Duet Partners
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Weekly Briefing Note for Founders

19th December 2022
CATEGORY:

This week on the startup to scaleup journey:

  • Entrepreneurs are not risk takers
  • Thesis-based investors have greater patience
  • The State of European Tech


Entrepreneurs are not risk takers

Ask anyone to describe entrepreneurship, and you won’t have to wait long before you start hearing words like “difficult,” “risky,” and “failure.” Yes, entrepreneurship is hard. And, yes, the chances of failure are high. But, just because the specific outcomes of entrepreneurial efforts are always in doubt, it doesn’t mean entrepreneurs are risk takers. In fact, the truth is the exact opposite. These are the words of Aaron Dinin, serial founder and Entrepreneurship Fellow at Duke University. And they are prophetic because the road any founder seeks to travel is one of taking a thorny problem that is unexplored and finding a neat, repeatable solution. So good entrepreneurs are always doing their best to remove risk, not just for their startups but for their customers and investors alike.

Unfortunately, in the mythology of entrepreneurship, people see the inherent uncertainty of the work and assume entrepreneurs must like risks. As a result, says Dinin, when people become entrepreneurs they sometimes decide risky behaviour is a good thing and this often causes them to fail. This behaviour is most prevalent in first-time founders who are still learning the art. This is precisely why investors are always more wary of such inexperience. Serial founders, on the other hand, understand that the whole purpose of the startup stratagem is to de-risk every aspect of the growth journey. Anyone who has studied lean startup theory and the associated Customer Development Process, recognises that that the real purpose of finding product/market fit is to de-risk the subsequent growth plan. Aware that premature scaling is the biggest startup killer, every effort is made to fully test the business model before real scaling begins.

Contrary to popular belief, successful entrepreneurs don't like to make choices based on gut feelings and intuition. They know that this is just inviting risk. Instead, they would rather obtain the data they need to make the best decisions possible. For example, the process of creating an MVP and using it to solicit customer feedback is a big data-gathering exercise that is vital for the business to learn and progress. Similarly, the process of funding preparation is now heavily data-led. The latest investment research tools are the engine of this data mine and play a critical role in the discovery of well-matched investors, deal comparators, and other key insights such as competitor analysis. The best entrepreneurs are therefore not the ultimate risk takers but the ultimate risk managers. They are happy to start out with the most outlandish problem/solution thesis, but will only build a business around it if they think the risks are covered.


Thesis-based investors have greater patience

In last week's article, Venture Capital is broken, we said the '80/20 rule' pervades the world of venture more than we might imagine. Yet more confirmation this week: In his review of fund performance, US VC, Mark Suster of Upfront Ventures, shares some insights that dispel the myth that the 'growth at all costs' mentality - the underpinning VC credo of recent years - is the only winning approach. For true aficionados of sustainable value creation, venture is a much longer term, patient game. Suster looks back over 25 years of investing and it is immediately clear that the 'power law' governs venture returns. Each of Upfront's Seed funds, which are typically $200-300M in size, is spread over 30-40 investments. In any given fund, 5–8 of these investments, around 20%, will return more than 80% of all distributions. But the big question is to what extent can VCs predict these 'winners' so they can double down on certain investments to drive the greatest returns?

One theory is that those companies that are able to secure big up-rounds in the first 12-24 months after the the Seed round should be the ones that go on to deliver the biggest outcomes. in Suster's case, around 25-40% achieve these quick up-rounds, which translates into 12-15 companies. It then should only take 15-25% of those (2-3 companies) to pan out to return 2-3x the fund - every VC's dream return over the long haul. But the big reveal is that some of the best value creators didn't fit this mould of the biggest capital raisers and consumers. As Suster says, "We’ve created more than $1.5 billion in value to Upfront from just 6 deals that WERE NOT immediately up and to the right." These companies didn’t raise as much capital (with less dilution for founders and investor alike), they took the time to develop true IP that is hard to replicate, and they often only attracted 1 or 2 strong competitors. This cohort may ultimately deliver more value than Suster's 'up-and-to-the-right' companies. With 5 out of these 6 businesses still in the portfolio, the final upside could be even greater - if they are tended with care.

But this longer-term view - often termed 'patient capital' - is not a mainstream view in VC. At least not in recent years. As we pointed out last week, this focus on 'real technology' companies has become unfashionable. This is partly because such companies are difficult to assess and often exhibit high (but not insurmountable) technology risk. But when they do succeed their technology can be extraordinarily valuable. Suster's strategy has been to apply extreme discipline to 'stay in our swimming lanes' of knowledge and 'not just write checks into the latest trend'. As a result, over recent years, they largely sat out fundings of NFTs or other areas where they didn’t feel like they were the expert or where the valuation metrics weren’t in line with their funding goals. The best investors in any market will say they need “edge” … knowing something (thesis) or somebody (access) better than almost any other investor. For founders seeking patient capital, searching for true thesis-based investors sounds like a good place to start.


The State of European Tech

The key findings of the State of European Tech 2022 report confirm many of the investment trends we have been uncovering over recent months. But what are the key takeaways for founders looking to raise capital in 2023? In terms of the big picture: Around $85B will be invested in European tech this year. This will be down 18% from the record $104B in 2021, which seems a very modest decline in the face of the major macro market downturn we are experiencing. But dealmaking activity - the actual number of deals - is expected to be down by 33%, pushing up average deal sizes. We already know that this is being heavily influenced by the reduction in late-stage deals, but the report says rounds below $5M will be similarly hit. It's therefore no surprise that founder sentiment has flipped dramatically over the course of 2022, with 82% of founder respondents to the survey believing it is now harder to raise venture capital than it was 12 months ago.

How do venture stage investors see this same picture? VCs surveyed say they are undertaking more extensive due diligence as well as providing increased 'structure' in term sheets to reflect greater investor protections. This is all taking more time to bring together than it did in 2021. Term sheets are also getting repriced or pulled more frequently, especially if there are any post-offer jitters through final due diligence. And where investors remain uncertain about price but love the company there is an increasing incidence of convertible loan notes and SAFE notes that kick the valuation can usefully down the road - we have clearly not reached market bottom quite yet. The messages for founders looking to raise capital in the coming months are clear: Preparation is critical. Think and plan well ahead. Start the process early and allow more time for every step. Above all, understand your investor audience and what they are now looking for. Align your investment proposition with these expectations. Then create an utterly compelling narrative, supported by a beautifully designed pitch deck. This is all now table stakes.

The big mistake, especially at early stage, is to start writing the pitch deck before nailing down the investment proposition. Nine times out of ten the proposition is more elusive than first imagined. It is evolving in real time as you strive to confirm the precise problem/solution thesis, the go to market plan, the business model and the growth strategy. But the moment comes when you need to freeze this picture and commit to a clear, unambiguous narrative. Everything that happens for the next 6 months - through the whole process of outreach, engagement, term sheet and final deal closing - must then follow that pathway and reinforce that narrative. Despite real headwinds, the European venture market is still very active but quality counts more than ever. For the best opportunities a big chunk of the record $84B in dry powder available at the end of 2021 still sits in European venture and growth funds. How will you claim your share?


Happy reading!

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