Duet Partners
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Weekly Briefing Note for Founders

5th August 2021

This week on the startup to scaleup journey:
  • Why startups fail
  • Reference checking investors
  • Corporate investors must fight harder for a share in the cap table
  • Will VCs become the next generation of industrial conglomerate?

1. Insights of the week

Why startups fail

One of the most unexpected challenges for founders is nailing the problem they should be focusing their business on. It's not unusual to find that the original ‘problem to solve’ does not stand up to closer scrutiny - it becomes elusive as you dig for deeper insight. Markets naturally shift and industry trends can be accelerated or halted more abruptly than anyone could imagine. Experienced founders know that the speed with which they can test their problem/solution thesis is absolutely vital. Time is of the essence. Ineffective business model iterations or product development loops that take too long to execute, end up leading to the number one reason for startup failure - running out of money. But the number two reason, according to the latest research by CBInsights, is often the real underlying cause - no market need.

For those that do figure out the need and create a great solution (i.e. product/market fit), the succour punch is then to find that another company has built a better offering. Getting outcompeted is the third most likely reason a startup will fail. But companies that successfully navigate these early stage failure points are not yet out of the woods. As Harvard Business School professor, Tom Eisenmann, points out in his unambiguously titled book, Why Startups Fail, the three biggest trip wires are then: Premature scaling (spending money on activities and people before they are required); not staffing quickly enough (when growth takes off); and 'cascading miracles' (taking on too many low probability bets).

The term ‘cascading miracles’ first came from John Malone, an entrepreneur who built TCI, Tele-Communications Inc, the biggest US cable company. It basically means that many things have to go right and if any one of them doesn't, the venture fails. Classic combinations are breakthrough technology innovation, plus an untried 'go to market' strategy, plus an innovative business model. Succeeding with any one of these could be a huge triumph; expecting to conquer all three is likely to be a bridge too far when it comes to convincing investors. Founders are often very adept at replicating success patterns - few ideas, after all, are totally original. But serial founders are also adept at avoiding failure patterns. Few of these are original either.


Reference checking investors

The founder/VC relationship is a critical success factor in the fortune of any startup. Investors that come in at early stage will likely be involved with the company for many years. They will play several important roles, not just as financier, but potentially board director, advisor, introducer and many others. This is a marriage, not an affair. Given how important it is to select the right partner for the journey, it is alarming how many founders only do the lightest of due diligence on investors before tying the knot. The results are predictable. Often the most common gripe that founders have is their frustration with incumbent investors. The relationship is either weak, ineffective, or may have even broken down. Bottom line; the trust isn't there.

Founders have a responsibility to themselves, as well as their employees, to really do their homework before inviting a VC onto the cap table. It's not just the fund but the specific partner that will manage the relationship. A founder's choice of investor also sends a strong signal to the rest of the investor community. It's not unheard of to see prospective investors pass on a deal when they see certain other names on the cap table. They just don't want the hassle. Serial founders are significantly more wary of these risks. Building the (trusted) investor network is given greater priority with each new startup. Tools such as Landscape are also enabling founders to (anonymously) share their investor experiences. But solid reference checking with other founders and advisors that have first hand knowledge of how that VC partner operates is essential.

This is unlike reference checking a prospective employee. The stakes are much higher and if things go wrong they may be impossible to change. This is going to be a deep dive not just on experience but reputation. Astute founders will do at least 4 or 5 reference calls. Ideally this will include other founders that may, for whatever reason, have moved on. Those conversations are likely to be much more honest! The most valuable insights will reveal how that investor behaved when things went wrong. Did things get ugly or did they step forward to help? Doing this research can take time, so founders must factor this into their campaign schedule. Waiting until you have a term sheet may be too late, so starting early - when your gut tells you there may be a fit - is the best approach.


Corporate investors must fight harder for a share in the cap table

Startups have never been in such demand. VC investment by corporates is on track to reach an all-time high in 2021. €34B has already been invested in 1H21, 1.6x the investment level of 1H20. In the US, the last three years have seen double the number of corporate investment deals compared to 2013. Nearly 1,000 unique corporates have already completed a deal in 2021. Across Europe, VC investment by global corporates hit a record €5.7B in 1H21, double the €2.8B invested in 1H20. Whilst the total amount of investment by corporates is increasing sharply in absolute terms, there are strong headwinds emerging - as we highlighted in our latest blog, Corporate investment in startups is booming.

A little-known fact is that the percentage of overall VC investment allocated to corporates has actually been in decline for the past 5 years. It currently stands at 17% globally and 14% for Europe. Corporates are having to fight harder for a share of the cap table as non-traditional investors such as the big investment banks, PE funds and hedge funds - like Tiger Global - are muscling into the VC scene at late stage. European Startups reported that between 2016-18, Corporate VC as a % of total funding stood at 37% on Megarounds (deals >$100M). From 2019-21 this has fallen to 26%. As a result, corporates are considering earlier stage participation to take meaningful allocations. At Series A, corporates take around 15% of total funding and this has remained steady for the past 5 years. This could start to increase as they get squeezed out of more later rounds.

Corporate VCs are now active in nearly every industry, from those already online like Mobility and Food to those in the transition such as Education, Health, Housing and Banking. Many big companies have now realised that scale is not always an advantage. Entrepreneurial dynamism is thriving, born partly from a realisation that scale is now available ‘as a service’ – for example via Foxconn (manufacturing), AWS (hosting), or the Facebook Platform (distribution). A small group of smart people can now quickly become a threat to an established player. Partnering with startups is becoming an essential capability. For many corporates, it’s the only viable way to tap into the innovation culture. As a result, many new CVC funds are being developed and strengthened. The price to play is going up, so expect bigger allocations and earlier stage interest to increase.


Will VCs become the next generation of industrial conglomerate?

It may seem strange to imagine that entrepreneurialism is in decline, but it's true. This is a case of where the narrative doesn't align with the facts. The narrative tries to convince us that this is the age of the entrepreneur and the rise of a new digital economy, driven and supported by vast swathes of venture capital. But we know that this disguises the reality - and so do VCs. The part about the swathes of capital is certainly true. Never before has so much capital been deployed by VC funds. Investments into tech businesses are hitting record levels as new funds are announced with even greater regularity. But as we have commented many times before, the number of first-time financings, as well as the number of new companies making it through, has plateaued. This phenomenon predates Covid, but was accelerated by the pandemic. The cumulative number of active businesses is in fact declining. The number of new formations is lagging those ceasing to trade.

The problem is particularly acute in the US, where the supply of capital now exceeds the demand. It's become a founders' market. As a result, deal sizes and valuations continue to rise as VCs race to compete for the best deals. The issue is less acute in the UK, but the cumulative number of active businesses is in decline here too. Founders are not broadly aware of this fact, but this is something we have started to highlight in our investment planning. Founders are optimists and are not easily put off by the low odds of making it through to a successful exit. That comes with the territory. But for the Venture Capital community, this slow but noticeable shift has already been driving some of the larger VCs to rethink what their future role in the ecosystem will be. The overall desire is to support more businesses through the funnel, so that those that deserve a shot at crossing the finish line don't fall unnecessarily at some intermediate hurdle.

Legendary VC Marc Andreessen has a vision for his own firm, Andreessen Horowitz ('a16z'), that he calls 'HP 2.0'. Hewlett Packard (HP) was one of the 'founding companies' of Silicon Valley, although styled in the form of a 1970's industrial conglomerate. 'HP 2.0' is a reimagined form where the VC provides certain centralised functions (Corporate HR, Corporate Finance, M&A, regulatory..) and the portfolio companies are the quasi-autonomous operating businesses. The irony is that one of the (many) reasons why the conglomerate model fell out of favour in the '70s and 80's, was that (in Andreessen's words) "VC's strip mined the talent out of these companies and into startups." But there are facets of the old model, those that protect and nurture new ideas, which he believes can be resurrected. The early building blocks of the a16z architecture are taking shape with a huge multi-stage funding capability now under one roof. The entire journey from Seed to IPO - and even beyond - can be funded. Talent and other resources that don't survive the journey in one business can potentially be redeployed in another. This casts the entrepreneurial journey in a strange new light.


2. Other pieces really worth reading this week: 

How public markets can help address venture capital’s limitations
British venture capital firm Draper Esprit recently moved its listing from the AIM to the main board in London, the LSE. Draper has always felt like something of an anomaly, TechCrunch notes, a generalist venture capital firm that was itself public. But this July, Forward Partners listed its shares on the AIM, and there are other venture firms in Europe that are also listed.
At first blush, the setup may seem odd; venture capital firms invest in companies that they hope to see go public one day — why would they float themselves?

10 timeless startup lessons
On the Square One podcast this week,10 timeless lessons from one of the greatest tech entrepreneurs of our generation, David Sacks. The short-form takeaways are here, courtesy of Romeen Sheth. "Lesson #10: Your startup is a movement. Treat it like one. There’s an analogue between grassroots politics and startup evangelism. The best campaigns; Define a larger cause, Articulate the problem better than anyone else, Attack the status quo, and Define the category."

Why Facts Don’t Change Our Minds
We love great articles that analyse the art of persuasion. A founder's job is often to be a great persuader. Why Facts Don’t Change Our Minds is a wonderful piece by one of our favourite writers, James Clear. "The way to change people’s minds is to become friends with them, to integrate them into your tribe, to bring them into your circle. Now, they can change their beliefs without the risk of being abandoned socially."

Senior female VCs call out major funding disparity in Europe
The gender imbalance in VC is as unsurprising as it is exasperating, and despite an awareness of the issue, the numbers are still dire. Despite a record amount of capital invested so far this year in Europe, female founders have received only 0.7% of the total funding, or €400 million (about $473 million), according to PitchBook data.

Happy reading!

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