This week on the startup to scaleup journey:
Serial entrepreneurs raise more capital
Raising capital is getting harder. Concerns of harshening economic conditions and the lack of liquidity from public listings have led investors to become more prudent in their investment allocations, limiting both the number of investments and founders they choose to invest in. Investors inundated with pitch decks and fundraising requests are looking to mitigate as much risk as possible, as quickly as possible. It seems logical that investors would prioritise investment in successful ('serial') entrepreneurs. But it is hard to gauge the degree to which this is happening and what the implications are for first-time ('novice') founders, or for that matter founders that have been through the start-up experience at least once but have yet to have a successful exit ('unproven'). Recent research by Pitchbook sheds light on the subject and confirms that serial - and in many cases unproven founders - are able to leverage their lower risk profile with investors.
The median number of years since founding at the time of a startup’s first VC round offers insight into the advantages that serial entrepreneurs possess over their unproven and novice peers. Between 2006 and July 2022, serial entrepreneurs closed their first institutional round after 1.13 years, compared to 1.34 years for 'unproven' and 1.92 years for 'novice'. Founders with some experience are not only able to leverage their network but also appreciate the speed of business model execution required in the early stages. Deal sizes also varied considerably. Median Angel & Seed deal sizes for serial entrepreneurs in 2022 YTD were 2.5x larger than novice-led deals, while early- and late-stage rounds led by serial entrepreneurs were roughly 3.4x larger. As Pitchbook points out: "The larger divergence in median deal sizes between serial and novice entrepreneurs in the early and late stages suggests that even market proven products and demonstrated revenue growth cannot overcome the inherent investor confidence afforded to serial entrepreneurs."
An important insight is that at both Seed stage and Early stage (often associated with Series A and B transactions), serial entrepreneurs are willing to give up a greater percentage of their company. This is nearly 2% more than unproven entrepreneurs and 6% more than their novice counterparts. This trend reverses course in the late stage (typically Series C onwards), suggesting that momentum from prior fundraising rounds allows serial entrepreneurs to give up less equity later on. The trade-off of receiving more capital at an early stage for a larger investor equity stake allows serial entrepreneurs to more rapidly scale their businesses and reach their next milestone. This acceptance of greater dilution is more than offset by bigger valuations, especially as the point of exit appears. Median valuation variances between serial and novice entrepreneurs were 3.7x at late stage. First-time founders must expect investors to put increasingly greater weight on the experience of both the founding and the executive team. The greater this bench strength, the lower the risk profile appears. The lower the risk profile, the more attractive the proposition.
Can UK VC brush off macroeconomic uncertainty?
Despite increasing macroeconomic uncertainty, UK & Ireland deal activity has remained strong during 1H22. Pitchbook data confirms £15.4B invested across 1,879 deals in the first 6 months of this year. This compares very favourably with the £28.2B invested for the whole of 2021 over 3,857 deals. It seems as though a looming recession and surging inflation are not (yet) curbing investor enthusiasm. These are not only UK market headwinds but are being felt abroad too. This has already led to a big VC pullback in other geographies during 1H22, notably the US. UK startup businesses that are now generating revenues will be most anxious as consumer markets tighten further. Maybe revenues haven't yet seen a dip, but is this sustainable? As VC Gil Dibner highlights this week, is the real revenue slowdown just beginning now? A key indicator is the increasing number of public SaaS giants that are starting to miss their numbers and/or reduce their guidance for future quarters.
Late-stage businesses are poring over their forecasts again, having already pared them back and made big operating cost reductions earlier in 2022. This has impacted valuations considerably. At the other end of the scale, Pre Seed and Seed stage businesses that have yet to generate early revenues may feel more insulated from the poor optics of a declining revenue outlook. But if initial revenues are being pushed to the right this will have the same dampening effect. Early revenues are a sign of real market engagement, a tangible form of validation, even if they may not yet represent product/market fit. Here you need some consistent revenue growth over a reasonable period of time (several months at least) from multiple customers. Whatever the stage, the importance of sound forecasting - both revenues and costs - using a robust financial model, has never been more critical. Experienced founders will be using such a tool with vigour, stress testing all the inputs with the entire executive team on a regular basis.
There was a time, not long ago, when a startup only needed a cash flow forecast for a Pre Seed round. As the business was almost certainly pre revenue, people only really cared about costs. That has all changed. CEOs must now demonstrate a much higher degree of financial literacy from the very formative stages and equip themselves with a financial model before pitching to institutional investors. The level of scrutiny that such models receive in due diligence is increasing, almost beyond what seems reasonable. You might expect such close examination from Series A onwards but recent insights from Pre Seed and Seed rounds confirm that every line and every assumption is being picked over. With such an uncertain macroeconomic outlook we all know that any long-term forecast right now is not much more than a guess. But investors want to see your assumptions and know you have the ability to quickly model changes and make informed decisions. That much is certain.
Those who define their category win their category
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." He describes how once you’ve defined the category, you can flesh out the category requirements and position them in a quadrant chart. "This is the time to talk about features. You can position yourself and de-position competitors by explaining what functionality is critical for a product of this type."
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 business model, all greased by 3) breakthrough 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.