Early investors are really investing in the stage, not the company
Last week we talked about how founder/investor relationships are built on trust. Our claim was that this trust is often misunderstood. Founders typically believe it is forged from an alignment of interests. But investors believe it is forged from an alignment of expectations.
Understanding investor expectations is therefore crucial when raising capital. The ultimate expectation is that the startup will be very successful and provide an exit that delivers a big financial return.
But for the early investors there is an additional and equally important expectation: that the funding they provide will enable graduation to the next stage of investment.
Different stages
In the venture world, startups are funded through a series of capital stages. Different investors will specialise in different stages.
It's extremely rare for an investor to invest meaningfully across every stage of the journey - from Pre-Seed to Growth. Each group of stage-specific investors 'passes the baton' to the next group of investors, until an exit hopefully materialises.
So, whilst each investor is technically investing in 'the company', in practical terms they are really investing in 'the stage'. No group of investors has the ability to get to the outcome alone.
To graduate from one stage to the next, startups must deliver clear evidence of progress. In doing so they are reducing their risk profile and thus inviting bigger cheques to be written by larger, less risk averse funds.
Any incoming investor will also need to be confident that the company is set up to deliver against the next set of stage criteria. Otherwise, the baton will not be passed in the future. Founders must therefore demonstrate a solid grasp of what these criteria will be.
And herein lies one of the biggest uncertainties when preparing for a capital raise. Criteria vary. The industry, vertical market, business model, and the position in the macro market investment cycle will all influence these expectations. Just compare the market conditions of 2021/22 to today.
Fortunately, there is one constant: A lowering risk profile always correlates with heightening customer commitment. And criteria that reflect this growing customer commitment are prized above all others.
SaaS vs DeepTech
For the ten years up until 2022, mainstream venture markets were dominated by software businesses. During this time, investors universally adopted a set of 'standard' financial metrics that applied right from Seed stage. These included ARR, ARR growth rate, CAC payback, Net Dollar retention, and Burn Multiple.
But in non-SaaS markets, which have increased share in recent years, the criteria are not so straight forward. For example, a DeepTech startup may go for years without any product revenues. Financial metrics just don't apply in these circumstances. In fact, any startup that is building a complex, enterprise-grade solution will likely need to find other ways of demonstrating heightening customer commitment as a proxy for risk reduction before appreciable revenues arrive.
Failure to demonstrate heightening customer commitment between the initial moment of innovation and the final product rollout to customers will create too high a risk profile for early investors. And if that heightening commitment is underpinned by customers spending money with the startup, the more compelling the story.
US VC Main Sequence Ventures has created a framework for thinking about this challenge. They call it the DeepTech Customer Ladder. This shows how startups can work with customers to capture and deliver value while they are still building their product. Each rung on the ladder is a step change in commercial proof and risk reduction.
Early rungs on the ladder
There are 3 classic DeepTech early-stage engagement types that demonstrate increasing levels of commitment:
There are other variations on these scenarios depending on industry, vertical market, and business model, but the broad objective is always the same - paid projects that deliver a step change in commercial proof and risk reduction.
These early engagements can also present risks that must be carefully managed by the startup. The most critical are IP ownership and exclusivity. In all cases it is vital that the startup retains ownership over all IP relating to the product. Co-ownership of any resultant IP is a big red flag to investors.
On rung 2, the operational trial, the customer is by default securing some degree of exclusivity by virtue of the fact that they are receiving early access to the product. On rung 3, early pilot, some formal exclusivity is often required to get deals over the line. Provided the exclusivity is geographically or use case restricted for a specific time period, investors will usually be comfortable.
Everything must step up by stage
We can see that to graduate from one capital stage to the next, new and bigger investors are required. They each bring greater capital capacity as well as valuable insights into the road ahead.
And just as new investors are required for each stage, so too are other key resources. Funding events act as a trigger for stepping up to that next stage of maturity and making big decisions.
New investors will expect CEOs to seize this moment to drive change. This can mean:
Boards change - This can involve anything from the addition of a new investor director to broader, wholesale change. Major new investors (in consultation with the CEO) will look carefully at the constitution of the board before investing to make sure it is optimised for the next stage of the journey.
Executive teams change - As the startup begins to scale this is the time to make sure the key leadership roles have the right level of experience to pull the business up to the next level. Again, new investors will expect the CEO to have a plan in place.
Customers change - Following the technology adoption curve, the 'innovators' helped get the show on the road. The 'early adopters' validated the product. The 'early majority' validated the business model and the go to market strategy. They all have an important place in the future of the business but must be treated differently to extract maximum value. New investors will want to know how.
Products change - Funding unleashes new phases of development that delivers new products. New investors will want to understand the product pipeline and how this opens up adjacent and new markets.
These changes can be critical in ensuring graduation to the next stage of investment.
Stages determine value
There is one final reason why stages (as defined by the major funding events) are so meaningful to both startups and investors: They provide an official marker of enterprise value.
In each major equity round the new investors will effectively set the price of the round. Startups that have met the key 'criteria' to graduate to this next stage will expect an uplift in valuation. This will not only minimise dilution for existing shareholders but will allow the current investors to mark up their books.
VCs use the price per share from a new round to calculate the implied value of their original investment. If the new price per share is higher than in previous rounds, the value of their existing shares has increased (at least on paper). This helps the VC demonstrate asset appreciation and justify their performance to their limited partners (LPs). This can also directly affect their compensation, so they care deeply about this point.
This explains why VCs are less keen on 'internal rounds'. In this scenario there are no new investors to set the price. Justifying performance to LPs can then be more challenging. In addition, there’s a risk of inflating valuations artificially, which can backfire when the company seeks external capital in the future.
All investors must be cautious about setting an unrealistic valuation in an internal round. This is a classic mistake during pre-Seed and Seed rounds undertaken by private investors only. When the first institutional investors arrive, reality often hits.
In summary
Founder/investor relationships are built on trust. This is forged from an alignment of expectations.
Early investors expect that the funding they provide will enable graduation to the next stage of investment.
Stage investment criteria vary but there is one constant: A lowering risk profile always correlates with heightening customer commitment.
Unlike SaaS businesses that are measured on financial performance from the earliest stages, DeepTech startups must pursue engagement types that demonstrate increasing levels of customer commitment.
At each major stage, new investors will expect CEOs to seize the moment to drive change. CEO's must be ready with their ambitious plans.
Externally led rounds are most desirable at stage boundaries. This enables VCs to mark their books to market and (hopefully) justify their performance to LPs.
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