This week on the startup to scaleup journey:
VC investment down in 3Q22 but founders respond
According to the latest report from CB Insights, global funding continued to slide in 3Q22 to $74.5B, hitting a 9-quarter low. This represented a 34% drop QoQ — the largest quarterly percentage drop in a decade — and is down 58% from the funding peak in 4Q21. While not as severe, the number of deals declined by 10% to 7,936 — the lowest level since 2020. European startups raised $14.8B in 3Q22, a 36% drop QoQ and a 7-quarter low. Deals here dropped by 11% to 1,584. US and Asia also saw sharp drops in quarterly funding. US funding fell by 32% to $36.7B, whereas Asia funding fell by 33% to $20.1B. A closer look at the US data reveals why so many market watchers there are full of doom and gloom: investment levels were down a dramatic 52% YoY in the third quarter. This compares with a 38% drop YoY for Europe, which is still a big drop but not as numbing as in the US. A remarkable feature of the US figures is that deal count actually increased in Q3 over the prior quarter. This shows that the overall momentum in dealmaking there is still strong, despite average deal sizes plummeting.
According to CB Insights, the UK has also witnessed a significant drop with investment down 55% QoQ and 59% YoY for the third quarter. But we must remember that 2021 was a barnstormer of a year in the UK. It is more instructive to look back to 2020 and 2019 figures to get a truer sense of how the market is shifting over the longer haul. In 3Q19, $3.1B was invested across 350 deals and in 3Q20 it rose to $3.5B over 358 deals. This makes the £3.3B recorded in 3Q22 across 408 deals approximately flat versus these earlier years. What does this all a mean for UK companies looking to raise their next round in the coming months? For those that raised their last round in 2021, especially late-stage businesses, valuation haircuts are almost unavoidable if an equity round is the only option. But for those who last raised back in 2019 or 2020 the picture is not so bleak. Valuations and deal activity levels are comparable with those earlier market conditions. What has changed is market sentiment due to a very different economic climate. Investors are now more cautious, more demanding in terms of deal criteria, and are just taking longer to evaluate opportunities.
What is very noticeable from our ringside seat is how UK startup boards are now becoming far more proactive with investment planning. Some, looking to raise in the latter half of 2023, are already evaluating funding strategy options and resetting internal expectations for what true 'fundability' will look like. Others, that are currently preparing campaigns for early 2023 start, are going to extraordinary lengths to ensure their propositions are truly compelling. We can see daily at close quarters how founders are looking to gain every advantage as the battle for capital intensifies. There is much greater focus on target investor selection, often involving a deeper look at international investors and non-VC sources. And more time is being devoted to pitch deck and financial model preparation to allow for greater levels of stress testing before going 'live'. Even though the current market headlines make grim reading, the best startups will still get funded through 2023: VCs and other institutional investors are sitting on record amounts of dry powder that must find a home. Despite what they say, investors are under constant pressure to identify the future winners that will deliver the big returns they have promised.
“Default investable” vs “Default uninvestable.”
VCs are spending increasing amounts of time on 'portfolio management', a euphemism for making follow-on funding decisions for each company. The triage usually boils down to 3 options: Should we 1. Support them with further capital? 2. Look to now sell/exit our position? or 3. Let them fade away without any further funding? The 'fade away' option is hardest to deliver. The founder knows their company is being cut loose, left to fend for itself. Such negative signalling will almost certainly deter any new investors. Not even the current investors think they even have the prospect of selling what they have in an early M&A deal. If VCs are telling the founder to put up the for sale sign (option 2), at least they believe something of value has been built - even if this means a sub-optimal exit. The first option, 'support with further capital', sounds like the hot ticket, but can come in several forms. If the startup is truly investable and an external lead investor steps forward, the result will likely be a fully-funded business plan. But if the startup is not yet investable in the eyes of externals, the internal investors will often position their investment as a 'bridge' to a point where it will be. To create the right funding strategy, founders must have a realistic understanding of how investable their business is in the current market.
Picking the right funding strategy is hard for 2 reasons: One, it requires an understanding of how new investors will assess the business and how high that bar now is. Second, it requires a completely dispassionate and honest appraisal, so hard to do when this is your creation, your baby. When we help founders through this process the easy part is finding 'the bar'. The tough part is then facing up to the reality of the company's state of funding readiness. But for those who aren't investable today the payoff is a plan that delivers this. The core of this plan must be the growth strategy. Provided this is the case, VC Hunter Walk says: "You can manage the cost of it. You can alter the slope of the curve for a period of retrenchment. You can take a step backwards to continue experimenting, go after a different set of customers, rethink whether you truly have PMF, but you need to emerge on the other side of it with a startup that’s investable. Reducing burn and ‘months until cash out’ is only helpful to the extent that you are giving yourself time. Using your capital to relieve pressure of execution by saying “we now have 24, 36, 48,♾️ months of runway” isn’t the goal. In fact, switching to this mentality blindly and solely almost assures you won’t be in a position to raise when the capital runs out."
Veteran VC David Sacks captures this concept so well when he says, "Startups: Instead of thinking about whether you are “default alive” vs “default dead”, think about whether you are “default investable” vs “default uninvestable.” The 'default alive' phrase comes from the blog of Paul Graham, co-founder of Y Combinator. Default alive depends upon being cash flow positive, which for early-stage startups these days is almost impossible. Sachs, whose sole focus is SaaS, describes a 'default investable' startup as one whose metrics are good enough to raise another round of investment in the current environment. For SaaS businesses that are already trading this is relatable. But for other business models, such as those often associated with DeepTech, the test is more complex and goes beyond these basic metrics. Even to close an internal bridge round, a founder must be able to demonstrate that this is a bridge to a very specific landing point, not just a runway extension with a promise to figure this out later. This landing point will need to have the key attributes of being externally 'investable'. Founders must ensure that as investors assess their portfolios, they believe that a solid landing point has already been reached or there is a credible plan to get there soon.
Making early-stage board meetings high value-add
It's not often we come across a CEO/founder of an early stage business that truly looks forward to board meetings. When we dig deeper we often find that this is because they don't provide the value-add that founders want or expect. The meeting just feels like an examination of the CEO's performance by the investor directors. The traffic is mostly one-way. This is perhaps not surprising, as we explained in our recent insight, 'How to avoid being fired as CEO'. The unspoken truth is that investors are primarily there to monitor their investment. But board meetings should also be an opportunity to surface new insights and ideas that the CEO and the management team can then explore. Ideas must come from everyone. If boards aren't collectively doing this, then something is wrong. This is usually down to one of 3 factors: the wrong people, the wrong expectations, or the wrong agenda. The first of these is really make or break. The wrong people can wreck everything, and it's the CEO's job to make sure this doesn't happen.
At Seed stage, boards often comprise just the founder(s) and the lead investor. If other investors have meaningful shareholdings they may also have board seats. Founders quickly discover if they have chosen their source of capital wisely. If the investor director is experienced in supporting founders at this stage and there is great chemistry, then they are off to a flying start. If not, deflation can quickly set in. It is also a particular feature of UK startups for the early institutional investors to require a non-executive chair to be appointed at Seed stage. This can work well and is particularly valuable where there is a relatively inexperienced CEO/founder. The idea is then to find a chair with early stage operating experience - most likely a former CEO themselves - that can support and coach the CEO, in addition to running board meetings. Irrespective of the rationale, the selection by the founder of any board-level appointment, including the non-exec chair, is an absolutely critical decision. It just takes one bad selection to undermine the effectiveness of the board, and in turn the CEO. A founder must make these decisions as if their life depended on it.
To get the most out of the investor directors, experienced founders will quickly set the tone. This involves developing a pattern for board meetings so the directors know what to expect from the CEO, as well as knowing what the CEO expects of them. The way to encourage this is by careful management of the agenda and giving the non-execs time to prepare beforehand. The trick is not just to get papers out well in advance (1 week is often ideal), but to include an overview of the 1 or 2 major topics for debate. Experienced founders will preview these topics in their pre-board 1/1 calls. This is also the moment to get any difficult news out of the way so there are no surprises in the meeting itself - a golden rule. The Company update (the major headlines, cash position/runway, financial projections, key metrics dashboard, recruitment..) should be limited to no more than 30% of the time. 70% of the time can then be devoted to these major topics - strategic matters, key initiatives, and debating the big operational challenges du jour - where the investor directors are expected to contribute to a truly collaborative discussion. In the current market this is what founders are really looking for. [Further great insights on this topic here from VCs Pete Flint and Mark Suster.]