Duet Partners
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Weekly Briefing Note for Founders

4th May 2023

This week on the startup to scaleup journey:
  • 2023 outlook for VC investment
  • Is the M&A window closing for startups?
  • VCs seeking weekly reports from founders

2023 outlook for VC investment

The VC community is very bullish on the impacts of artificial intelligence (AI); anticipates further declines in VC funding; and expects valuations to become more attractive over the next year. These are some of the findings of a recent Pitchbook survey of 58 global VC investors, undertaken in early April. Respondents were first asked which areas of technology they expect to drive the most innovation over the next 12 months. AI was ranked highest at 31.6%, ClimateTech second at 20.4% and BioTech third at 12.5%.  Overall, 70.7% think generative AI will have a 'very disruptive' effect across many markets and be a primary driver behind a new wave of technology unicorns over the next 5 years. Respondents also said they expected climate technologies will continue to benefit from both regulatory and consumer demand for carbon-controlling technologies and the continued efforts to make power grids more sustainable. Meanwhile, the biotech industry has continued to forge ahead despite the broader pullback in the market and has also benefited from modern AI technologies accelerating the pace of drug discovery.

Respondents were then asked about the state of venture funding and how the events of the past year have impacted the funding environment. For the most part, VC investors expect investment to decrease over the next year, with 29.3% expecting a moderate decrease and 13.8% expecting a strong decrease. In terms of which macroeconomic and sociopolitical factors are having the biggest downward impact on investment the overwhelming response (72.4%) was 'higher interest rates'. However, there was some optimism in the results, with a solid 32.8% expecting funding levels to stay the same and 24.1% expecting an increase in funding. VC funding levels have declined for the past four quarters and reached a pre-pandemic low in Q1 2023 (as we reported last week). Additionally, 77.6% of respondents said they expect valuations to become more attractive (i.e. reduce) over the next year, indicating the group does not yet believe the market has bottomed out. Still, the respondents signalled a marginal degree of optimism related to fundraising, with 50% saying their own fundraising plans have not changed or have been pulled forward. Overall, the majority expect 2023 to be a strong vintage year for fund performance.

When asked about the “tech wreck” of 2022, half viewed the impact as positive and half viewed it as negative. Respondents who saw a positive impact said the downturn could remove unproductive participants from the market, funnel more capital only to the best companies, and encourage leaner teams that can move faster. Respondents who viewed the impact as negative said the tech wreck could lead to less funding for startups, scare off innovators and entrepreneurs, and cause companies to focus on maintaining current positions as opposed to pursuing growth opportunities. And therein lies the rub for VCs. Some investors, especially those with less well-known funds, are starting to express anxiety at the lack of quality deal flow. There is no doubt that some founders (those that have the available cash runway) have pushed out funding in the hope that the market will improve before they have to raise again. But those with high quality propositions in hot markets that have pressed ahead with campaigns are finding strong interest. If they aren't carrying highly elevated valuations from a prior round in 2021 then the stars are now very much aligning for this particular cohort of companies.

Is the M&A window closing for startups?

With funding timelines lengthening and fewer deals being completed, more and more startups have been exploring M&A options - well before they had imagined. Over recent quarters, VCs anxious that some portfolio companies would run out of cash before raising their next round have been asking founders to hedge their bets. As a result, the number of founders undertaking  'dual-track' campaigns - a funding round and an M&A process in parallel - has been on the rise. With M&A cycles typically taking much longer than equity funding, investors are anxious that founders start the process whilst they still have a decent amount of cash runway on hand. Entering an M&A discussion with only a few months of cash remaining is no more than a 'fire sale' with the prospect of any kind of investment return wiped out. Founders have therefore been taking a much keener interest in M&A markets whilst at the same time evaluating their own M&A 'positioning', which is often heavily geared to the stage of the business. Through 2022, acquisitions of VC-backed companies remained elevated following the bumper 2021, but in 1Q23 the numbers took a dive. Does this mean that the acquisition window is closing? Again, the answer lies in what stage the business has reached and whether it can help unlock new value for the acquirer.

Exits overall in 2021 hit an astonishing €136.5B across Europe, according to Pitchbook data. IPOs made up the lion's share at €105.9B, followed by corporate acquisitions at €25.2B, then PE Buyouts at €5.4B. In 2022, exits dropped significantly to €37.3B, largely as a result of IPOs collapsing to €12.3B. But acquisitions maintained momentum at €22.6B, whilst buyouts halved to €2.4B - mainly due to the rising cost of debt for LBOs. Worryingly, the most recent figures show continued and dramatic falls. In 1Q23, European VC exit activity sunk to a 10-year low of €1.6B, reflecting a 70% QoQ decline. This included just €950M of public listings, only €650M of corporate acquisitions, and a paltry €50M of buyouts. Substantial VC exits effectively ceased in Q1 as unfavourable macroeconomic conditions and weaker valuations dampened exit appetite. Even so, when faced with the prospect of a failed fundraising, any potential prospect of an acquisition has to be investigated for any loss-making business. Sensing a closing window, late-stage businesses have been taking huge valuation haircuts to get acquisitions done. For example, US-based transit tech company Via acquired London-based Citymapper at the end of March for €93.0M. The exit valuation was roughly half the €220.9M pre-money valuation for Citymapper during their May 2021 crowdfunding campaign (post Series C). 

But what about startups that haven't yet reached such an advanced stage? Kittu Kolluri, founder and managing director of Neotribe Ventures, offers insight in his recent TechCrunch article. He says that positioning will depend on whether or not you have found product/market fit. If you can't demonstrate "proof of value" by the time you are targeting Series A then he says "Pivot big or start looking for the exit". If you are through Series A you are now looking for "proof of market". i.e., Do you have a sales model that allows you to economically acquire customers at a pace and volume high enough to expand your business? If so, you are now in Series B territory. If not, it again could be time to look for the exit. In our recent piece, VCs tell founders to put up the 'For Sale' sign, we discussed how startups must then tailor their approaches, using an ascending hierarchy of value linked to stage. It begins with your star engineers and product developers and their skill sets. Next comes your technology, then your product and the advantages it has to offer. Then come your customers and revenue. Even though the late-stage window seems to have closed, there will always be a market for startups that can help unlock new value for the acquirer. The secret is understanding what this is before making the approach.

VCs seeking weekly reports from founders

In our recent piece, Your Board is probably going to fire you, we talked about the unique dynamics of the startup board. The biggest misconception that founder/CEOs have is that the VCs they bring onto the board are there to 'add value'. As founder and investor Jerry Neumann puts it in his blog: "The VCs are not on your board so they can help you, they can help you without being on the board. They are on your board for one reason: to monitor their investment so they can do something if things aren’t going how they want." As portfolio pressures rise on VCs, some are seeking greater frequency of reporting beyond the monthly board meeting. Gil Dibner of Angular Ventures says in his latest blog that any CEO with revenues should now be reporting to key stakeholders on a weekly basis. He offers a structure oriented around quarterly numbers, KPIs, cash burn, and other updates and 'asks', adding that "the best format seems to be a shared google doc, so that everyone can comment and ask questions. This way, your communication with stakeholders is one conversation, you don’t need to answer any questions twice, and everyone gets the benefit of all the clarifications and commentary that everyone needs. It keeps it as one stakeholder conversation between board meetings."

In today's climate, reporting to investors and other stakeholders is more important for CEOs than ever. No-one wants surprises. This sensitivity is understood, especially for investors that are going to be asked to support new financing rounds, changes in direction, or other big decisions. But even if a weekly report is lightweight and takes only 30 minutes to compose, there is a big question for founders over information management. This takes us back to one of Neumann's core pieces of advice in ensuring founder/CEOs 'carry' the board and lock in their support at all times. He too espouses the 'no surprises' mantra, but suggests a very different approach that resonated with our earlier piece: Pre-Board 1/1 calls are a power tool for CEOs. The board meeting is indeed not the place to convey important information for the first time. Reactions can be unpredictable, so always handle this 1/1, advises Neumann: "And when you do, do it on the phone and one board member at a time. Tell them the news, tell them what you think the company should do about it, and then listen to what they have to say." You will present the exact same information in the board, but everyone will have heard it already. You will present your plan to deal with it, as informed by the comments of the board members you previously heard.

Founders will need to choose the communications method that best suits them. A key consideration is the efficiency of communication. It's certainly true that composing a single message that is sent or shared with the board as a group is the most efficient method of getting the news out there. But there is another, even more critical consideration: in such a group setting you are not controlling the dialogue. If every recipient decides to pitch in with additional questions or advice, especially on contentious issues, this could very quickly descend into a downward spiral. Undertaking individual 1/1 phone calls instead might appear to be a bigger time sink than an email or google doc report, but they do allow a founder to more efficiently manage the reaction, whilst still keeping investors appraised of key developments. The 1/1 call  - or better, a zoom call - is also more personal. You can better read someone's immediate reaction, understand their feedback, discuss their individual concerns, and build on the important relationship you are establishing. Here, you are more likely to tease out the real value-add that they can each bring as individuals. Remember, there is no value-added board. There are no value-added board members. There are value-added people. And that's the real value-add you are seeking as CEO.

Happy reading!

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