Duet Partners
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Weekly Briefing Note for Founders

31st October 2022

This week on the startup to scaleup journey:

  • A VC's fund size will dictate their investment strategy
  • Emerging fund managers are like first-time founders
  • If you're wrong about the problem the solution doesn't matter.

A VC's fund size will dictate their investment strategy

VC returns are governed by the Power Law: The overwhelming majority of investments will not deliver good returns, but a few of them will generate returns that are truly phenomenal. VCs will generally say that around 10% of the investments within a fund will produce around 90% of the returns. Crucial to this is the requirement to have enough ownership at exit to deliver these returns. For a VC that initially invests say at Seed stage, they will get diluted with each subsequent round unless they are able to 'follow-on' to maintain as high a stake as possible. This requires that they hold back a certain proportion of each new fund (the 'reserve allocation') for follow-on investments. This in turn limits the number of new investments they can make. Fund managers will therefore determine the number of investments they can make by balancing the typical Power Law distribution effect against the reserve allocation required. In other words, fund size determines fund strategy, especially the stage at which the fund will invest.

In his blog, fund manager Alex Iskold looks at two extreme examples to demonstrate the point: A manager of a $10M fund and a manager of a $1B fund. If the first manager decided to be a Series A fund, it would be extremely concentrated. It may be able to lead 1-2 rounds, but that's it. Given the power law nature of outcomes, it would be extremely unlikely for this manager to generate a good return. Such a small fund would instead need to focus on pre-Seed deals to arrive at the right portfolio size. On the other hand, the manager who is managing a $1B fund has a very different problem. She has so much capital to deploy that she doesn't bother with the super early stage. Investing in pre-Seed and early Seed companies would rarely make sense as it would take 500 deals at a $2M check size to deploy $1B. Even with 50% reserves, that would be 250 deals. VC firms are just not set up to handle that many transactions and the ongoing support that would be required. Instead, this VC needs to write large checks, and follow on as much as possible.

As a result, funds often specialise at a specific stage of investing. Iskold proffers the following bands: Less than $50M fund - usually pre-Seed and small Seed. A $150-$300M fund - usually Seed and small Series A. A $500M fund - usually Series A. A $1B fund - usually stage agnostic, but typically no earlier than A, and more likely B+. Rules of course get broken from time to time, so these ranges are only a guide. But they do give founders real insight into which funds would be a good match given the stage of their startup. Another factor to take into account is the maturity of the fund. A freshly minted fund is more likely to invest in earlier stage opportunities at the beginning of its life as it has longer to run until the Limited Partners in the fund expect returns. Most VC funds are typically 10-year funds. A fund that is nearing the end of its initial investment period (typically the first 2-3 years) is likely to be looking for later-stage opportunities than normal, where a potential exit event may then be only a few years away. In picking funds that are a potential fit, founders should seek insight into the fund size, its vintage, and the amount of dry powder still available to deploy.

Emerging fund managers are like first-time founders

As the VC climate changes, it's not just founders that are having to rethink their fundraising approach. VC fund managers are also looking out at a very different fundraising environment. LPs made the highest ever level of commits to VC funds in 2021. As the market pulled back and other asset classes dipped over the past six months, they began experiencing the classic 'denominator effect': Many endowments and foundations - long-time venture investors - now have venture allocations in excess of 30% of their entire capital base. In their analysis of the outlook for funds, TechCrunch forecasts that: "As a result, in 2023, we fully expect LPs to place less emphasis on venture as liquidity takes a premium and LPs rebalance their portfolios. Even though the best vintages originate during downturns, it’s difficult to allocate to something you’re already substantially overexposed to."  This spells particular difficulty for emerging managers, the 'first time founder' equivalents of the VC fund world. As TechCrunch explains, many LPs have already made rough allocation decisions for the next fiscal year and plan on a combination of re-upping with existing managers and cutting their worst performing. Few plan to add a meaningful number of new managers as they seek safety in traditional names.

Not only do emerging fund managers need to source capital but they also need to create deal flow, just like any other VC. This usually originates from 1 of 3 sources: 1. Inbound: from relationship referrals and direct 'cold' approaches, 2. Outbound: from direct reach-outs to founders, especially if they are a thesis-driven investor, and 3. ‘Chance Encounters’ from events, demo days and the like. Susie Meier, VC investor at Notion Capital, says building meaningful relationships with the wider ecosystem is key to forming one’s reputation; and ultimately getting access to the most exciting founders and ideas. She observes however, a few strong relationships tend to have a bigger impact on deal flow than a huge volume of brief intro calls. Building those relationships can take time, but being respectful, honest, and helpful will undoubtedly accelerate the process. She adds that credibility is ultimately built on more than just ‘liking’ someone. It’s about being able to exchange insights on a particular industry/sector: market dynamics, competitive landscapes, and differences between products or teams. Emerging managers are particularly incentivised to develop these relationships, without which they will struggle to participate in the market.

There are so many parallels here with founders and how they build their own relationships within the funding ecosystem. These are the relationships they will need to leverage when fundraising. But unlike their VC counterparts, founders are not in the market every day. Capital raising is, by its very nature, an infrequent event. It therefore takes a special effort, especially for first-time founders, to build those relationships in advance. This requires building a picture of the investor landscape for their sector well before funding is needed. And it's not just with those investors that may be relevant for the next round, but also those that will become important for future stages. Just as VCs like Notion look to 'nurture' relationships with founders over time, so too should founders look to nurture relationships with certain key investors. This is not just 'networking' but an exercise in building trust. In the venture world, people only buy from people they trust.

If you're wrong about the problem the solution doesn't matter.

Entrepreneurs are often cast as visionaries. They can see a different future for the world, a country, a market. As Paul Graham says, they do this by being able to live in the future, then build what's missing. Some are able to harness their personal charisma and energy to build amazing teams and products that reshape or create entire industries. But in the formative stages of company building, investors are wary of founders that claim to be driven by a highly-defined vision. The vision-obsessed  founder can miss the real problem to solve. The one that leads to true scalability. The risk is that the starting thesis essentially becomes a solution thesis, where all eyes are focussed on the product rather than the customer. 'Build it and they will come' becomes the unspoken mantra. The product is 'released' but there are few, if any, takers. USPs that appeared relevant at the beginning of the development are ignored by the market. This is especially true when markets get squeezed - like now.

This haste to focus too quickly on solutions is not confined to early stage. Frank Slootman is one of the tech world's most accomplished executives in enterprise growth and led Snowflake to the largest software IPO ever. In his book, Amp It Up, he says "In meetings, I often object to presentations where 90% of the content is about the solution, not the problem. My co-workers find it frustrating that I always want to walk back to the beginning rather than rubber stamp a program or project. They want to jump right into the action phase, so they see in-depth discussion about possible explanations as a waste of time. Of course, when you end up being wrong about the problem and therefore ineffective, that's a much more serious waste of time." This need to go back to the beginning and feel strong resonance with the underlying customer problem (or opportunity) is also the essential starting point for investor understanding.

To be clear, being passionate about creating a solution is not in itself a weakness. It is about having the courage to alter course when things aren't working. This also creates a more credible narrative for investors to buy into. No startup story ever follows the intended script. VCs, in particular, know that the bedrock of a successful startup is a clear problem/solution thesis. Those startups that are then able to prove the thesis and generate real commercial traction - even if it takes several pivots to get there - are then well on the way to product/market fit. This cycle repeats as the company expands its offerings. Slootman says: "Build a reputation as a rapid course corrector. You don't need to be right all the time to succeed if you can admit quickly when you're wrong. This will set you apart from the majority of people who get wedded to narratives too quickly and then refuse to revisit the analysis for fear of looking bad politically."

Happy reading!

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