Weekly Briefing Note for Founders

23rd January 2023

This week on the startup to scaleup journey:

  • Which VC triage bucket is your startup in?
  • Investor reserves under pressure as markets falter
  • The death of the generalist VC

Which VC triage bucket is your startup in?

Startup survival rates peaked in recent times as the bull market raged. But the years of low startup mortality are coming to an end. Following a global funding reset, investors are now under continuous pressure to decide which portfolio companies to support and which to drop. Dropping means stepping back from any further funding rounds. For many founders this means their startup won't survive - at least not in any meaningful way. Negative signalling from current investors, especially VC funds, will dissuade new investors. It was always the case that the Power Law applied to portfolio outcomes, where the majority of the companies in any fund would ultimately fall by the wayside over its 10-year life. This would leave a small number of outliers that, together with a few other decent exits, would return 3x the fund. But now, VCs are under increasing pressure to make early, pre-emptive calls on the likely winners and losers. They need to concentrate their precious reserve allocations - and their time - on the safest bets as markets falter. Many started to quietly triage their portfolios as global markets went into reverse during 2H22, putting companies into one of 3 'buckets': 1 - those they would continue to support enthusiastically. 2 - those that they might support if they could see revitalised momentum and real 'hope value' emerging, and 3 - those that they would just drop.

Bucket size will vary depending on the age of the fund. A fund nearing the end of its investing period may just be focusing on a relatively small bucket 1. For those in buckets 2 and 3, this is depressing news. But the really sad part is that founders likely won't find out which bucket they are in until they go to raise their next round. The tell tale signs of being in bucket 2 or 3 can, however, be quickly sniffed out: Partners no longer showing up for board meetings. Senior members of the VC's investment team being replaced on boards by more junior members. No or low responsiveness to founders between board meetings. Investor directors and NEDs debating the founder's performance behind closed doors - usually resulting in awkward and tense board meetings where the founder feels more and more isolated. What can founders do to swing the tide back in their favour? For bucket 3 candidates, maybe it's already too late. For bucket 2 candidates though, there's everything still to play for. But how? Aside from the obvious quick return to fortune and suddenly delivering on the big objectives once promised, it's about having a plan. A plan that promises to draw in a new lead investor at the next round - one that current investors can syndicate behind. The serious prospect of a new lead investor emerging will quickly get everyone sitting back up in their seats. So what's in such a plan?

First, it must be based on a brutally honest assessment of where the company is now versus where it needs to be. Not in the context of company objectives that might have been set many months ago, but in the context of what criteria will make the company investable in this new funding environment. In other words, the CEO/founder should lead an 'investment readiness review', delivering a credible (well-evidenced) funding strategy that then dictates revised priorities for the coming months. To do this, founders must demonstrate that they understand where the funding market is going in their specific sector; the true stage of their business through the eyes of an investor; and which funds are now the best targets. When presented to the board the reaction of the current investors must be palpable:"The appraisal of where the company is and where it needs to be now seems credible and realistic. This initiative gives us confidence we are headed in the right direction. We would love any of those investors to come in alongside us. Let's get behind this." Regardless of bucket, founders should always own a clear, evidence-based plan to deliver the next round that is supported by the board and major investors. if that doesn't feel like where you are today, it's time to take action.

Investor reserves under pressure as markets falter

As we highlight above, VCs are under increasing pressure to make early, pre-emptive calls on their likely portfolio winners and losers. They need to concentrate their precious reserve allocations on the safest bets as markets falter. This pressure comes from two sources: Failed capital calls and more 'internal' rounds. Contrary to popular belief, the money raised by a VC in a given fund doesn't all sit in the fund account from day 1. Fund managers 'call down' capital from LPs at regular intervals, primarily during the investing period of the fund (usually the first 2-3 years for a typical 10-year fund). These are requests to transfer money to the fund manager's bank account in line with the original investment commitment made by the LP. But as public markets tank and recession looms, LPs are being forced to adjust their asset allocations. This means when the capital call comes they may just say, 'No'. This is already hitting emerging managers particularly hard, as highlighted in Forbes. The bottom line, as we head into 2023, is that VCs may have less capital to deploy than they first thought.

In normal times, most VC funds keep around 30-40% of their fund in reserve. The larger portion (60-70%) is used to fund new portfolio companies. These proportions will vary depending on the fund manager's strategy, but for larger, well-established funds, this is a common approach. The reserve allocation is then used to support their portfolio, usually driven by one of two needs: 1. To maintain their pro-rata ownership percentage in companies that are doing well. As more and more money rolls in at higher and higher valuations, usually led by increasingly bigger funds, this strategy 'protects' the existing investor's stake, so maximising their return at exit. 2. To bridge the company to a key milestone. This is not for a company that is struggling or dying but one that just needs a little more time, maybe a few months, to either attain solid fundability (in the eyes of a prospective lead investor) or get acquired. Bridges are 'internal' rounds and in market downturns they become more common. The result is that VCs end up pushing greater chunks of their reserve allocation into bridge financings for companies they believe offer the greatest prospects ('Bucket 1' above), leaving less for the others.

Every time a founder seeks more bridge financing from an existing investor, the level of scrutiny goes up. Often they will have to pitch to the VC's investment committee again, as if it were a completely new investment decision (just with less due diligence). The terms will also become increasingly punitive for founders and other non-participating investors. This usually means accelerated dilution and less control, which inevitably amps up negative sentiment. This is why convertible loans are often the founder's favoured bridge construction. But after this funding, if a company fails to reach the desired milestone, the founder usually faces serious problems in raising more capital. Even if the partner at their lead investor wants to push for it, they will have to burn significant political capital in selling this within the fund. They will also be competing with other partners over a diminishing pool of reserve cash and this can get brutal. When VCs finally stand back and refuse to invest any further, the startup is then on its own. Unless there is a big and rapid change in fortune or a credible and innovative plan to attract a new lead investor, this often spells the beginning of the end.

The death of the generalist VC

In research undertaken by European VC firm, Creandum, 98 VCs and 121 founders were surveyed on the topic of VC value-add. Respondents covered every financing stage and institutional investors with $30M to $2B in assets under management. As expected, the differences between how founders perceive this relationship was different than for VCs. Founders reported less frequent contacts, less operational support received than VCs reported giving, and  -  perhaps most revealingly -  quite different priorities. One of the starkest contrasts was the way each group scored how impactful and helpful the VC had been for portfolio companies on a scale of 1 to 10. The average VC scored themselves a 7 while founders perceived them as a 5.3 — a 32% difference. On a positive note, the study showed founders and VCs both reported personal relationship and chemistry with the counterpart as the single most important decision-making factor. This supports the theory that startup financing is foremost a relationship business.

But after this initial deal-making, what then matters over the long haul? Our insights suggest that founders really value two things: operational guidance and industry insight. From an operational perspective, an investor who has lived the startup journey doesn't just bring practical guidance, they bring real empathy with the founder's lot. But this requirement is a tough one to meet. In the UK, just 8% of investors have experienced first-hand what it’s like to work in a startup and only 4% have had a prior role at a technology company, according to the DiversityinVC Report. Instead, venture professionals here typically have prior experience in consulting (20%), general finance (18%) or investment banking (12%). This contrasts with top-tier venture capital firms in the US, where 60% of investors have experience working at - or running - a startup. Even so, an experienced VC partner can still bring valuable perspectives from seeing similar operational challenges at other portfolio companies. By adding this extended peripheral vision, great VCs can really sharpen the founder's thinking.

The other key area of value-add is industry insight. Increasingly, we are seeing a shift away from VCs being generalists and adopting a thematic or thesis-based approach. Such investors use this market focus 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. Even at Seed stage, we are hearing well-known investors talk increasingly of the death of the generalist VC. Hunter Walk of US seed fund, Homebrew, says "..the breadth of problems startups are solving, the range of markets they’re participating in, and specifics of what they’re trying to accomplish during their first few years of operations, are so diverse that you cannot credibly hold evaluative criteria in your head for all startups. You might invest as a generalist but I don’t believe your returns will outperform." He contends that founders are looking for lead investors who can de-risk their path forward. Being a pure generalist VC makes it very difficult to convince savvy founders that you have the industry relationships, relevant pattern-matching, and density of experience to be their best lead investor. We think many founders would concur.

Happy reading!

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