Duet Partners
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Weekly Briefing Note for Founders

9th March 2023

This week on the startup to scaleup journey:
  • Most startups will not grow into their 2021 valuations
  • VCs seek 'category winners'
  • The startup mission: find a repeatable business model

Most startups will not grow into their 2021 valuations

All boats rose on the valuation high tide of 2021. But since then valuations have dropped back sharply to pre-pandemic levels. Some founders that raised big rounds at the height of the market believe they have the time (and the runway) to grow back into those inflated valuations. But a recent analysis by TechCrunch shows that few will grow fast enough to accomplish this over the next few years. "If you are growing faster than 75%, you can entertain the discussion. If you are growing slower than 30%, there is a strong chance that you will never be able to match your 2021 valuation." For many, the prospect of a down round now looms - although if current investors no longer see a reasonable prospect of returns, founders may be told to put up the 'for sale' sign. But in cases where there is still real belief and existing investors are supportive, down rounds will happen. A bridge round, perhaps in the form of a convertible loan, may push out this pricing event. But unless the business performs very strongly as wider markets continue to deteriorate, this awkward moment is almost certain to arrive. Should founders view this as a point of failure, or can there be real hope that fighting to live another day truly makes sense?

A recent investigation by Pitchbook throws light onto the post down-round prospects for startups. Even though this only relates to the US market, the insights are still illuminating. Using a dataset of 1,421 companies raising a down round between 2008 and 2014, the research tracked the ability of beleaguered companies to continue growth via further capital raising. Note that an aged dataset like this is essential for full cohort analysis in subsequent years. Remarkably, just 188 (13%) of those companies tracked were unable to raise further financing or complete an exit immediately after taking a down round, thus suggesting that down rounds aren’t an instant company killer. The high number (755 or 53%) of companies able to eventually exit also corresponds with the high proportion of down rounds occurring at late stage, where the comparison with depressed public markets is unavoidable. Here, investors are less likely to abandon a company; they instead look to recoup investment where they can, even if it is less than the total invested in the company. The majority of such exits undertaken by this cohort in 2021 occurred via corporate acquisitions with the balance split evenly between PE buyouts and public listings.

Of the exits completed after taking a down round, a much higher than normal proportion of this group exited through a buyout from a private equity (PE) firm. They are often better candidates for some form of restructuring typical of the PE modus operandi. Since 2016, 166 buyouts of companies that had previously taken a down round have occurred, constituting 19.4% of the exits for this cohort. Within the broader venture ecosystem, just 11.5% of exits occur via PE buyout. The data also shows that investing into a down round could prove to be an investment strategy with decent returns. Pitchbook concludes: "The fact that 88% of known exit valuations for companies taking a down round were higher than the down round valuation should increase the confidence in down round participants. The [recent and ongoing] decline in capital availability, especially for companies with lagging financials, is a natural market occurrence. Down rounds are a part of markets, but rather than heralding the end of the company, the data shows they should rather signal a shift in company expectations."

VCs seek 'category winners'

Startups that create a new category typically capture over 70% of the total category market cap. This is why VCs invest in 'category winners' - or those that look like they will become one in the future. When VCs assess an investment proposition, one of the first things they examine is the description of what the business does. This provides the initial clue about 'category'. The second, more revealing clue, is the problem the startup is addressing and the solution being created. Experienced founders make sure they carefully explain the problem to ensure the investor is 100% clear why the mission is unique. If a VC thinks they already understand the problem (either because it is already well-known in the market or they have heard other startups pitch a similar story) they will assume someone else has already defined that particular category - and therefore has an advantage. This is very hard to sell around. It's therefore vital that the founder's insight reveals a problem/solution perspective that is both exclusive and exciting (has huge market potential).

A powerful way of pressing home the founder's unique perspective is through product/market positioning. A quadrant chart is often used as it can provide a simple and visually compelling rendition of how the category will be perceived by potential customers. This can either be a completely new category (quite rare) or the redefinition of an existing category (more common). Importantly, the quadrant chart describes how a customer will see a problem and thus evaluate a potential solution. As VC David Sachs says in his excellent article on category leadership,"Business understands problems by categorizing them, so convincing the world that a new category is valid is tantamount to winning."  Celebrated author and investor, Geoffrey Moore, describes how huge market potential is then essential for creating real investor excitement. His insights into the 'supremacy of category power' explain why the most successful disruptors seek out new categories where they can unleash the 'trapped value' that others have not yet seen. This potential for hidden value release is the ultimate founder insight.

But there are several misconceptions around category creation. The most common error is conflating category creation with first-mover advantage. The incorrect premise is that category creation is about being first to market with a new product or service. But this is rarely the case, as Apple so clearly demonstrated in smartphones. The challenge is broader than the product and this is often where technical founders stumble. Research shows that the emphasis should be on creating the first high-functioning 'flywheel', which is the combination of 1) a radical product/service innovation, plus 2) a breakthrough and repeatable business model, all greased by 3) big data insights about future category demand. This is supported by an analysis of the Fortune 100 fastest-growing companies over the last decade. Of the roughly 600 unique companies across the 10 years analysed, companies with such a flywheel effect accounted for only 22% of the companies, but drove 52% of the revenue growth and 72% of the market cap growth. Founders must ensure that VCs hear a story that shapes the birth of a new category and the flywheel that will lead them to win.

The startup mission: find a repeatable business model

What is a business model? The simple definition is that it's how a company makes money. We are usually drawn to thinking of the transactional aspects of the model i.e. SaaS, eCommerce, subscription, etc. But when an institutional investor asks about your business model they are looking for much more than this. Steve Blank, one of the founding fathers of the lean startup movement, defines a startup as: " ..a temporary organisation used to search for a repeatable and scalable business model." Once this is achieved, the startup can scale to become an established business. In their seminal book, Business Model Generation, Alexander Osterwalder and Yves Pigneur add further substance: “A business model describes the rationale of how an organisation creates, delivers and captures value.” It incorporates ALL the essential elements that must be present to enable the business to succeed as it creates, delivers and captures this value.

In the Tech industry, there has been a dawning realisation over recent years that the business model is the competitive differentiator – especially when a strategic inflection point is occurring. Those who have read Only the Paranoid Survive by former Intel CEO Andy Grove, will recall the power of inflection points and how they can be exploited through the business model. Competing on technology, product or price alone creates a high vulnerability to disruption. DeepTech businesses, in particular, can be challenging businesses to fund due to their early capital intensity. But the payback can often be through the very complexity of their business models. For highly embedded technologies this derives from their stickiness and is often linked to the multiple engagement (revenue) points they have in the supply chain - for example, from channel partner to OEM to end-user. These multiple revenue streams are all part of the same business model. For other businesses however, multiple revenue streams may emerge from trialling multiple business models, and this is where problems can occur as the business looks to scale.

As Haje Jan Kamps says in his latest article in TechCrunch, "It’s hard to test more than one business model at a time. Showing an investor that you have five business models doesn’t show that you are closer to finding one that works. Instead, it shows that you’re unsure." That’s somewhat expected during (early) Seed stage as nobody expects you to "hit a home run the first time you swing the bat." But as you approach the growth take-off point - usually associated with Series A funding - you should have a clear operating plan that radiates certainty that you have landed on a model that is repeatable and scalable. This is not a time to hedge. The business model at this stage is now the 'full stack' of how your company operates: How you deploy your resources (money and people) to create products and attract paying customers, and how you retain those customers. Business model innovation, rather than technology innovation or sustaining innovation, has now become the key to building resilience in high growth companies. How would you describe yours?

Happy reading!

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