First-time financings are in steep decline across Europe

Through 2019 we noticed a concerning trend with incoming enquiries from founders. An increasing number were from startups struggling to secure their first institutional or VC raise. These weren’t 'no hopers'. These were, on the face of it, exciting early stage companies with compelling propositions and highly credible private backers. But VCs had been turning them away.

With the recent release of 2019 market reports from the likes of Pitchbook and Beauhurst, this trend has been brought into sharp focus. Deal count at both Seed and Venture stage in the UK is in worrying decline. Across Europe, first time financings with institutional investors have fallen to half their peak in 2014.

A record year for investment – but this masks the real story at early stage

Beauhurst’s 2019 UK equity investment report, The Deal, revealed some stark insights under the heading ‘The seed stage takes a dive’.

Whilst Growth stage investment levels are off the charts, deal count at both Seed and Venture stage has continued to slide.

Even more alarming is is this chart from Pitchbook's 2019 Annual European Venture Report.

It’s not just first-time financings that are under sustained pressure. The total number of VC transactions across Europe was down over 15% from 5,929 in 2018 to 5,017 in 2019.

We are truly in a new era of VC

The more market insights we study, the more it becomes clear that this dramatic decline in deal activity at early stage is now the new norm. Whilst the amount of capital flowing into new fund vehicles is at a 10-year high, the number of new VC funds being raised continues to fall. This means there is an increasing concentration of capital being controlled by a smaller number of larger players.

With record levels of dry powder, more and more European funds are looking to invest both internationally as well as through sequential funding phases. Rather than just focus say on Series A, an increasing number of funds now have the firepower to invest right from Seed through to Growth stage. This should make life a lot easier for founders lucky enough to secure their pre-Series A or Series A round from one of these bigger funds.

US funds are also continuing to ramp up international investment activity. This includes Corporate VCs (CVC) as well as some of the better-known US VC funds. In general we are seeing larger, more syndicated rounds: Typically, a UK VC will lead then pull in a US VC and well as other international investors. Increasingly, these include CVC’s that want to play in one of the hot tech spaces (Fintech and AI related sectors remain a huge attraction).

Unicorn potential is increasingly the target

According to Pitchbook, by the end of 2019 there were 40 European startups with a valuation exceeding $1 billion. 14 of these became unicorns last year. The big investors all have initiatives to seek out the next cohort – as early in the lifecycle as possible.

In part this explains why investors poured over €32 billion into European companies in 2019, up from €24 billion the year before. As deal numbers actually dropped 15% in the same period, average deal sizes have surged. VCs are placing bigger bets.

In the UK, Beahurst figures confirm a record number of ‘megadeals’ (over £50M) in 2019. With 35 announced during the year this was a 30% increase on 2018. Two thirds of these companies were based in London. 80% of megadeals in 2019 involved participation from a one or more foreign investors.

The founder mindset

Startups that are setting out on their journey now have a steeper hill to climb. Vision and ambition are not enough. They need exceptional propositions that address huge potential market opportunities. They need business models that can be efficiently validated and scaled. To achieve this, they require a radically different founder mindset than was prevalent only a few years ago.

At Duet, we help startups strengthen their investment propositions as a prelude to funding. With a fresh pair of eyes we find the weak spots, the things that will hold them back, the things that will put investors off. Sometimes (rarely) these are obvious – the market is too small or too crowded, or the cost of market entry is prohibitive. Mostly the issues are more nuanced.

It is often a combination of more subtle things that will conspire to block the path ahead. By running simple stress tests on all the key proposition components, we can usually see the patterns emerge.

A common theme through 2019 related to the founder mindset and, in particular, the approach to finding Product/Market fit. Nothing is less appealing to an investor than a startup that has spent an inordinate amount of time and money trying to find this true scaling point, but is still lost in the weeds without a plan.

It’s about developing the customer not the product

Big company theory convinces us to obsess about the product. In the startup we need to obsess about the customer. We need to find the customer type that is the optimal fit for our value proposition.

We are not in the business of constant product development in the hope we will convince enough early adopters. In the formative stages, we should be in the business of constant customer development to find the early adopters that will be optimal targets for our minimal viable product (MVP). Our recent article What is a Minimum Viable Product? provides deeper insight here.

The MVP is created from the founder’s vision, not from some big market research exercise. These exercises are the modus operandi of established companies, not startups.

Founders must then embrace experimentation, using the MVP to gauge feedback from as many prospective customers as possible. Some users will hate it and some will love it. The majority will probably want you to change it (to suit their particular needs).

If you have a decent cohort that love it, put your energy there. This is your initial target market. The rest (very politely) can wait until you have developed commercial momentum.

Customer obsession is now the critical founder competency

In this new era of VC, the quest to develop exceptional propositions that address huge market opportunities has to be at the centre of any startup’s mission. The potential to scale efficiently is critical. Modest cost increases must then deliver outsize revenue and margin growth.

For founders to succeed in the competition for capital, they have to first develop a game plan that prioritises early adopter engagement to find the initial target market. They must be obsessive in the quest for product/market fit and employ intelligent methods to seek this out efficiently.

On the back of this a ‘go to market’ strategy must be developed that can provide early evidence of scaling potential. Then the transition from experimentation to execution can truly begin. The big guns will then be knocking at your door.

About the author: John Hall is CEO and co-founder of Duet Partners. His 30-year tech career began with major US semiconductor and software companies. He was based in Silicon Valley during the '90's. Before Duet he was CEO of a VC-backed consumer electronics company, sold in 2009 following several rounds of capital raising. In the past 10 years since starting Duet he has advised dozens of founders on the startup to scaleup journey and is a retained Board advisor to a number of UK technology companies.