This week on the startup to scaleup journey:
Founders dust off campaigns that were put on hold
As global markets started to freefall in the first quarter, VCs began to hit the brakes. As a result, many startups pushed the pause button on funding rounds - getting serious attention from VCs was going to be almost impossible with such swirling uncertainty. The biggest collapse of tech stocks since the 2000's ensued, only showing signs of some abatement in recent weeks. Across Europe, investment momentum demonstrated apparent resilience through Q2 but this was really the culmination of deals that had stared life way back in 2021. The true reality hit in Q3 as we reported last week with a big reset on deal momentum. Now, as we head into the final quarter of 2022, it feels as though the dust has started to settle. Founders have grasped this new reality and are coming to terms with what investors are now looking for. Campaigns that were put on hold earlier in the year are being restarted. New campaigns are now being developed for 2023. Even though we are emerging into a very different funding world, companies must raise capital to deliver their ambitions. Life must go on.
How different is this new landscape? Have the fundamental rules of the game changed in VC? There is clearly a change in sentiment - investors are far more cautious and will spend more time assessing risk (see below). But the fundamentals remain the same: The overarching driver of investor interest is 'growth'. It always was and always will be. If your business is growing strongly, other sins will be forgiven. Investors peddled that 'capital efficiency' was the new mantra as markets collapsed. That might be true for incumbent investors anxious about cash runway, but new investors aren't going to make the big investment calls based on efficiency metrics. Cristina Vila, CEO of Cledara, who just closed a $20M Series A, puts it so well: "As founders, we need to make sure we read between the lines because we can’t blame our inability to raise on market conditions. If you hear something along those lines from investors, well, continue working on your business and speak to other investors that will actually believe in your growth, your vision and your strategy." Vila is also dismissive of other VC sensitivities: "Another piece of advice we heard a lot from investors was to raise less due to market conditions. Founders shouldn’t be swayed by this kind of counsel. We understand our business, we know what we want to build and we have a strategy to do it. We have modelled it all to know how much capital we need to achieve our vision."
But the 'vision thing' is a topic where new traps exist. The road to delivering the ultimate vision can be long and uncertain - a tricky message to deliver to early-stage investors in the current climate. If this is ultimately about a binary outcome that requires a huge a leap of faith now, investors will often say come back when you have more evidence. Finding waypoints that are themselves breakthrough moments that deliver increasing customer engagement will lower the risk profile. After an initial attempt at selling the big vision failed, Cledara pivoted the way they communicated the vision and broke it down into logical smaller pieces. "The magical thing is that by doing that, investors that believed started to imagine what is possible and make the journey their own. Look for that magic." says Vila. Cledara was fortunate - they started raising when they had plenty of runway. They could afford the pause and took the opportunity to regroup a few months later. Getting ahead of the game like this is now so crucial. Experienced founders will always try to buy themselves time to test the market and see how the proposition plays. Some tweaking is nearly always necessary before the 'big push' and should always be factored into the timeline.
How investors assess risk
The essence of any investor due diligence is finding the right risk/opportunity balance. Every investor has their own tipping point. The best venture opportunities are by their very nature risky and uncertain. If they weren't, many others would have already tried. And the bigger the ultimate prize the more risk an investor will be tempted to take. But everyone has their limits. The same applies to founders and their boards. Big decisions will rightly require some form of risk/opportunity assessment. But problems occur when startups and investors do not align on how to measure the overall risk/opportunity profile for the business. Institutional investors will often use a scorecard to bring this whole picture together, similar to the one we use in Investment Analysis. In the current climate, understanding how investors are now sharpening up their approach to risk has become a key factor in ensuring a business is fundable.
VC Gil Dibner provides some useful insights on risk assessment in his latest blog. The way he thinks about risk in early stage tech companies is influenced by the type of business he is evaluating. He sees two broad categories: (1) engineering risk and (2) go-to-market risk. Engineering risk companies are building something where there is significant risk around whether or not it can be built at all. This works best when there is little doubt that the market will want some version of the product. These companies can often afford to defer their struggles with go-to-market (GTM) for a later date. In many cases, the bar for some initial product-market fit (PMF) is also lower, because the core value proposition is so large and unique that customers will accept a lot of imperfections in its delivery. Go-to-market risk companies are typically building something where there is little engineering risk, but significant PMF/GTM risk. Both PMF and GTM pose significant risks and challenges, primarily because customers will face multiple competitive offerings and the company can only achieve meaningful success if it quickly emerges as the leader in its category.
Dibner contends that from both the venture capital and entrepreneurial perspectives, these are two completely different playbooks - often requiring different types of founders, teams, investors, and board dynamics. In our experience, few investors have such a mature and well-reasoned perspective and an openness to invest in both scenarios. The vast majority of VCs are investors in GTM companies, what they may refer to as 'execution risk' companies. Such investors generally have little appetitive for anything that has a heavy R&D phase. But for those that do, often referred to as DeepTech investors, the prize is that the power of the technical breakthrough creates huge momentum in overcoming those later PMF and GTM challenges. Founders and their boards must also operate the right playbook at the right time and there are huge risks involved in getting this wrong. For example, if the technology commoditizes over time, the playbook will need to change. Founders that align their assessment of risk with that of prospective investors will be better prepared for funding success.
Thesis-driven investors are changing the due diligence landscape
With the rise of the 'thesis-driven investor' the process of due diligence has fundamentally changed. Now, a big piece of a VC's due diligence can be undertaken before they even have their first conversation with a startup. In our recent insight, VCs using latest tech to screen hot startups, we highlighted some of the methods that VCs are using to identify potential investments at a very early stage. For example, data-driven sourcing and intelligent ML-based screening are now being used widely to identify and engage with startups even before they start looking for their next round of investment. This shift to a 'pre-due diligence' model was highlighted during the investment frenzy of 2021 when deals were being closed in just weeks. Some founders reported being hugely impressed with the extensive research some of the major funds, such as Tiger Global, had already undertaken before the first pitch meeting. Market and company research is now being front-loaded by big investors to give them edge in wooing hot startups. Accel is another good example, going so far as to publish its own SaaS research based on its Global Euroscape cloud index.
To tick the right boxes in this early discovery and assessment phase, startups must pay increasing attention to their public profile. VCs use a wide array of online resources to identify and analyse startups. Many use advanced data aggregation tools with APIs into the major commercial dataset providers (such as Pitchbook, CBInsights, and Crunchbase, to name just a few) which are used to suck in key company data points. Web crawlers then identify changing information from other sources such as LinkedIn, Twitter, Google News, App Store, product review sites, payment sites, website traffic sites, and dozens of others to track various 'growth metrics', such as headcount. Accel has even catalogued the top talent of 200 leading European startups across their target sectors. As soon as those individuals emerge with their own startups, Accel is ready to back them instantly. Founders must therefore pay the greatest attention to ensure that these key sources of data are kept up to date. This is relatively easy to do for public sources but it becomes much harder for the big proprietary datasets like Pitchbook where they may not have direct access. This is where existing investors or advisors - who will likely be subscribers - can really help.
And just as investors are able to discreetly source deep insights into startups, so too can startups learn more about investors. The big investment datasets only work because they detail the full 'biographies' of every company - and this therefore must include the activities of their investors and all the deals they are doing. This is not only enabling founders to undertake their own pre-due diligence on funds but to also gain deep insights into the funding journeys of their competitors. Data, together with advanced analytics, is truly changing the entire funding landscape. Most importantly, this repositioning of due diligence and its bi-directional nature, reshapes the way in which founders must prepare for funding, especially from thesis-driven investors. For example, the pitch deck presentation is no longer the official starting point of the campaign but the 'concluding remarks' that wrap up the investment case. Whilst generalist VCs may view the pitch as a stepping stone in building conviction, the thesis-based players see it more as a final validation of their prior research. Founders must therefore carefully plan the funding strategy for the next round as soon as the current round is done and start laying the paper trail that leads to their door.