Duet Partners
Tel: +44 (0) 20 7416 6630 / Email: partners@duetpartners.com


Weekly Briefing Note for Founders

8th December 2022

This week on the startup to scaleup journey:
  • Venture Capital is broken
  • Winners and losers in the VC shakeout
  • FTX sends shockwaves across VC

Venture Capital is broken

The 80/20 rule pervades the world of venture more than we might imagine. For example, we know that only 20% of Seed stage companies will cross the chasm to growth stage (Series C) or exit. But what is less well known is that right now only 20% of VCs are delivering decent returns to their investors - the bottom 80% are losing money. The root of this is not just the current economic downturn but something far deeper, says one of the industry's heavyweights. Peter Thiel’s Founders Fund believes that venture capital is broken. The reason: Since the late 1990's it has shifted away 'from backing transformational technologies' to 'become a funder of features, widgets, irrelevances'. Too many companies are today just solving 'incremental problems', which during stock market bubbles can sometimes produce remarkable returns - but they are not enduring. For such investments, VCs have to time these moments of investment and exit almost to perfection, with luck often playing a big part. As a result, in aggregate, 'the bottom half of venture has produced flat to negative returns for the past decade'.

As the Founders Fund manifesto states: Real technology companies tend to create durable returns, making timing much less important. If you invested in webvan.com, your window of opportunity was measured in months; if you backed Intel, your window of opportunity was measured in decades. Theil believes that investors should therefore seek companies developing 'real technologies'. In contrast to mainstream propositions that attract the majority of VC investors, real technology companies are characterised as follows: 1. They are not popular (popular investments tend to be pricey; e.g., Groupon at so many dozens of billions). 2. They are difficult to assess (this contributes to their lack of popularity). 3. They have technology risk, but not insurmountable technology risk, and 4. If they succeed, their technology will be extraordinarily valuable. Sourcing and assessing such startups requires a combination of deep domain expertise and patient capital. This is where many European VCs fall short. As a result, the deal flow 'filter' gets set to only select those with a clear revenue model and demonstrable traction. It's not surprising that many real technology startups in their formative stages find it difficult to raise capital here.

Fund size is also a big factor in this equation. Small to medium size European tech funds will say that they simply don't have the firepower to invest in startups that carry any appreciable technology risk. The road to exit is simply too long and uncertain. They have to be content with pursuing 'market risk' only opportunities - and even then many want to see evidence of real revenue momentum before committing. This isn't venture capital as it used to be - it's really growth capital by another name, driven by FOMO and the herd mentality of safety in numbers. The result is that increasing numbers of European tech founders that believe they have category-creating technology will seek out the big multi-$B US tech funds at the earliest possible opportunity. This has been a contributing factor in the increasing US investor involvement in the European tech ecosystem over the past decade. In 2012, US investors participated in 469 European deals totalling €3B. By 2021 this had risen to 2,561 deals totalling €68.5B, according to Pitchbook. The big reset that is currently occurring in VC could be a catalyst for fixing the 80/20 money-losing profile. Let's start backing more of our true tech visionaries that promise more enduring returns.

Winners and losers in the VC shakeout

The VC landscape is changing. As the current market downturn hits home we are already seeing winners and losers emerge as the investors in VC funds, the Limited Partners, change allocation strategies. Founders must align with the VC funds that will be the likely winners and be wary of others that could fall by the wayside. The funding journey from startup to scaleup is long and arduous - dependable partnerships are crucial. VCs themselves are not going to talk publicly about their current angst, so the most useful insights often come directly from LPs. These institutional investors work on the basis of percentage asset allocations. They allocate w% to the public markets, x% to real estate, y% to fixed income and z% to private equity and venture, etc. As the value of their assets go up, the absolute dollars that they allocate to VC increases. This is exactly what happened during 2020 and 2021. As a result many VC funds had little trouble raising capital, including many first-time funds as well as second-time funds that had yet to prove their ability to generate exciting returns. This has all now changed.

Vintage Investment Partners is a well-known 'fund of funds' that invests across the global VC ecosystem, with over $3.5B AUM. Managing Partner, Alan Feld, writes in his blog that in a down market, institutions experience the 'denominator effect'. As the public market and the liquid asset values start to decline, the total asset value managed by institutions also starts to decline. Liquid assets are marked to market. And venture assets? Many funds keep valuations at or close to the last round; they are not marked to market (until their auditor forces them to lower valuations, typically in the year end statements) and many still remain at the high values of last year. If an institution is close to reaching its full allocation to venture, in a public market decline, their actual allocations usually exceed their planned allocations. Not only do they stop making new commitments, but they also start looking for ways to sell some holdings, particularly those that are 'eating' cash and not 'generating' it.

The implication is that the proven venture teams are able to raise capital (and often are over-subscribed) and the teams without a proven track record cannot raise at all. Many of the teams with 2x MOICs (multiple on invested capital) that believe that they are doing well but have not (yet) marked down will find a frosty reception from potential LPs. VC fund managers that have shown subpar returns are now facing some serious questions as they pitch for more capital - if they could not return money in the greatest bull market in a century, why should an LP think that they can deliver great returns in a dead IPO market and with M&A priced on the basis of lower comparables? Those VCs that quickly invested their last fund and only kept limited reserves are now finding themselves out of the game. The patient VCs who did not run through their money are quickly becoming the big beneficiaries. LP are working hard to align themselves with these top decile VC funds as they cut off the money supply to others. Founders must do the same.

FTX sends shockwaves across VC

The recent FTX failure has sent shockwaves across VC. It's not hard to understand why. FTX was a Bahamas-based cryptocurrency exchange that lured in some of the biggest names in the investing world. In his recent bankruptcy proceeding filing, John Ray III, the new CEO and Chief Restructuring Officer at FTX, gave a brutal condemnation of what he had found: "Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here. From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented."  Veteran VC, Bill Gurley, this week sets out the key lessons in his uncompromising blog entitled: 'Venture Capital Red Flag Checklist'. Gurley's stature within global VC makes this a call to action that will be broadly adopted to avoid FOLS (Fear of Looking Stupid) across the community. Founders take note - the bar has just risen.

In the FTX case, Gurley concludes that there is a reasonable probability that the absence of standard governance guardrails and constraints actually enabled reckless behaviour. With such guardrails in place, the company may have evolved in an entirely different direction, which would have been better for both founder and investors alike. VCs will now pay even greater attention to potential red flags when they evaluate a business. Foremost is the lack of a legitimate board. In early stage businesses, especially prior to the first institutional round, the directors must not only adhere to their fiduciary duties but be seen to do so as well. Ignorance is no excuse. Filling a board with people who lack solid experience in private company development is now just very high risk. Founders must be across this from the get-go. Overlapping corporate interests are another hot potato. Gurley says that no one operating a venture-backed startup should be simultaneously running another corporate entity that has overlapping interests, competing interests or even potentially competing interests. In the formative stages, founders often have multiple interests as they undertake initial viability experiments. But once they seek institutional money, they have to commit 100%.

As institutional money arrives, investors are going to be more particular about governance matters. This will first be seen in due diligence enquiries where there will be increasing focus on empirical evidence or actual results to support the major claims being made. Financial models will undergo increased scrutiny. Any data that doesn't flow from traditional accounting practice or uses unconventional terms or definitions for key economic metrics will, at the very least, trigger more investigation. Term Sheets will revert to best practice that was often skipped in the froth of the 2021 funding spree. For example, such offers will be more likely to stipulate an annual audit by a reputable accounting firm, especially through the growth stages. Similarly for legal advice. The guidance of a reputable law firm on all corporate matters, not just fundraising, will become necessary to imbue investor confidence. Gurley's checklist extends across many other useful topics. These items will influence the 'optics' of a business and most importantly, signal the type of culture the founder has created. The fundraising process was always an exercise in developing trust. This has just moved to a new level.

Happy reading!

back to newsletters

Subscribe to our Newsletter

Stay informed. We will email you when a new newsletter is published.

* indicates required

To subscribe to our Blog Articles click here