Duet Partners
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Weekly Briefing Note for Founders

7th October 2021

This week on the startup to scaleup journey:
  • How VCs search for hot startups
  • Neutralising market timing anxiety for investors
  • The Power Law of VC
  • Developing a writing culture in the startup

1. Insights of the week

How VCs search for hot startups

Innovations in technology are the enabling force behind many startups. But founders might be surprised to learn that these same innovations are also changing the way in which VCs themselves operate. Just as startups use technology to create differentiated propositions that will open up new markets, so too VCs are using technology to identify, qualify and help pick their future portfolio winners. As the supply of capital looks set to exceed the demand generated by startups at a global level (not just in the US), the aim is to make the process of deal sourcing and screening much more efficient. In this more competitive environment, VCs are employing data-driven sourcing and intelligent ML-based screening to identify and engage with hot startups even before a deal is on the table. For those that don't have the brand recognition of the big multi-stage funds, the adoption of advanced tools may become critical in the race for survival. Being able to reach out to founders and start building relationships at a very early stage has become an essential tactic. Simply waiting for inbound deal flow will (eventually) become a losing strategy.

Earlybird Venture Capital is pan-European VC based in Germany. This firm is particularly forward thinking in the re-engineering of the VC investment process. In a recent article, The Future of VC: Augmenting Humans with AI, Principal, Andre Retterath, describes how the process is changing. The use of data and intelligent algorithms is now central. There is a huge range of online sources VCs use to first identify new startups. APIs into all the major commercial dataset providers are then used to suck in key company data points. (This is why Duet routinely checks client profiles in the key datasets at the beginning of every project). Web crawlers then identify changing information from other sources such as LinkedIn, Twitter, Google News, App Store, product review sites, payment sites, website traffic sites, and dozens of others to provide insights on various 'growth metrics', such as headcount. This is all becoming fairly standard procedure for VCs today. But with over 10,000 potential investment opportunities arising across Europe every year, the battleground is now moving from sourcing to screening.

Screening methods employed today are used to 'score' companies on a range of growth metrics. This approach filters out companies that won't be a great profile fit for a specific VC fund. As the sheer volume of growth metrics rises, VCs are experimenting with ML-based approaches to more intelligently 'filter in' companies to target. Some of the early results here are remarkable. Retterath says, " It's clearly time to trust the algorithm as it significantly outperforms human VCs in screening European early-stage startups."  But a key element is still missing and that is the human factor. The relationship between VC partner and founder is a chemistry that can't be determined by an algorithm (well, maybe not yet). VCs agree that using ML techniques to augment the human VC will likely provide the optimum result. In the meantime, founders must pay the greatest attention to ensuring that key sources of public data are kept up to date. If your 'growth metrics' aren't tracking, even the algorithm will ignore you.

Neutralising market timing anxiety for investors

In the daily cut and thrust of building any startup, minds tends to focus on the operational challenges: Bringing the key components of the business model together - product development, customer engagement, hiring, go to market tactics, and so on. These are the factors that the business feels it either has direct control over, or those it can - or must - strongly impact. We could call these the 'internal' factors. The 'external' factors, such as macro market trends, which would have been examined at the genesis of the project, typically don't get much attention when the team is in the trenches, fighting to gain traction and prove out the model. This approach feels instinctively right - spend the majority of your time on the things you can directly impact. Investors on the other hand have an inverse view of the world. In the early meetings, they will become preoccupied by the things you can't influence - in particular the macro market conditions. If they believe your market timing is off - either too late or too early - this will probably be enough for a 'no', irrespective of how compelling the rest of your investment proposition is. Most VCs (including CVCs), and certainly those that operate at Series A and beyond, will tolerate execution risk but not market risk.

It is often not until investment preparation begins in earnest that the question of market timing is re-examined. Founders know the 'why now' question is bound to come up. But if external market factors - technology, economic, political, social, etc. - are no longer acting as a tailwind, it might simply be too late to adjust the story before you need to pitch. The impact of this can be profound: If investors feel market timing anxiety, a founder may struggle to pull a round together. This hiatus can be avoided if a more regular assessment of market conditions is undertaken. It sounds easy and obvious, but unless formalised in some way this checkpoint often doesn't happen. Time slips by. That's why during Investment Analysis (usually undertaken 9 to 12 months before capital is required) market trends are a core part of the research. If the market is still nascent, or perhaps has already peaked, there is still time to recalibrate the business strategy, make necessary adjustments and rethink the funding plan. Immediate tell-tales signs are no competitors on the horizon, or a slew of competitors that are now funding ahead of you.

Whilst VCs often consider themselves to be market experts, especially those that invest thematically, a new disruptive force may open their eyes. Startups that are redefining current markets because of this will be given more airtime. But a true disruption has a 10x effect, not a 2x effect. Describing a startup as 'disruptive' when it is clearly not will just dent a founder's credibility. Where credibility can be boosted is in the articulation of a unique insight; one that demonstrates mastery of understanding of external market factors that will conspire to open up the new opportunity. Startups whose story relies on such a narrative must process a deep appreciation of these factors as they will be a source of rigorous debate with VCs during due diligence. Founders that effectively position their insight, their value proposition, and their product in the context of such changing conditions, will neutralise market timing anxiety.

The Power Law of VC

The guiding principle behind investment returns in the corporate world is the distribution law. Very few investments into new projects or initiatives will either be complete failures or home run winners. More likely they will sit somewhere in the middle of the distribution law 'bell curve' and provide decent returns. Good corporate management teams consistently provide such returns. The world of VC investment on the other hand is completely different. Investment returns are governed by power law. The overwhelming majority of investments will not deliver good returns, but a few of them will generate returns that are truly phenomenal. VCs will generally say that around 10% of the investments within a fund will produce around 90% of the returns. And this is true even at the industry level: A large percentage of VC returns are captured by a small percentage of VCs. That’s why VCs are constantly trying to position themselves in the “winning” part of the curve. But this is a rarefied space. To raise capital, founders must convince VCs that their vision will propel them into the 10% category. Promising performance levels that would look impressive under distribution law is not enough.

Nicolas Sauvage is President of TDK Ventures, the corporate venture arm (CVC) of TDK. He observes that a VC must be capable of taking a contrarian view in order to see the potential of a founder's vision long before others do. While corporations cannot afford to invest in a vision nobody yet believes in, for a VC to be good, it cannot afford to invest in the obvious choice. If lots of people believed in the vision that inspired the founders to launch the startup under consideration — if there was consensus, in other words — there would already have been plenty of investors. "Rather than investing based on a high probability of success, our focus is on startups launched by entrepreneurs who believe with all their heart that what they’re doing is going to change the world. Once we believe they are capable of doing just that, we invest. Success in the world of VC is driven by being able to discern the opposite of obvious, and to build a contrarian view of the future based on unique insights." The founder's job is therefore to convince the investor that their insights have this power - that they have the potential to truly be an outlier.

Not all startups will be suitable for VC: Not all founders believe they are building a business that will be a financial return 'outlier'. Distribution law  returns may be closer to the mark. Investors that operate in this domain will likely prioritise profitability before growth; will be much more sensitive to dilution; will be more likely to offer debt than equity; and generally seek quicker returns. Horses for courses. But for many founders, the potential for the home run is utterly alluring. For those that step up to this particular plate the bat they hold is their unique insight. This is where the power in their value proposition is concentrated. This shapes their contrarian view of the future. With such potential, founders must ensure that their funding strategy draws in the right type of investor - it's not unheard of for certain distribution law investors to masquerade as power law enthusiasts to capture deal flow. But with the right investors on board and the belief that they can 'change the world', that rarefied space can be found.

Developing a writing culture in the startup

In the startup world, speed is key. Creating a time advantage over emerging competitive threats is always front of mind. The small team advantage plays out in the very early stages. Quick and informal discussions, few meetings, and a big emphasis on action. As early scaling begins and growth becomes the driving force, the team expands. The experimentation phase is almost over - company building has started. 20, 30, then 40 or more people are suddenly trying to work effectively together. The communication challenge grows exponentially. The notion that writing more and speaking less can now provide a formula for success might seem a bit misguided. Yet this is the path that some of the most successful startups adopt. Books have been written about Amazon’s writing culture. There’s an entire section in their 2017 Shareholder Letter dedicated to espousing the benefits of the Six-Page Narrative. At Stripe, the writing culture has been firmly embedded since the formative years. In 2013, when headcount stood at 45, Greg Brockman wrote openly about this culture and why Stripe even makes email public within the company. To many outsiders this seemed as if it could be a recipe for disaster. Now, with headcount exceeding 4,000, Stripe has become one of one of the most feted growth stories of recent years.

Former Stripe employee Brie Wolfson provides some remarkable insights in her highly practical and informative blog. She says, "I’ve come to believe that Stripe’s culture of writing is one of the organization’s greatest superpowers. Half of the story of what makes this so would be obvious to onlookers – Stripe has always treated documentation as a first-class product. People from every corner of the company author blog posts. The company publishes a magazine about building and operating software (Increment) and books about technological and economic progress (Stripe Press). But what most people don’t see is the massive library of content produced inside the company for Stripe-employee-eyes-only. And that’s where I think the real magic happens."  Former Stripe employees that go on to found companies often make writing a core part of how their new companies operate. Some embed this within their values and even state this explicitly on their jobs page.

Founders that embrace the writing culture do so in part because of the great efficiencies it delivers. This may seem counterintuitive - taking the time to write something up might seem more like a braking action than an accelerating action. But a good paper-trail can supplant and improve meetings, for example. When there is good documentation around a meeting (briefs, meeting notes, etc.), meetings can be leaner and more productive because people don’t have to be in the room to know what’s happening. Only those who are actively contributing to the discussion then need attend. But as Wolfson comments, documentation only gets organisations half way to building the system of knowledge shared. Nailing distribution (i.e. ensuring the right people can find the information) gets organisations the rest of the way. Now, as remote work further encourages writing-centric companies instead of speaking-centric ones, founders have never had a better moment to embrace the writing culture. Many believers will say it's a great proxy for the open door policy, makes companies less political, and above all, is a forcing function for thinking and communicating more clearly.

2. Other pieces really worth reading this week: 

How 'solo VCs' are changing the venture game
A recent report by Pitchbook describes how solo VC deal activity on the rise. These are often founders looking to recycle their exit gains into the startup ecosystem. These newer entrants into the venture game are also raising funds in the hundreds of millions of dollars and special-purpose funding vehicles with backing from top-tier limited partners. In some cases, this has enabled a nascent group of investors to beat out traditional venture firms for hot deals.

NFX’s New $450M Fund For Pre-Seed & Seed
Hot on the heels of Greylock's $500M seed fund, this week US investor NfX announced their huge Fund III. Although primarily focussed on US startups, NfX has previously invested in 27 European companies, including 13 in the UK. They say, "NFX’s Fund III is the largest fund exclusively dedicated to pre-seed & seed startups. Your success at pre-seed and seed is our only business. We are not a multi-stage VC. Everything about NFX is designed to help pre-seed and seed companies win." This is no idle boast, having seeded 25 unicorns to date.

The Q3 2021 Global Venture Capital Report: Record Funding Trend Held Strong
As reported by Crunchbase this week: The record funding pace continues into the third quarter of 2021 with $160 billion invested globally, matching the huge funding increase in the second quarter and up 78 percent year over year. Prior to 2021, global funding had not reached over $100 billion in a single quarter. Funding in 2021 has far superseded that amount, with the first quarter tracking at $135 billion, the second quarter reaching $159 billion, and the most recent quarter peaking at $160 billion. More details in the report.

Happy reading!

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