Duet Partners
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Weekly Briefing Note for Founders

5th October 2023

This week on the startup to scaleup journey:
  • VCs boost pre-Seed investments
  • The Value Chain of Capital

VCs boost pre-Seed investments

With investor attention shifting to the very earliest phases of company development to catch new waves of innovation and value creation, pre-Seed rounds are finding increasing appeal with VCs. And as startups are raising more rounds prior to Series A, some additional segmentation beyond just "Seed" is helpful to investors and founders who may find a growing alignment of interests at this most formative stage. Historically the preserve of Angel investors and Accelerators, pre-Seed rounds are now attracting institutional capital at an increasing pace. Certain VC funds are now specifically labelling themselves as 'pre-Seed investors'. This is most notable in the US and Europe. The pre-Seed investor base has grown over the past few years, as more investors, including VC firms, nontraditional investors such as CVCs, and Accelerators, have entered the pre-Seed market. This trend has been driven by several factors, including the pursuit of greater return potential, the desire for strategic advantage, or a goal to foster regional ecosystem development. As this layer of the ecosystem develops, investment research houses such as Pitchbook are collating new datasets to capture and analyse market trends at the pre-Seed stage. This is enabling institutional investors to more easily identify, assess, and engage with startups that sit near the very beginning of the venture life-cycle.

So what is pre-Seed? Pitchbook's definition says: "The pre-Seed stage is defined as a group of young, unbacked startups getting their first check from one or more institutional investors, as well as those raising what is considered to be a pre-Seed round by the founder and the investor." Specifically, these companies are less than two years old and have not (yet) received funding from an institutional investor. Once they receive this funding they transition into the Seed phase of development. The challenge for investors is that at the pre-Seed stage, most startups are pre-revenue and many do not have a working prototype yet, much less a fully developed product. This means that the due diligence process is distinct from that of more mature companies. As a result, pre-Seed investors are taking a huge bet on fledgling startups. Founder/Market fit is thus a primary diligence consideration. Here, investors will try to answer a set of questions that will typically include: Why and how is the founding team well-positioned to succeed? Have they encountered similar issues they are trying to tackle in their own lives? Will their background help them gain a competitive edge over others trying to solve the same set of problems? Even though the risks are higher, investing at this level is particularly attractive to certain smaller VC funds that are being regularly pushed out of Seed deals by the bigger, multi-stage funds. This has become their new entry point.

What do we know about the shape of these pre-Seed investment rounds? According to Pitchbook, US pre-Seed median DEAL SIZES have been following a gradual, upward trajectory over the past 10 years. Between 2018 and 2020, the median pre-Seed deal stayed flat at $300K, subsequently rising to $500K in 2021 and remaining at the same level through 1H23. European transactions have followed an almost identical pattern, with the exception that median deal values have edged up higher to $600K in 1H23. But pre-money VALUATIONS in the US and Europe vary considerably. European pre-Seed pre-money valuations have followed a steady upward path over recent years: from $1.6M in 2020, $2.4M in 2021 then peaking at $2.7M in 2022, before falling back slightly to $2.4M in 1H23. US valuations by comparison were much higher at $4M in 2020, $4.5M in 2021, hitting $5.8M in 2022 and now standing at $6M in 1H23, more than double that of Europe. There are other notable differences: A historic cohort analysis of 2,654 European companies that received institutional financing at pre-Seed between 2010 and 2016, showed that 2,155 had either gone out of business or did not advance through subsequent rounds of funding. This left 539 (20%) that were either still alive or had exited via acquisition or IPO. The comparable figure for the US was 16%, based on a much higher initial cohort of 4,274 startups. This supports the theory that US startups are far more likely to curtail operations if they are not hitting growth targets and progressing to the desired exit. European companies that falter tend to keep going longer in the hope that fortune can still be found.

The Value Chain of Capital

One of the hardest lessons that first-time founders have to learn about valuation is that it is not necessarily a measure of the 'intrinsic' value of the business. It starts off a little like this in the pre-Seed phase, when founders essentially set a share price for Angel investors in the very early rounds. But when the first round of institutional capital is undertaken, reality hits. Valuations are now set by the market and, just as in public markets, these are strongly influenced by market sentiment that may push prices up or down depending on the broader macro picture. We are living through an extreme version of this scenario right now. In the current market, valuations being offered by new investors at each round are now heavily a function of their belief in what future investors will offer in subsequent rounds. This is what some investors refer to as the "Venture Capital value chain". With the dramatic valuation reductions seen in many late-stage companies over the past 12-18  months, early-stage investors are paranoid that offering too high a valuation now could wipe out any chances of attracting bigger funds in subsequent rounds necessary to drive growth - or if an exit is in the offing, deliver weak or negative returns on their investment.

The recent Instacart IPO provides a vivid example of the Venture Capital value chain in action. Instacart went public at a $9.9B valuation, down from an all-time-high in early 2021 of $39B. It was one of the first big IPOs since the market corrected and attracted significant analysis, including this video from Aswath Damodaran, an economics professor at NYU. In the video, Damodaran shared a breakdown of the equity return from each of Instacart's funding rounds. As Kyle Harrison later observed in his excellent blog on this analysis, every investment round from the Series C in 2015 to the $39B Series I in 2021 failed to beat the S&P 500 in terms of returns. These late-stage VCs would have been better off simply investing in the stock market. In fact, every round since the Series E in 2018 was basically flat or negative in terms of absolute returns on the IPO price. But the most remarkable insight was that all of Instacart's funding up to and including the Series B totalled a mere $55.7M. As Harrison observed: "But as of yesterday {29/9/23], the company had raised a total of $2.9B in funding, they had existing debt of $774M, and an ending cash balance of ~$1.8B. Roughly, that means the company had to burn ~$1.8B to get to the size of business they are today."In other words, the big later-stage funding rounds were crucial for growth and the IPO story but these investors were not rewarded.

A closer look at the returns made by Sequoia demonstrates very neatly how the Instacart investors were impacted: Sequoia invested $8.5M at the Series A in 2013 at a $75M valuation. This delivered a stellar 132x return at the IPO. But they also invested $166M at the Series I, making a horrible 0.25x return. Overall, Sequoia invested $300M to generate a $1.4B stake - an excellent 5x return overall. But, if you only invested in the later rounds, you lost everything. As Harrison points out, the Sequoia example demonstrates two things about the value chain of capital: 1. Capital Dependency: A company's "terminal value" can look great for early investors, while being dependent on later investors. 2. What's It Worth: The success of an early investor's return is determined based on what a later stage investor decides the company is worth. The result? Incoming investors are now focusing more than ever on what the next stage of capital will want (investor view), not necessarily what the best business might be in the long-run (founder view). This is why investors have dumped the 'growth at all cost' mantra in favour of a return to capital efficiency. By reducing 'the ask' on future rounds, incoming investors will then be more likely to make the returns they seek. And the earlier you invest, the higher your chances of a stellar outcome. Hence why Seed valuations are still running so high.

Happy reading!

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