Weekly Briefing Note for Founders

2nd January 2023

This week on the startup to scaleup journey:

  • Armchair economists: stop the doom and gloom
  • Thematic vs Thesis-driven investors
  • 2023: On the cusp of a new era

Armchair economists: stop the doom and gloom

This is the time of year when VCs share their outlook for the year ahead. Rather than provide dozens of links to these 'founder memos' we can save you all a lot of time. The advice can be summed up as: '2023 is going to be a tougher year for startups as recession bites, so tighten the belt'. But founders, quite rightly, have become a bit jaundiced about VC's dispatching such doom and gloom predictions. Think back to April 2020, the stock market crashed and VCs thought this was finally the downturn everyone had been expecting. As Scott Lenet admits in his blog on the subject, "As investors, we fancy ourselves to be armchair economists, and we trotted out advice to help our portfolio companies survive the financial winter that appeared to be upon us. We were all wrong." As hindsight makes obvious, the stock market rebounded and the good times continued to roll through 2020 and 2021, when record amounts of capital were deployed. While individual sectors or companies struggled and supply chain shocks caused economic challenges, the flow of capital was essentially uninterrupted.

We accept that the second half of 2022 has ushered in a tighter funding environment - as we have been reporting here - but we must keep this in perspective. Across Europe, venture investment levels are indeed down compared to 2021, but 2021 was an absolute barnstormer of a year. 2022 full year figures will easily eclipse any year prior to 2021 by a significant margin: By the end of 3Q22, according to Pitchbook, VC deal activity across Europe already stood at €76B. The full year figures for 2020 were €49B, 2019 - €39.5B, and 2018 - €30.6B. You get the picture. So yes, 2022 and most likely 2023 will not reach the record heights of 2021, but the best companies will still get funded. Financial prudence is always a virtue, but you can't ultimately save your way to growth: Startups by their very nature are 'default dead', not 'default alive'. Unlike growth stage companies that are shifting into 'default alive' mode as they become cash generative, most startups need funding to survive and progress to the next stage. What they do need is greater encouragement to think ahead and be bold, prepare the most compelling investment proposition, then go out and truly excite investors.

The tough macro environment we are all facing in 2023 will produce winners, just as we have seen in previous downturns. It will shape a generation of founders who will take the necessary steps to be more robust, more strategic, more determined, and more resilient than ever before. Over the longer term, some VCs expect the venture market to recover from this 'crisis' much faster than it did after previous economic dips, such as the dot-com bubble in the early 2000s. The ecosystem has since matured and is now able to recycle capital and talent faster than before. Those whose businesses are still in the earliest stages and more insulated from public market volatility have a particular opportunity to steal a march on their later stage counterparts in scooping up newly-available talent. And despite the general despondency, there is no shortage of capital pursuing venture deals. There's a whopping $2.5 trillion of dry powder globally, 8.5x the amount in 2000, ready to support those founders that can step forward with the next game-changing idea.

Thematic vs Thesis-driven investors

Venture investors fall into 3 broad categories of focus. Understanding these categories and how they influence a VCs approach to investing is crucial for founders raising capital. The first broad category is the generalist. As the name suggests they invest across industries with no hard sector focus. They may have a stage preference (Seed, Series A, Series B..) or business model preference (SaaS, Marketplace..) but when it comes to the application space they are essentially opportunists. Thematic investors identify big themes and pursue them to the exclusion of others. Energy, Healthcare, Financial Services, and Information Technology would be classic examples. These investors fill out their portfolios with companies that fit those themes. Thesis driven investors focus even more narrowly and deeply. They develop a detailed picture of where their particular area of focus is going, often over a 5 to 10 year horizon. Once that picture is mapped out and a future vision is developed, these investors evaluate every investment they make in the context of that thesis. If it doesn't fit their vision, they don't invest.

Thematic and thesis-driven VC investors use their focus and domain expertise to give them 'edge'. They believe that their deeper understanding gives them greater ability to spot opportunities as well as evaluate risks, which LPs also love to hear about. Leading US VC, Fred Wilson of Union Square Ventures (USV), says that thematic investing is good for bigger firms. It allows each partner to pick one or two themes and go after them. Thesis-driven investing is good for smaller firms. It requires a tight team that works to keep themselves on the same page executing after a singular vision. USV is a thesis-driven firm. Wilson believes thesis-driven investing produces the best returns when the thesis is directionally correct and probably also the worst returns when the thesis is wrong. Thematic investing, he contends, works less well because it can lead to "bucket filling" where the firm just runs around filling the themes with deals without much thought to why and how they will work. It also leads to a lot of "me too" investing which is a scourge that the venture industry can't seem to figure out how to rid itself of, especially when markets are on the up.

The thematic and thesis-driven investors also use their focussed approach to provide 'edge' with founders. Post-investment, they profess higher value-add to startups over generalists due to their greater market insight and industry knowledge. Thesis-based investors in particular will have spent considerable time researching their chosen area of focus, assessing how markets are likely to play out, how value-chains will likely be developed and which businesses models will be most likely to prevail. A good example is Chrysalis Venture Capital, a global VC that majors on industrial innovation. They are a leading thinker in such areas as the future of electric vehicle charging, carbon capture, and fusion energy. Like many others in their class, they have a strategic window into these areas via deep collaborations with leading industrial companies, research institutes and National labs. It is not difficult to imagine how such a combination of industry insight and access can be leveraged by startups, especially those with complex propositions which are a function of a highly tech-driven solution. The key takeaway for founders is to understand the focus category of target investors. This can really help shape the approach and downstream expectations.

2023: On the cusp of a new era

Business leaders looking out into 2023 have much to ponder. The past two and a half years have been extraordinary. What we are seeing is surely more than the progression of just another business cycle. The unnerving combination of a global pandemic compounded by energy scarcity, rapid inflation, and geopolitical tensions boiling over has people wondering what certainties are left. This is different from other tremors like the Asian financial crisis in 1997, the dot-com bust in 2000, and the global financial crisis in 2008, claims a paper from the McKinsey Global Institute. Most of these events were on the demand side and were largely contained in a region or a sector. Today, however, we face a supply-side crisis. The world is much more globally entwined, financially leveraged, and carbon constrained. Working out how to respond to the current moment and the path ahead is complex, but what is certain is that in this time of radically shifting macro forces, major opportunities abound. But they can no longer simply be viewed in the context of 'markets'.

McKinsey's analysis offers a framework to imagine the new era. Business leaders, whether they be CEOs of big multinationals or founders of tech startups, must be cognisant of 5 critical macro forces that have become ever more interwoven: World order; Technology platforms; Demographic forces; Resource and energy systems, and Capitalisation. In Tech, some of the key platforms of the most recent era’s digitisation and connectivity seem to be approaching saturation. For example, the physical limits of Moore’s law are being approached — while the expense of adhering to Moore’s law is growing exponentially. Similarly, we are approaching saturation in smartphone adoption. Shipments have now been in decline globally since 2018. Yet a set of already potent 'transversal technologies' are combining to create another big surge of progress in the next era. These include advances in Applied AI, bioengineering, immersive-reality tech, and quantum computing, to name just a few. And the major accelerant is that technology is now permeating virtually every sector of the economy. This has become the key enabler for so many startups.

In the formative years, startups have typically felt insulated from the big macro forces, but they can no longer be ignored. Investors will increasingly factor these topics into founder discussions, searching for opinions and insights. For example, the impact that the next wave of technology will have on work and social order. New technologies are already presenting opportunities and challenges to the nature of society, the balance between digital and physical domains, the financial system, the food system, the energy system, and the health system. Then there is the overlay of Tech and geopolitics, which is a hot topic for DeepTech founders. Emerging questions concern the nature and extent of data localisation, the balance - and sharing - of critical technological capabilities between nations, the role of technology in changing institutions, and the future frameworks for standard setting. Business leaders, especially founders, must show that they are aware of the direction of travel of these macro forces and to which questions their companies are most sensitive. In particular, they must identify which leading indicators will act as early warning signals for an upcoming change of direction so they can steer towards a better outcome in the new era.

Happy reading!

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