Duet Partners
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Weekly Briefing Note for Founders

4th November 2021

This week on the startup to scaleup journey:
  • 10 year VC funds becoming 'obsolete'
  • VCs are stressed out too
  • Essential Cap Table concepts for founders
  • Climate Tech is back in favour

1. Insights of the week

10 year VC funds becoming 'obsolete'

Following recent moves by Andreessen Horowitz and General Catalyst, Sequoia this week announced a major revamp to its fund structure. This represents a dramatic shift in strategy. These big VCs are repositioning to provide greater investment flexibility to startups and abandoning the artificial timelines for LP returns. The new structure lets Sequoia hold public shares long after the IPO of a portfolio company and seek the best long-term returns for LPs. It's not hard to see why, as public valuations are soaring. For example, Sequoia first invested in Square in 2011. The company already had a market cap of $2.9B at the IPO in 2015. Five years later Square grew to $86B, and today is worth a staggering $117B. Sequoia's sole focus will be to grow value for portfolio companies and limited partners over the long run, irrespective of whether this requires private or public market investment.

Sequoia's investments will soon flow through a singular, permanent structure. "Moving forward, our LPs will invest into The Sequoia Fund, an open-ended liquid portfolio made up of public positions in a selection of our enduring companies. The Sequoia Fund will in turn allocate capital to a series of closed-end sub funds for venture investments at every stage from inception to IPO." The big deal here is that this signals a shift to a strategy of longer term or 'patient' capital. This starts at Seed and extends through the full lifecycle of a company. "Patience and long-term partnerships generate exceptional results. For Sequoia, the 10-year fund cycle has become obsolete." Proceeds from these venture investments will flow back into The Sequoia Fund in a continuous feedback loop. Investments will no longer have “expiration dates.”

As part of the announcement, Sequoia also revealed that they have become registered financial advisors (RIA). General Catalyst and Andreessen Horowitz both became RIAs in recent years, a change that allowed them more flexibility in backing non-traditional assets outside of private markets. This represents a further disruptive effect on the VC model that will require an adjustment for LPs. It's thought unlikely that smaller funds could pull off such an audacious move. For the big firms, this 'reinvention' is necessary as an increasing number of PE firms and Hedge funds, such as Tiger Global, represent a serious competitive threat to the major incumbents. This is the first fundamental change to the 10-year VC fund cycle since the 1970s and it's likely that more big firms will (have to) follow suit.

VCs are stressed out too

Global venture funding has shot off the scale in 2021. We've all seen the figures, but perhaps haven't yet appreciated the tectonic impact this is having across the venture world. The Q3 highlights from CB Insights were eye-popping: $158B invested in the quarter versus $77B in the same quarter a year ago. That's 105% growth, which is unprecedented. And 3Q20 wasn't a low ball number due to Covid. On the contrary, 3Q20 was the highest Q3 ever. Just about every data point (other than the number of deals) is still surging ahead: valuations, exits, new fund sizes, and a faster pace of investment. For founders with quality propositions this is a time to replenish the bank account. You might think that for VCs this is also the time of plenty, but the picture is very mixed, depending on investment strategy: The 3 big VC plays are either; 'become huge', 'index the market', or, apply VC as an 'artisanal craft'. As VCs search to find their new anchor points, the tectonic plates seem to be shifting every quarter. This is causing real anxiety for fund managers.

VC blogs echo the fact that some of the most experienced venture investors are stressed. The Angular Ventures blog this week captures the mood: "Private conversations between VCs these days are very consistent and strangely apprehensive. While many are excited by the returns they are seeing, the market environment is disconcerting and fills many of us with uncertainty. It fills me with uncertainty. Everything is marked up to insane levels overnight. Every deal I pass on seems to be funded the next morning at twice the price the founders wanted when they spoke with me the previous day."  VCs are struggling to resolve some big questions: "How long will it last? Do I need to completely rethink my operating model? Do I need to write smaller checks earlier? Do I need to write bigger checks later? Maybe I should write bigger checks, but earlier? What if I totally abandoned my ownership targets? Should we move faster? Can we move faster? What if we raised a fund that was 10x larger?"

The 'become huge' strategy is not open to all, but some of the most established players have already gone down this route with new Seed stage funds that look like Series A funds of only a few years ago, such as Sequoia ($195M), Index ($200M), Andreessen ($400M), and Greylock ($500M). But it's the 'index funds', notably Tiger Global, that are dramatically changing the landscape. John Luttig's excellent post analyses this phenomenon, saying that the index mindset is now more obvious in VC than in any other asset class. This can be seen with big funds being very aggressive in pre-empting rounds, moving very quickly though due diligence to Term Sheet, not wincing at paying 'high' prices, and taking a very lightweight approach to company involvement post-investment. "VC is commoditizing more broadly – finance types have flooded in, growth funds are raised and deployed far more quickly, investment teams have scaled, and deal-level competition has intensified. It is no longer the boutique asset class that small funds were betting on. You need scale to make an indexing strategy work – this could drive a consolidation era of venture capital, with far fewer funds."

Essential Cap Table concepts for founders

A cap table (or Capitalisation Table) is a vital document for capital raising. It sets out who owns what percentage of the company and comes under real scrutiny during investor due diligence. At the point the company is founded, this is a very straight forward document but can quickly get complicated as the company develops: Stock options, warrants, convertible notes, as well different classes of shares (Ordinary & Preference) can conspire to gradually make the cap table a complex beast. VCs will usually include a detailed cap table (on a pre and post investment basis) in their offer of investment (Term Sheet) to ensure the impact of their planned shareholding is completely clear to all parties. Given its importance, founders will have to attest to the cap table being up to date and 100% accurate before negotiating with new investors. However, the true value of the cap table really shines through when you sell the company, as it determines how much money everyone gets!

The cap table is also a tool for modelling ownership values in different business scenarios, helping all parties assess their positions as the company grows. It also makes founders aware of scenarios they should try hard to avoid as the business progresses through various funding rounds. Many of these are captured in this very useful article by Kevin Lu of AirTree Ventures. The biggest killers are excessive liquidation preferences and large participation overhangs, which can potentially wipe out founder returns at exit. Preferred shares impart additional rights on top of those provided by common shares, generally giving priority to the security holder for cash returns in a liquidation event. Participating preferred shares receive their full investment amount AND a pro-rata share of remaining ownership in a liquidation event. More founder friendly are Non-participating preferred shares. They receive their full investment amount OR a pro-rata share in the liquidation amount. Founders must acquaint themselves with these different classes of share and the future impact they can have.

From an investor perspective, certain cap table profiles can be a turn off. The biggest of these is the presence of a difficult shareholder with a meaningful stake, followed closely by far too many shareholders for the stage of the business. The last thing an institutional investor wants to do is 'negotiate' their investment with a long list of tricky incumbents. They will more likely just 'pass'. Investors also want to see founders carrying decent equity positions that can survive hefty dilution through future funding rounds, still leaving them suitably incentivised. Founders that have given away too much equity in the early pre-seed and seed rounds may end up with a marginal shareholding when diluted at the Series A. For similar reasons, VCs will want to see a decent employee stock option pool in place before they invest, so their own position is not diluted post-investment. Being aware of these factors in the very formative stages may help founders avoid disappointment further down the line.

Climate Tech is back in favour

Under the Paris Agreement, 59 countries — representing 54% of global GHG emissions — set a net-zero carbon emission target before 2050. Against this backdrop, there has been a new and sustained focus on the climate tech industry, the focus of COP26 this week. Emerging climate tech startups are targeting a broad range of industries as they seek to decarbonise the economy, across energy, transportation, building, food systems, and industrial processes, as Pitchbook's latest emerging tech research reveals. "This represents an important shift from the ill-fated Clean Tech 1.0 trend between 2006 and 2011, which focused primarily on the energy sector and ultimately caused investors to lose nearly 50% of the roughly $25 billion of venture capital invested. This time around, startups are focused on the broader global climate change emergency in an effort to decarbonize across all sectors of the economy to reduce greenhouse gas emissions (GHGs)."

It is estimated that existing technologies can reduce up to 65% of emissions needed to reach net zero by 2050, but the remaining 35% will require new technological breakthroughs. This revitalised 'sector' is already providing opportunities for enormous growth and VCs are active again. Between 2013-2019, capital deployed in climate tech grew at 5x the venture capital overall growth rate according to PwC, even though climate tech only made up 6% of the total venture capital invested in 2020. In this 6-year period, US$60 billion of early stage capital was invested globally into startups contributing to tackling the net zero challenge. Nearly half went to US and Canadian climate tech startups (US$29 billion), with China coming in second at US$20 billion. The European market attracted a more modest US$7 billion. Mobility and Transport solutions dominate US and China investment. 

Breakthroughs that make technology commercially scalable are being sought in many areas, such as hydrogen electrolysis from seawater or alternative-fuel/battery-powered aircraft. Investment momentum is increasing rapidly, with Pitchbook reporting over $30B already invested in 2021. PwC pointed out the strategic role of corporate venture capital (CVC) and how this is key to many climate tech startups - particularly those with high capital costs, targeted at disrupting asset-heavy incumbent industries with high barriers to entry, such as in energy, heavy industry and transport. For Mobility & Transport, 30% of the 2013-2019 climate tech deals included a CVC firm, and in Energy, 32% of capital deployed came from CVCs. Overall, nearly a quarter of climate tech deals (24%) include a corporate investor, bringing not just capital but essential knowledge in how to deploy and scale new innovations in the market.

2. Other pieces really worth reading this week: 

Startup Boards
Some great perspectives from seasoned VC Mark Suster in this post. "While the management of a startup company deals with the day-to-day decision-making within the company, ultimately the Board of Directors has the legal governing responsibilities for these things." But on some matters the Board does not have the final say. There are times where the company still needs “shareholder consent” in order to achieve key objectives and founders must be keenly aware of these.

What is it about Peter Thiel?
In the New Yorker this week an excellent profile of billionaire VC and legendary entrepreneur, Peter Thiel. "Silicon Valley is not a milieu known for glamour and charisma. Still, Peter Thiel has cultivated a mystique. A billionaire several times over, Thiel was a co-founder of PayPal, the digital-payment service, and the first outside investor in Facebook. He went on to co-found Palantir, the data-intelligence company that has worked with the U.S. government. He has co-written a business best-seller, “Zero to One,” and launched a hedge fund; he now runs three venture-capital firms."

A more nuanced look at Corporate VCs 
In the Institutional Investor this week, some new insights into the world of CVCs. "While conventional wisdom may say that corporate VCs dislike early-stage deals and active LP positions, a recent survey from Silicon Valley Bank says otherwise."

Happy reading!

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