequence of diligence, doing a fair amount of market-related work on their own in order to: 1) move quickly during a future process, or 2) to preempt a round. The same behaviours are now becoming apparent in the UK. Armed with increasingly sophisticated research tools and databases, institutional investors are proactively profiling and assessing startups that they think will be a great fit for their investment thesis. This can often begin many months before a startup declares its fundraising intentions.

Experienced founders are increasingly conscious of this early investigative work and are making greater efforts to shape the public image of their companies, even from a very early stage. We already know that investors take time to build conviction. The need to socialise the business with select investors well before a formal funding process starts has never been so important. But this is inevitably time consuming and has to be highly focused. To efficiently achieve broader coverage ahead of the campaign, founders are using a diverse array of methods to create the aura of a 'big growth story in the making'. For example, regular investor updates, a technique originally adopted from the US market, have firmly taken hold here. These are designed to supplement the huge amount of public data (e.g. Companies House, LinkedIn, Crunchbase, etc) that is already being electronically scraped and analysed.

Any announcements that are posted or appear in the press will almost certainly get picked up in the major datasets and fed into the intelligence hopper, potentially sounding the alarm for VC action. Despite this awareness, many founders struggle to get their marketing game together fast enough, with all the other pressures of navigating the early stages of the startup to scaleup journey constantly competing for attention. But a radio silence approach can be damaging and a missed opportunity to control the narrative. Any significant milestone - a key hire, a new customer win, a major new partner, a funding round - is a candidate for a press release. This will help keep you on the tracking radar. Sooner or later this will trigger the initial call - from the investor trying to get ahead of the game.


Why are fewer first-time funds being created?

European VC funds raised a record high of €19.6 billion in 2020 according to Pitchbook. This was a remarkable 35.2% year on year increase as Limited Partners (LPs) and General Partners (GPs) across the continent shrugged off long-term apprehension posed by COVID-19. The quantity of closed VC funds ticked up to 172, reversing the decline observed during the last two years. GPs have been able to close larger vehicles as the pool of capital sources and commitment sizes expand. In 2020, VC funds over €100 million in size represented 82.0% of the total capital raised in Europe. But funds under €50M have become an ever diminishing proportion of the pie. These funds are typically characterised by first-time fund managers, often looking to invest in the earliest stages of the startup lifecycle. If there are fewer maiden funds, startups will find it increasingly difficult to raise their first round of institutional capital. So what's going on?

Changes in the US market may provide insight. As Pitchbook reported, 2020 was a record year for venture fundraising in the US with nearly $80 billion of fresh capital, and this year is on pace to exceed $100 billion. But fundraising by first-time managers hasn't been keeping pace with that growth. Last year, only 87 managers succeeded in closing their Inaugural fund, a sharp drop from the 145 and 162 first-time US VC funds raised in 2019 and 2018, respectively.  LPs say the reduction in first-time funds is, ironically, largely a result of venture capital's recent success. Existing fund managers are taking up a bigger portion of LPs' VC allocation due to 3 factors: 1. VCs are raising larger funds, 2. Many are coming back to market with subsequent vehicles at a much faster pace than in the past, and 3. Since startups have been raising capital at higher valuations, these assets in effect are growing faster than LPs' holdings in other investment buckets like public equities or real estate.

Many pension plans, endowments and foundations have found themselves suddenly exceeding their target allocations for venture assets. This means that some LPs are constrained by how much they can invest in existing VC relationships, let alone bet on new managers. Significant cash returns back to LPs will gradually solve the over-allocation problem and free up funds for first-time and emerging VCs. Despite gains from the SPAC reverse merger boom in the US and the strongest IPO market in two decades, the majority of VC fund returns are still only "on paper" and can't yet be recycled into new funds. Meanwhile first-time institutional investments into startups across Europe remain in decline, from a high of 2,372 deals in 2014 to 1,531 deals in 2020. The competition for Seed stage investment therefore remains intense. But once any business is truly starting to scale, a sea of capital awaits.


Domain knowledge is critical in DeepTech

Founders in DeepTech businesses face particular challenges. The journey to exit can be much longer and far more capital intensive than other tech-enabled businesses. Often this requires invention, not just innovation - think new forms of clean energy generation, breakthroughs in materials science, robotics, and even semiconductors. Given the higher risk profile, fewer investors will have the appetite for the ride - even though the ultimate gains could be game-changing. Those that do will want to be confident that they won't get marooned as the sole investor. At early stage especially, founder conviction will play a significant part in making up for the slower cadence of commercial progress - compared to say enterprise software businesses. Such conviction, insight and belief can only really be born out of deep domain expertise. Someone on the founding team will need to possess this knowledge and have gathered the initial insights that make the whole proposition credible.

In Paul Graham's blog, Crazy New Ideas, he says: "There's one kind of opinion I'd be very afraid to express publicly. If someone I knew to be both a domain expert and a reasonable person proposed an idea that sounded preposterous, I'd be very reluctant to say "That will never work." When the average person proposes an implausible-sounding idea, its implausibility is evidence of their incompetence. But when a reasonable domain expert does it, the situation is reversed." Such domain expertise initially acts as a proxy for customers, and that could be enough to give you your first one or two rounds of investment from a DeepTech VC. The priority will then be to build something that you can put in customers' hands - something you believe will address the core problem you are trying to solve. A software business will call this an MVP, a DeepTech business is more likely to call it a prototype. The aim is the same - customer feedback.

DeepTech businesses often have a particular issue with nailing down market focus. If they are creating a 'platform technology', one that can be used in a multitude of applications, the urgent job is to decide where the low hanging fruit is. This is almost impossible to finally determine without some form of early adopter engagement(s). A DeepTech startup will often stand or fall based on selecting the right type of initial customer relationships. Domain knowledge is often essential in this judgement. Customers must provide corporate prioritisation for the project, some degree of flexibility in the specification, clear IP ownership rights (if there is any joint development), and a willingness to act as an investor reference. Founders with domain expertise are also less likely to get hoodwinked by cute R&D departments just looking for the inside track on the latest technology.

Chinese investors are quietly becoming more active

European startups that once wondered if they should set up shop in the US to attract US investment have been answered over the past 3 years. US investors came here instead. US funds have been pumping huge amounts of capital into Europe’s VC-backed companies. Less than halfway through the year, US investors have already put €10.1B into Europe’s startups in 2021, according to Dealroom; easily surpassing the €9.3B invested in all of 2020. Meanwhile, Asian investors have been quietly increasing their participation in European deals. According to GP Bullhound, Chinese investment reached an all-time high in the first quarter of this year in terms of number of deals (43), participating in $568M worth of transactions. Whilst Fintech companies are the major targets so far, Chinese investors are also investing in DeepTech hardware and software companies. Some of this uptick in interest has been spurred by the US/China trade war.

In the US vs. China race to build the chip technology of tomorrow, startups in China and the US have been subject to a venture capital land grab from investors who believe nascent chip designs will propel a future ruled by artificial intelligence and machine learning. Global VC investment in semiconductor companies set a quarterly record for deal value at $2.64B in the first quarter of 2021, with 70% of the funding going toward Chinese companies, according to PitchBook.  In China, the increase in chip investment underscores the priority the government has placed on strengthening its chip industry aiming to reduce its dependence on foreign imports. In recent years, China has launched semiconductor-focused funds reportedly totalling around $50 billion. A similar figure has been earmarked in the US as part of the American Jobs Plan.

Any technology that propels AI forward is going to illuminate the radar for both US and Chinese investors. For a taste of what is driving this surge in activity take a look at BBC's Panorama, "Are you scared yet, human?"  European founders may elect to steer clear of investors whose motives are not entirely clear. Silicon Valley startup Pilot AI Labs, which according to reports in the Wall Street Journal regretted taking on Chinese VC firm Digital Horizon as an investor as it impeded its ability to work with the US Department of Defense. As Sifted points out, there is always the risk that companies with Chinese investors could become embroiled in politics in a way they might not want. But Chinese investors will be at pains to point out that having them on board enables a startup to look east as well as west when starting to scale. Unlocking Asian markets can be a big pull in certain sectors and Chinese investors know this is an ace that only they can play.

2. Other pieces really worth reading this week: 

A Founder's Guide to Writing Well
From the First Round Review a powerful piece on writing skills for founders. "Of the many skills attributed to successful entrepreneurs — vision, execution, persuasion, perseverance, grit, resilience — effective writing inevitably fails to make the list."

A Path to the Minimum Viable Product
From the blog of Steve Blank, the 'father of modern entrepreneurship', a great primer of the role of the MVP and how to make sure you build the right one by using an MVP Tree.

The greatest investors make large concentrated bets where they have a lot of conviction
Stanley Druckenmiller is interviewed this week in The Hustle. The investing legend tells us whether we are in another tech bubble, the appeal of Bitcoin, what makes a great investor and more. Hugely insightful piece on the macroeconomics of our time.

Choose one co-founder to lead investor negotiations
From the Forward Partners blog, some great pointers on how startups with multiple founders should face off with investors when negotiating a deal.

Happy reading!

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