Weekly Briefing Note for Founders 31/8/23

4th September 2023

This week on the startup to scaleup journey:

  • Seed valuations rise again but VCs more selective
  • Due Diligence gets tougher - and everyone benefits

Seed valuations rise again but VCs more selective

The recent news that Seed-stage valuations across Europe rose again in 2Q23 surprised many. Founders that had been holding back funding campaigns as valuations tanked in 4Q22 are now revisiting their plans. Seed-stage valuations hit an all time peak of €6M in 3Q22, dropped alarmingly to €4M in 4Q22 before moving back up to €5.1M in 1Q23, and on to €5.4M in 2Q23. The valuation bounce-back isn't the only cause for optimism: Median deal sizes at Seed also hit their all-time high of €1.84M in Q2. But the other side of this coin is that far fewer deals are being done as greater investor caution has taken hold over the past 12 months. Seed deal count is down 50% YoY with 364 deals across Europe in 2Q23 compared to 872 in 2Q22. The game on the field has changed and competition for capital has intensified. Well prepared, compelling Seed-stage propositions are still getting funded at levels that even exceed the heights of 2021/22. But those approaching funding campaigns as they might have done during the investment frenzy of that period are almost certain to fail. Sadly, this is already a huge cohort. But those applying the same level of planning and focus to investment preparation as investors are now applying to their own due diligence, will move the odds of funding success significantly in their favour.

Investment preparation comprises two main elements: 1. Planning; which includes deciding on the amount to be raised, the target valuation, the use of funds, the investors to be approached, and the big messages to be delivered, and 2. Materials; which includes the creation of a pitch deck, a financial model, and a data room. When markets are buoyant and investors are chasing startups (2021/22), investment planning gets squeezed. It is essentially merged with materials preparation as time is of the essence. The bar has been lowered by investors and deals are being done quickly. Everything becomes tactical. In harder times (today), the bar has been raised and there is much greater uncertainty of outcome. Founders are now chasing investors. Investment planning suddenly takes on increased significance and so needs to be undertaken (well) in advance of materials preparation. Planning has become strategic and options need to be carefully weighed. Founders must be far better informed about the investment market and be able to make mission-critical choices about the funding pathway ahead. Where cash runways permit, founders then have a window to elevate their investment proposition to ensure it better aligns with the latest market requirements, before finally developing materials. Once a pitch deck is started, assumptions get locked in. It becomes hard to zoom out again to see how the bigger picture may be shifting.

Duet has been advising startups on investment preparation for the past 14 years. From the aftermath of the 2008 financial crisis, to the Covid pandemic and subsequent market correction, we have worked with over 50 founders on $400M+ worth of deals of every shape and size. Our investment planning service, Investment Analysis, provides founders with critical insights as they make these mission-critical choices and develop the most compelling investment propositions. Recent enhancements leverage the very latest investment research tools to help founders identify well-matched investors and also prepare for deeper due diligence. For example, not every startup is right for 'mainstream VC', so they must seek out alternative categories of venture investor that court different aspirations and expectations. We now track all of these on a global basis to see who's active and what kind of deals they are doing. And for due diligence, we now dig even deeper into the competitive landscape, undertaking a detailed peer group analysis that generates a 'market map' and exit predictor scores for all the key players. This helps founders assess competitive positioning through the eyes of an investor. However founders approach funding, solid preparation has become critical once again. Naturally, this requires extra commitment. But the good news for those that see the strategic, rather than just the tactical value in investment planning, is that many other founders still do not. This, at least for now, confers a special advantage to the enlightened in the intensifying competition for capital.

Due Diligence gets tougher - and everyone benefits

Founders whose first capital-raising experience was in 2021 will likely have little insight into what due diligence (DD) traditionally involves. In those heady days of rapid, FOMO-driven investment decisions, conventional DD simply became an obstacle for investors wanting to jump onto the latest deal. Any thought of even a half-decent due diligence process could be enough to blow them out of a syndicate. So they didn't bother. As a result, even some of the biggest rounds barely included any meaningful dialogue between investor and founder. Each of the five funding rounds software startup Rippling closed on its way to an $11 billion valuation was conducted primarily through texting, says cofounder and CEO Parker Conrad, in a Forbes article. In other cases, some investors that were offering terms during the first (and only) CEO phone call, such as Tiger Global, may have at least undertaken some cursory due diligence in advance of this initial contact. But in terms of traditional due diligence, this just seemed to evaporate. As VC, Kyle Harrison, recently put it: "What you get is far from an ecosystem of thoughtful investors attempting to make wise capital allocation decisions, and instead get the closest humanity may have come to 'a thousand monkeys in a room with a typewriter,' except instead of typewriters they have checkbooks."

But now everything has changed. Not just as a result of a venture market that has undergone a big reset, but from the calamitous investment decisions made by certain big VC firms. Some of these were entirely FOMO driven, like the extreme case of Hopin, wonderfully exposed in Kyle Harrison's latest blog. Or worse, they were based on a string of fraudulent propositions such as FTX and Headspin (who raised $100M off fictitious financial statements). Now, in a 180 degree shift from FOMO to FoLS (Fear of Looking Stupid), VCs have moved back swiftly to the playbooks they used in 'normal', pre-pandemic times: Commercial, technical, financial and legal due diligence checklists have been dusted off. VCs now want to unpack the entire story and understand how the business model really operates. They want all the founder's key claims about the business to be evidenced. And why not? You want your key investors to have the full picture before they commit. If it takes until the third board meeting after the close for them to truly discover that all is not quite as it seemed pre-deal then, at the very least, all the trust is blown away. And in a 10-year relationship, that's not what anyone wants right at the outset. The upshot of all this: Founders must prepare for deeper due diligence and longer funding campaigns.

And it's not just VCs that are getting back to basics. Founders are stepping up their own DD when they assess investors. Just as certain founders may be guilty of touting a very 'selective' picture of the investment proposition, so too will certain investors 'spin up' their own pitch to a founder. One danger zone is in the micro funds arena, just above the individual high net worth investors but below the more established Seed funds. This could be a first-time fund manager looking to muscle in pre-emptively on a deal, maybe before they have even closed their own vehicle. Other red flag moments are investors trying to write cheques too quickly (against market trends), perhaps shortcutting the most basic due diligence on your startup. If you can't find their investment track record or other CEOs that will take a reference-check call, then founders must be extra cautious with such investors. Dubious names on the cap table can also put off later investors. As Kyle Harrison says in his article, The Diligence That's Due,"If you're looking for ways to obscure details, and tell the best picture, then you're going to get an investor who gravitates towards obscured details, and rosy pictures." This is what experienced founders call "too good to be true money'' - for a good reason.

Happy reading!

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