This week on the startup to scaleup journey:
Go to Market is more important than the product
We often meet startups that are generating initial revenues but struggling in their quest for growth funding. The founders are puzzled. Surely with several £M's of sales they are solid Series A or even Series B material? With such clear evidence of demand, why can't they convince investors to get behind the first scaleup round? But what investors know and some founders don't yet appreciate is that initial revenues are not always a sign of true scalability. Geoffrey Moore, in his classic work Crossing the Chasm, provides the real insight here as we highlighted recently. The first paying users, the 'Early Adopters', provide tangible evidence of product/market fit. They are the 'Visionaries'. But this, by definition, is a limited audience. True scalability lies in next convincing the 'Pragmatists' who represent the mainstream market. They are much harder to reach as, unlike the Visionaries, they are not actively seeking 'a solution'. They sit on the other side of the chasm. An investable Go to Market (GTM) strategy demonstrates how the company will cross the chasm to exploit the mainstream market and drive sustainable growth. Early adopter revenues alone, even if measured in £Ms, are just not enough.
Addressing the mainstream market presents many unknowns and the risk is that resources get spread too thinly. Experienced founders look first to establish an initial beachhead that provides clear evidence of growth potential. Leveraging insights from the journey to find product/market fit, they target the beachhead by designing a GTM strategy that will hopefully provide an effective and repeatable methodology. This might start with demand creation, then customer acquisition, onboarding, and so on. But just as the journey to product/market fit is one of experimentation, so too is the GTM journey. Rarely is the first approach successful. And as new products are added, they nearly always require an adjustment in the GTM. DC Palter's excellent article on the subject describes how his second (similar) product in IT software required a completely different GTM due to its lower price point. His discovery was that the development of successful GTM strategies takes much longer than expected as they are often deceptively challenging and require much higher levels of customer education than initially anticipated. Each successful GTM strategy ends up being tailored to each product.
The GTM challenge is unique to startups. Big companies already have big sales teams and advertising budgets, millions of followers on social media, resellers ready to push their newest products and customers ready to try it. Startups need to find a way to navigate through to customers to generate sales, and not just a small number of sales but tens of millions of dollars. Palter's advice is, get to know your customers. Not just what they need, but how they discover and evaluate new products and their preferred purchasing process. His most profound insight is the product ultimately needs to be designed for the GTM strategy, not the other way around. Early GTM planning is essential and must be resourced with skilled exponents. That's why it's a core part of our investment readiness scorecard. In the end, a great product that doesn’t have an effective way to reach customers is not a viable product. For that reason, growth investors (and for that read anything from Series A onwards in the current market) see the GTM strategy as more important than the product itself. Founders must therefore spend as much time and thought designing their Go to Market strategy as they do developing the product.
VCs are raising even more money
This week came with some big fundraising news as Swedish VC, EQT Ventures, closed its third fund at $1.1 billion, a 66.7% increase in size from its predecessor. This is a remarkable achievement considering current market conditions. As we said back in July, even as the venture ecosystem take a dive - with fewer deals and exits - fund sizes continue to get bigger as LPs seek out experienced managers to help them weather the storm. Capital raised by VC funds broke all records through the first half of 2022. According to Pitchbook, global VC fundraising in 1H22 hit $180B and seems well on track to beat the record $256B raised in the whole of 2021. As we commented back in June, LP money supply is a metric we all now care about and that metric has continued to improve through Q3. In the US, where the VC downturn has been the most marked so far, the median size of VC funds has grown 38.9% from last year to stand at $50 million in Q3 2022. While some of these vehicles began fundraising before the downturn, the numbers suggest that capital commitments have yet to dry up.
European VC fundraising displayed resilience through Q3 2022 with €19.7 billion raised YTD across 145 VC funds. Pitchbook's analysis states that if the current pace continues, fund count will finish below, and capital raised will land above, figures from 2021 by year end. In other words, average fund sizes are shooting upwards. The shift in financial markets globally has caused widespread uncertainty; however, stakeholders involved in fundraising efforts have pressed ahead. Funds closed indicate LPs and GPs are bullish on opportunities available in the VC ecosystem. Capital commitments have not dried up, and fund sizes have remained healthy in 2022 thus far. As interest in VC has crystallised in the past decade and activity has boomed in recent years, many analysts would have anticipated a sharper decline in fundraising levels. Nonetheless, multiple factors could be influencing fundraising figures and time lags could be in effect. For example, funds closing in recent weeks may have been open for several months. Therefore, a clearer picture will be evident in upcoming quarters as monetary and fiscal policy shifts take effect in the VC market.
As median fund sizes rise, founders must pay great attention to ensuring alignment between their own funding requirements and fund size. Big funds don't necessarily mean more cheques will be written - it's more likely that cheque sizes will simply increase. But with deal sizes in the later stages shrinking and exit activity slowing - particularly for IPOs, which have seen their value fall from $670.4 billion in 2021 to $29.9 billion this year - there aren't as many places for GPs to put their money. But these big funds are increasing their opportunity for greater levels of follow-on funding, which allows VCs to increase ownership stakes in their best-performing portfolio companies over time and so maximise returns at exit. And with many companies staying private longer, the big funds can stay the course, whilst the small funds get progressively diluted. This increasing ability to invest across multiple stages and sectors offers portfolio diversification that could further reduce risk. Sacrificing some returns for increased stability is an attractive choice for many LPs, so expect more mega-fund announcements to come.
True DeepTech breakthroughs carry little market risk
DeepTech founders know that the early stage funding process is going to be fraught with uncertainty. That's because most investors have a hard time coming to terms with technical risk (Will it work?). They are much happier when all they need to assess is market risk (Will there be demand?). This is the essence of mainstream VC. The majority of software startups carry little technical risk - they might be developing a new application but they are unlikely to be pioneering the core tech. For SaaS business models, which have driven a huge proportion of investment dollars over the past decade, the key metrics of success are well known at every funding stage. In the early stages, growth is almost entirely a function of applying capital: Equity raises from Seed onwards essentially fund customer acquisition. At Series A and beyond, the current year's performance is also highly predictive of next year's, all other things being equal. All these parameters relate to market risk. The better they are understood, the lower the risk.
But in DeepTech, things are not quite so straightforward. In the early stages, sometimes for many years, technical risk prevails. Think semiconductor development, advanced materials development, new drug development and the like. Here we are truly pushing the boundaries of science and we are in heavy R&D mode. The danger is that technical risk then compounds with future market risk making the overall risk profile unpalatable for investors. In the words of leading tech investor, Elad Gil, each major category of risk requires a 'miracle' to overcome: “If your startup needs zero miracles to work, it probably isn’t a defensible startup. If your startup needs multiple miracles, it probably isn’t going to work — with every miracle, you are multiplying in another low probability event to get an even smaller expected outcome.” Multi-miracle startups do of course succeed, but the road to commercialisation can be long and painful. Such startups can be almost impossible to fund via traditional VC. Success here is generally the exception not the rule. Think SpaceX for example, once a little startup that closed a $12M Series A back in 2002.
However, for businesses whose pioneering endeavours have created a genuine scientific breakthrough, there should be little real market risk. Seasoned DeepTech investors will immediately see this, provided that some minimum evidence threshold has been crossed. If we discover a vaccine that cures a major disease, design a chip that revolutionises how we communicate, develop a material that has unmatched strength and conductivity, few would argue that it will be hard to find a huge global market. Execution risk will of course always be an underlying doubt in any new business. But aside from this, founders can unwittingly raise investor anxiety by complicating the early stage funding proposition. For example, by expounding the need for other 'miracles', such as new business models or new go to market strategies - all at the same time. If the technical breakthrough truly is an industry game-changer, then there is no shame in leveraging proven customer engagement strategies and economic models to drive early growth. Revenue flows will always take longer to switch on compared to SaaS, but they will quickly overtake when the mainstream market suddenly sees the potential.