Duet Partners
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Weekly Briefing Note for Founders

6th May 2021

This week on the startup to scaleup journey:
  • Seed and Series A criteria shift relentlessly upwards
  • As round sizes rocket, Growth investors eye Series A & B
  • The transition from Founder to CEO
  • Picking your Board

1. Insights of the week

Seed and Series A criteria shift relentlessly upwards

Even before the record breaking year for VC in 2020, investment criteria at all stages had been getting tougher. The root cause: larger fund sizes driving up average deal sizes at alarming rates. Wing VCs 2020 US market analysis reiterated that “Seed is the new A, and A is the new B”. The median Seed round size had almost doubled within four years, rising from $2M in 2015 to $3.9M in 2019, making it look like a Series A from 2011. Series A rounds in 2019 were similar sizes to Series B rounds from 2010. Alongside these swelling rounds sizes, valuations had almost quadrupled over the prior 10 years. KPMG's latest European VC Report confirmed that European investment trends have been following a very similar pattern.

The knock-on effect of these dramatic changes has been profound, both for investors and founders.  On the investor side we have seen the emergence of a new breed of fund, the pre-seed fund. Institutional investors have becoming increasingly eager to participate in new opportunities almost from inception. These very early stage investors, such as Entrepreneur First and Seedcamp in the UK, will typically invest $100k to £200k alongside Friends & Family and Angels, enabling the initial MVP creation. Seed is now very much an investment phase rather than a specific event. Some investors will have a Pre Seed only focus, some bridge across Pre Seed/Seed, others just Seed, and many span Seed/Series A. Others will major on Series A only and these can be huge funds, like Balderton VII ($400M) and Accel London V ($500m).

On the founder side, the most eye-opening data point from Wing's analysis was that two thirds of Seed companies were already generating revenues in 2019, up from only 9% in 2010. This was a 10 point jump over 2018. By comparison, 77% of Series A companies were generating revenues (up fro 17% in 2010) and 92% of Series B (47% in 2010) in 2019. Some sectors, such as Pharma, will not see revenues until later stages. Revenue quality is also a critical factor. At Seed, investors will be the most open minded about revenue type (e.g. NREs, pilot projects and the like), but at Series A the bar is higher. Here the emphasis is on recurring or highly repeatable revenues generated by actual product sales. Founders planning their Seed and Series A campaigns must take stock of these changing stage dynamics.

As round sizes rocket, Growth investors eye Series A & B

Crunchbase data confirms that Private Equity (PE) investors are muscling in on traditional VC territory at early stage. VC firms have been leading a smaller percentage of deals as venture markets have become increasingly attractive to their bigger cousins. In 2011, PE & other alternative investors led 15% of all global rounds. In 1Q 2021 this rose to a remarkable 24%. Almost a quarter of global Series A and B rounds are now led by 'Growth' rather than 'Venture' investors as the overall pie grows ever bigger. In the space of just 2 years, such early stage investments ramped up from $25B in 1Q 2019, to around $39B in 1Q 2021. The huge rise in average deal sizes has tempted in new types of funds. Heavyweight PE firm Insight Partners (New York) became the top dog in leading global Series A & B investments through 1Q 2020, with 16 transactions.

It's the sheer scale of the rounds that is attracting the likes of Insight Partners and New York hedge fund, Tiger Global Management, who led 7 Series A & B deals in 1Q 2021. Breaking down the $39B early stage pie by deal size is revealing. In $50M+ rounds, just over $21B was invested across a mere 166 companies. For rounds below $50M, around $18B was invested in more than 1,300 companies. This means 54% of all early stage investment was concentrated in just 11% of deals. This is the primary hunting territory for big PE and Hedge funds. As they enter the scene, the competitive pressure on traditional VCs is increasing. A key battle ground is Series A, where the graduation rate from Seed stage is conventionally low and 'high quality' deal flow thins by around 80%. This is where many major VC funds traditionally join the cap table. In the first quarter of 2021, just over 400 companies raised a Series A at or above $8 million, led by 377 institutional investors. Competition here is intensifying.

For founders trying to pull together a Seed round, why does any of this matter? It matters because of the knock-on effect. As PE pushes down into early stage, some of the traditional Series A investors are dipping down into Seed to boost deal flow. They are trying to skim off the most promising opportunities as they develop, leveraging their brand to outflank smaller funds. This is turn is causing distress for the more specialist Seed funds, as we recently highlighted. They have nowhere else to cast their nets and the knock-on effect is complete. Founders with top flight Seed stage propositions may find that funding options are increasing, so won't be complaining.

The transition from Founder to CEO

Founders know that as their business grows from fledgling startup to high growth scaleup, their role will change. The words of Pete Flint, former entrepreneur and now Partner at VC NfX,  capture this transition perfectly:"In my experience, if you’re a Founder of a company that reaches real scale, there are two distinct phases you go through. Phase One (which is the Founder phase) is all about building a great product and finding clear product-market fit. Phase Two (which is the CEO part of your journey) is about building an enduring, sustainable company."  The transformation requires a clear awareness of how priorities evolve and how the role must evolve alongside. Investors at Series A will pay particular attention to how a founder is undertaking this critical transition.

Through Seed stage, a Founder's primary role is that of product manager. The focus is on who you are creating value for and how you are creating this value. The product, or MVP, encapsulates this. In the early stages you are undertaking experiments to discover your most ideally matched customer type. Even as customer engagements increase and early revenues grow, the 'founder as product manager' is not distracted by revenue per se. The goal in this phase is product/market fit; identifying the specific user demographic or market segment that derives the greatest value from the MVP. Early investors can sometimes unwittingly steer the founder off course by prioritising revenue as the sole indicator of progress. But VCs and other institutional investors will view such a narrow view of progress with caution.

Series A investors will evaluate how deeply a founder understands the needs of the growing number of constituents essential for growth. Customers are the most important constituent, so investors will probe every facet: the supply chain, the end users, channel partners, and the relationships that bind them all together. But by now there are now a growing number of other important constituents including employees, investors, and partners. Each of these stakeholders will have their own needs and objectives. The 'founder as CEO' must understand these so their contribution can be orchestrated and aligned with the growing business. Investors will give credit for systematic approaches in the management of all these relationships - especially those that involve clear KPIs to monitor and improve. This demonstrates a core capability for sustained growth, which is now the priority.

Picking your Board 

Board composition can have a significant bearing on the fortunes of a business. Founders that actively seek to shape their board with the right expertise build a vital source of advice and guidance for both the company and themselves. Prior to institutional investment, the executive directors alone will likely constitute the board. Founders will determine if they should appoint certain private investors or other non-execs (NEDs) in the formative stages. Early institutional investors, such as VCs, usually require board seats and will often stipulate the structure of the board through their investment agreement. Much can change at this point. The choice of institutional investor should therefore take into account both the quality of the Partner the fund will assign to the director role and the structure they propose.

The post-investment board will likely include a Chairman and one or more NEDs. Founders will have a key role to play in selecting the candidates for these crucial appointments, but the choice will not be theirs exclusively. Experienced founders will look to bring in complementary expertise necessary to accelerate the growth of the business. This will usually be industry experience, startup/stage expertise, business model expertise, or a combination. In our experience, investor directors often over-index for bringing in industry experience, believing that they (the investors) will contribute the necessary stage and business model insight. But this rarely materializes in the way founders find helpful. Often, an independent chairman and NEDs will have more time to assist the founders outside the board setting. But if they have no relevant stage or business model experience, this can be a real drawback.

First-time founders especially must ensure they have reliable sources to tap for advice. If this is not at Board level, then this could be through a small Advisory Board. Here the Founder/CEO must have free rein to appoint. This can be agreed at the point of investment to ensure certainty. An Advisory Board should be constituted exactly to suit the needs of the CEO and should be able to operate with the a high degree of flexibility and informality. One way or another, successful CEOs find a way to build a network of trusted advisors from whom they can seek counsel. Picking the right board members is the place to start.

2. Other pieces really worth reading this week: 

From Founder to Limited Partner
When start-up founders successfully exit their businesses, they are left with many options. Retirement does not seem to be one of them. Angel investing and advising are common practices, but interestingly, 45% of the VC firms analysed in a recent survey by Collective Equity Ownership were started by former tech entrepreneurs.

Breaking into the US Market
In our March 18th newsletter we talked about Expanding to the US and this week we provide further valuable insight from Speedinvest in their US Expansion Guide for Founders. There are many reasons why the US market holds great attraction. "Historically, the average acquisition price for US-based, VC-backed companies is about 3x average EU acquisition price. In 2020, the US VC space still set records in total capital raised, deal value and exit value, despite strong headwinds from the COVID-19 pandemic."

Cap Table 101
A great primer on cap tables by Kevin Lu of AirTree Ventures. Ideal for founders looking to understand the key concepts of cap tables and how they evolve with different funding rounds. "Through a venture capital lens, the cap table’s purpose evolves from first clarifying that there are no red flags prior to an investment decision, then to scenario analysis should new investors buy-in or shares be issued, and lastly to a payout (waterfall) analysis to calculate their overall return on investment."

How do European VCs compare to US firms?
A fascinating insight into the VC ecosystems of the US and Europe by Jacob Tasto of research house, DifferentFunds Inc. "This data-driven analysis of fundraising & investment cadences, fund strategies and more is based on a sample of 600 European firms investing venture capital across 74 unique European metro areas, comparing it to our existing dataset on 1,500+ US VCs."

Happy reading!

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