Weekly Briefing Note for Founders

10th October 2022

This week on the startup to scaleup journey:

  • Patient capital delivers big returns
  • Venture debt increasing as equity gets squeezed
  • Learning how to shape the narrative

Patient capital delivers big returns

The big topic of conversation in VC circles right now is where the market will go from here. We have a bizarre set of circumstances: VC activity (deals done and capital deployed) is trending down sharply at the global level whilst at the same time VCs have more capital to deploy than ever before. Pitchbook estimates that there is about $290 billion of VC “overhang” (money waiting to be deployed into tech startups) in the US alone and that’s up more than 4x in just the past decade. Veteran VC, Mark Suster, provides some real insight this week into the likely rate of deployment and how VCs will need to position themselves for the next phase of the market. Suster's belief is that capital will be patiently deployed, waiting for a cohort of founders who aren’t 'artificially clinging' to 2021 valuation metrics: "I talked to a couple of friends of mine who are late-stage growth investors and they basically told me, 'we’re just not taking any meetings with companies who raised their last growth round in 2021 because we know there is still a mismatch of expectations. We’ll just wait until companies that last raised in 2019 or 2020 come to market.'"

Suster sees this slower cadence as a return to normal market conditions. Investors will take more time to conduct due diligence and make sure there is not only a compelling business case but also good chemistry with the founders. From the frenzy of 2021 when many investors were forced to operate outside the boundaries of normal practice if they wanted to compete, Suster sees a bifurcation of the market into 'super size' or 'super focus' VCs. For all but the biggest, the rationale for focus is simple: investors in any market need 'edge' - knowing something (thesis) or somebody (access) better than almost any other investor. That will mean a more resolute focus on their selected stage, sector, and geography. Coupled with this is a greater caution over investing solely in 'conventional'  high growth outliers, where big up-rounds happen in rapid succession. Suster's analysis of his fund's portfolio shows that such companies have indeed been important to driving big returns. In a typical seed fund like Suster's Upfront Ventures that supports 36-40 investments, around 12-15 have typically seen big up-rounds in the first 12-24 months. Just 1 in 4 of these have then needed to 'pan out' (a big exit) to return 2-3x the fund, which is the ultimate goal. This is the 'power law' of VC returns.

But the biggest insight is that there is another group of 'outliers' that can have as big an impact on fund performance but do not fit this classic early growth model. From his analysis, Suster reveals that his funds created more than $1.5 billion in value to Upfront from just 6 deals that WERE NOT immediately 'up and to the right'. "The beauty of these businesses that [didn't have] this immediate momentum was that they didn’t raise as much capital (so neither we nor the founders had to take the extra dilution), they took the time to develop true IP that is hard to replicate, they often only attracted 1 or 2 strong competitors and we may deliver more value from this cohort than even our up-and-to-the-right companies. And since we’re still an owner in 5 out of these 6 businesses we think the upside could be much greater if we’re patient."  It's refreshing to hear a VC talk in such terms, even if they are US-based. Many of the greatest tech businesses emerge from a slow-build start and can take 10 years or more before their true potential can be realised. This is not a story that many investors would have listened to 12 months ago, but this patient approach is creeping back in. We need more funds to now truly embrace the longer-term potential value of IP-based startups that are so prevalent in the UK.

Venture debt increasing as equity gets squeezed

According to Dealroom, European startups are on track to raise €20.4bn in venture debt in 2022, up from €15.9bn last year. That would be nearly three times the amount raised just two years ago. At a time when equity finance is getting harder to raise, venture debt has increasing appeal. The main advantage of venture debt over traditional equity financing is that it is virtually non-dilutive. In terms of costs, there is usually an arrangement fee up front (typically 1-2%), then an annual interest rate (typically 10-20%, depending on the risk profile) and finally an equity kicker in the form of warrants - these give the lender an option to subscribe to a predefined amount of a company’s new equity (usually equal to a fraction of the overall debt facility) at an exit event. The dilution from such warrants is typically around 1-2%. Most providers will also offer an interest-only period at the start of the loan, often in the range of 6 to 12 months. The attractiveness of venture debt is also enhanced by the fact that unlike equity financing it doesn't require a valuation to be established. This also helps streamline the process making it less onerous than an equity raise.

Venture debt is offered by specialist lenders and is structured as a term loan, typically over 3 to 4 years. It is aimed at a particular strata of early stage businesses, notably high-growth scale-ups. These types of loans are particularly effective for companies that are yet to achieve profitability but have an established business model (generating early revenues) and clear prospects for growth. Funding is available earlier and in larger amounts than traditional bank loans, and these loans typically do not require personal guarantees. There are usually no fixed criteria in how these funds can be used and can include extending the cash runway (perhaps as a bridge to profitability), providing working capital for early production, supporting other capital expenditure (such as the purchase of capital equipment), and even making an early acquisition. Loan sizes typically range from £2m to £10m, but can be significantly larger for more established businesses. As the market expands and equity deals get harder, there is a growing cadre of entrants including some of the world's largest PE funds and hedge funds now coming in.

Founders evaluating venture debt providers should pay as much attention to their own due diligence as they would for an equity provider. The first priority is to keep the deal terms simple: ideally you are looking for no or few financial covenants (e.g. liquidity thresholds, cash burn limitations) and very limited governance requirements. The good news is that venture debt providers will likely not be seeking a board seat. Also vitally important is the relationship - that's not just the chemistry between you and the partner leading the deal, but the relationship the lender has with your VC backers. Why? The cash from your equity providers is essentially paying for the loan. The most established lenders will already have good relationships with the major VCs who they will see as critical partners in the development of their businesses. If and when things go wrong, restructuring the debt may become a necessity. This is when you will truly value of all these key relationships. Above all, you must feel comfortable that your business is at the stage where it can sustainably service its debt and a good lender will evaluate this point with you to find the best arrangement. If you have done your homework on this and your current investors are supportive, venture debt can provide a compelling, non-dilutive alternative to further equity financing.

Learning how to shape the narrative

In the early stages of creating a startup, experimentation loops provide essential feedback. You are testing ideas on people, using an MVP to solicit feedback from early adopters, engaging with different cohorts of users, and trying out different product features. Through a process of trial and error, sometimes many steps back for only a few steps forward, a repeatable formula emerges. A formula that enables a product to efficiently reach a market where there is clear demand and real opportunity to make money. This process may take years, but eventually you are ready to start early scaling. This is typically the moment of the Series A round. As you craft your investor pitch, you try hard to build a compelling narrative around the journey and where you are headed. But there is an issue. Some of the experiments that didn't work out so well have created a legacy that just doesn't align with this narrative. This may be customers you picked up along the way that don't really fit this future vision; early products that you would now like to kill, but need to support; revenues from these sources that bolster your top line but aren't representative of your future market opportunity. How do you factor all this into your story?

VC, Gil Gibner, talks about this in his blog, referring to the 'messy reality' of the things that don't align. "My advice is to get out in front of these discrepancies. Own them. Wrap your narrative around them proactively."  The message is clear:  Don't make it sound as if everything has just fallen into place, as you will almost certainly get found out. Instead keep things straight and build a more realistic insight: “Our total ARR was technically $700K, but we’re really only counting $300K of true on-thesis ARR because $400K of it was really for a different use case from two big customers that don’t really represent where we are going.” Or even: “Our biggest customer is actually Acme Inc, but I really don’t like talking about them because I don’t think they represent our real business going forward. They found us, and we could easily meet their needs, but we are not pursuing customers with that profile.” Rather than confuse things, this openness helps an investor see how you have gradually built a single coherent story. You may be anxious that in stripping back these non-aligning items you may be left with little that does align! If that's the case, you are probably not ready to build an investment case.

Sometimes, even the best intentioned plans hit a roadblock. A pivot may be forced. Perhaps some form of financial restructuring may be necessary. If the bank balance is tumbling and fresh capital isn't in sight, 'clean' narrative building must be put on hold. Survival requires going where the money is - what can we sell and to whom? Live to fight another day. Even these off-piste moments become part of the story, and in some cases become an integral part of discovering where the true demand really is. As the narrative is then rebuilt, it will give shape and direction for the team. It will help set new priorities, organise and motivate people to find the Series A jumping off point once again. As Gibner adds: "As a company scales, the ability to control and shape a narrative only gets more important, not less. (If you doubt this, just read some IPO prospectuses.) Series A investors are not just judging the quality of a narrative — they are judging your ability to shape your narrative and communicate it effectively."

Happy reading!

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