Startups must increase investor due diligence
There are a myriad reasons why a funding campaign might fail. But in the end these can all be boiled down to one of two fundamental factors: Either the investment proposition was not compelling enough, or the investors being targeted were not the right fit. In some cases, both conditions are true.
Startups usually invest a vast proportion of their campaign preparation effort in creating the most compelling proposition. In contrast, the amount of time that goes into identifying well-matched investors - and working out the most effective approach - is often much smaller by comparison. This is a mistake.
What we have learnt from our study of serial founders is that they focus hard on understanding their target audience before they create their proposition. And the amount of time they devote to each of the two fundamental tasks is comparable.
Understanding the investor audience has always been important. But it has rarely been more critical than it is right now. Fewer quality investors are truly 'in the game'. Hunting for capital in 2021 only required a shotgun. Today you need a rifle.
Two questions that founders should now have top of mind as they develop their investor target list:
First, do these investors currently have the capacity to invest? Many are struggling to raise new funds, so they are reserving what capital they have for current portfolio companies. They are effectively out of the game for now.
Second, does the lead investor partner have the ability to drive a deal to completion in a timely manner? Can they quickly rally their resources and efficiently orchestrate internal decision making? Changes in personnel across key funds over the past 12-18 months have underlined this concern.
Let's look at the backdrop to these questions and provide some pointers on how founders can address them.
Global funding drop
In the big venture reset, capital being raised by funds has collapsed over the past 24 months.
According to Pitchbook, VC firms are forecast to raise less than $200 billion in 2024, a 48% decline from 2021 levels. Fundraising is only expected to grow 2.9% annually through 2028, less than half the rate of other private capital strategies including private equity, private debt and real assets funds.
And with regard to the global outlook for the next 4 years: "After years of strong VC fundraising, we are projecting commitments will continue to decline into 2024 and will not recover to 2021 and 2022 fundraising levels by 2028, stemming from the lack of distributions."
The trigger for stronger distributions is the turning back on of IPO markets, which remain heavily depressed. Pitchbook's take is that with more interest rate cuts expected in 2H24 and valuations recovering in VC (in 1Q24, venture-growth valuations were up QoQ for the first time, by 5%), "we believe the market is warming up and setting the stage for a bigger window to open in 2025."
in other words, at least in the short term, don't expect much change.
European VC Fundraising
Capital raised by European VCs has followed a similar curve to VC investments, as we highlighted in our 2Q24 market summary.
At the peak in 2021, European VCs raised €33.7B across 440 vehicles. In 2023 this had fallen to €21.7B across 190 vehicles. At the half-way point in 2024, funds raised in Europe amounted to just €9.5B across 86 vehicles. By year-end this figure should reach around €19B, down again from 2023.
Interestingly, smaller funds (sub €250M) are gaining share over larger funds. Smaller funds, most commonly associated with emerging managers, now represent 57.6% of capital raised so far this year in Europe compared with a 41.6% share in 2023.
Even so, many VCs have failed to raise new funds over recent quarters as LPs have allocated capital elsewhere. With deal numbers falling, several fund managers have thinned out their investment teams. As Pitchbook reports, firms are still trimming the fat, and high levels of turnover reported in 2023 have continued in 2024, on both sides of the Atlantic. More on this below.
Deal rate collapse
As markets have corrected and new fundraising by VCs has been hit, deal rate (the number of investments into startups) has been cut in half. But these cuts are not evenly distributed. Some investors remain fully active whilst others have applied the brakes or stopped investing altogether.
Deal rate trends are now a critical factor in selecting suitable investors. In our recent piece, How to build a qualified investor list, we described the approach we use when building the investor target list. This starts with a longlist from which a working shortlist is derived.
The key metric to check when assembling the initial longlist is dry powder. This is the unused capital still available in a fund for new investments. As founders will generally find this information difficult to obtain, a good proxy is current investment activity. Look carefully at deal rate over the past 4 quarters. If it has collapsed to a trickle or zero, this fund (aka a 'zombie fund') is almost certainly not a target candidate.
Internal angst
Let's now come back to the impact on investors themselves.
According to Business Insider, many funds have already slimmed down their teams. But what we have seen through 2023/34 is just the "tip of the iceberg". A recent poll of partners, principals and associates at several high-profile VC firms revealed "some senior and midlevel investors at certain firms are being told that they have 6 to 12 months to find a new job. Some firms are opting not to promote junior investors after their two-year programs and encourage them to explore other options."
Many funds from the pandemic years didn't perform well because many companies were overvalued. Poor fund performance has made carry worthless. It may take many years for them to see any kind of meaningful financial return.
For some, market focus is also changing. As Insider highlights, many are now focusing on artificial intelligence, with firms like a16z merging teams to prioritize this sector. However, investors hired to focus on specific areas, such as consumer, fintech, crypto, or healthcare, are now being forced to invest in fields outside their interest.
Across Europe, there is not just increasing focus on AI, but on Climate, Industrial/DeepTech and, more generally, B2B business models. These may not be the areas that individual investors were originally hired to attack. They may suddenly find they have the wrong skill set and experience.
The result? Even for those still in the industry, being a VC has lost some of its lustre. As team sizes are cut, fewer promotions are available, limiting investors' career growth. As the market continues to correct, more staff turnover is likely, especially for those in more junior roles.
Select the partner as much as the firm
Serial founders will put as much focus on selecting the partner as they will the firm. For the lead investor, this partner will likely be on the board as an investor-director for many years to come. This relationship is therefore critical.
Careful investigation to identify the best-aligned partner is time well spent. The top firms say they will always make sure that approaches are routed to the most suitable investor. But with inbound increasing dramatically and greater competition amongst partners for the best deals, this can't be guaranteed.
Instead, startups must do their homework and choose wisely. When advising founders, our approach is to undertake a 2-level qualification: First, qualify the fund. Second, provide a full investment biography for the best aligned partner, based on their track record. This includes details of founders from their portfolio companies (past and present) to facilitate due diligence.
Investor outreach can now be precisely targeted and customised. But the biggest reveal is how investors react to the founder's approach and interact during the courtship process. Sometimes the warning signs are there right from the outset. But often they don't emerge until further into the funding process.
The key 'metrics' are responsiveness and openness. After the initial approach, the best investors will give you a 'quick yes' (i.e. agree to a pitch meeting) or a 'quick no'. If they are interested, they will move with intent, managing their internal process and orchestrating their firm's engagement through each step.
Sadly, this level of responsiveness is all too rare. Even if there is good initial intent it doesn't take long for a founder to figure out how much sway an investor has inside their firm. This is not just a critical factor in ensuring the deal gets done in a timely manner, but it is a key indicator for the future relationship.
The telltale signs quickly become apparent. The investor can't get the commercial due diligence process underway promptly. They struggle to get their colleagues bought in. The promised date for the Term Sheet keeps slipping and the excuses they make just don't seem to stack up. And when the Term Sheet finally arrives, they surprise you with some punitive terms.
In a recent campaign we advised on, a UK-based investor showed strong interest right from the off. Very quickly, the deal became theirs to lose. But the process to get to a Term Sheet was torturous. By the time it arrived (several weeks after the promised date), the founder had secured two other Term Sheets, both from high-profile international investors who had moved with real intent. The founder ended up turning down the UK firm's offer.
In summary
Campaigns fail for one of two fundamental reasons: Either the investment proposition was not compelling enough to excite investors, or the investors being targeted were not the right fit.
Serial founders focus hard on understanding their target audience before they create their proposition. And the amount of time they devote to each of the two fundamental tasks is comparable.
Experienced founders put as much focus on selecting the partner as they do the firm. For the lead investor, this partner will likely be on the board as an investor director for many years to come.
Well qualified investors must have the capacity to invest and the ability to get deals done efficiently. This means assessing their recent investment deal rate prior to the approach, then monitoring their ability to effectively orchestrate internal resources.
Bringing multiple term sheets to the table is more critical than ever before. This allows the founder to evaluate the behaviour and conviction of individual investors side by side, before making a final selection.
Let's talk!
To subscribe to our Newsletter click here