Duet Partners
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Weekly Briefing Note for Founders

15th May 2023

This week on the startup to scaleup journey:

  • Exceptional founders build a 'value stack'
  • Allaying investor anxiety over channel sales
  • VC fund performance in negative territory

Exceptional founders build a 'value stack'

One of the key traits of exceptional founders is the ability to know what not to do. They are able to eliminate ideas that are not worthy of their talents and time. First-time founders often struggle with this as they are still developing a mental framework for decision-making. In the startup this is different than in any other business scenario as the underlying requirement for success is exceptionalism.  By their very nature, successful startups are numerically exceptional: exceptional outcomes are enjoyed by only a very small minority that begin this journey - less than 1%. They are also exceptional, at least in part, because of good fortune: they were beneficiaries of being at the right place with the right product at the right time in a changing and powerful technology cycle. But, most of all, they become exceptional because the founder has a 'framework for executing' - a mental model for priority setting and decision making. This is either intuitive (unlikely) or built from prior startup experience (much more likely). The framework helps decide what is 'in' and what is 'out'. It ensures resolute focus on value creation. It is aligned with each phase of company development from idea to growth; from startup to scaleup. As VCs get to know founders during due diligence they probe this 'framework' to understand what makes this particular startup - and this founder - exceptional.

Terminology will of course vary from investor to investor. Floodgate Fund calls this framework the "Value Stack". It is at the core of their due diligence model. Co-founding Partner, Mike Maples, Jr., says: "We look at the value stack as a hierarchy of powers. Each of these is powerful on its own, but as these advantages are layered on top of each other they reinforce and amplify each other even further." The stack has 5 layers: 1. Proprietary Power. This is necessary because it helps a startup avoid competition once the idea takes hold. Many startups make the mistake of trying to be better rather than different. Having a structural competitive advantage is critical for avoiding mindless competition. 2. Product Power is about achieving product/market fit. The features and capabilities are not merely compelling — they rise to the level of changing people’s points of view about what’s even possible and create intense delight in customers. 3. Company Power involves implementing the basic types of foundations that allow the company to avoid management and technical debt. This often revolves around culture and enables everyone to execute better and faster, enabling rapid scaling. 4. Business Model Power involves translating a startup’s innovation into attractive profits that can improve rapidly. Company power amplifies this by enabling the company to capture the opportunity to do this before larger competitors can co-opt them.

Lastly, 5. Category Power - this is the highest level opportunity to create massive value. Maples says: "A great company designs and owns a category, making itself the “Category King.” Category Kings don’t just make something to sell to people. They introduce the world to a new “category” of product or service. They replace our current point of view with a new point of view. And ultimately, they change how people and businesses decide to spend their money. Category Kings usually capture 70–80% of the profit pool in their markets." These 5 powers align strongly with the classic phases of startup development and value creation. They may sound obvious but each requires true exceptionalism in both vision and execution. The first easy self-test for a founder is to examine the underlying problem/solution thesis for the business. If the resultant product is simply 'better' than others - even 10x better - that power is worth little unless there is strong differentiation that will enable a sustainable advantage over the long term. VCs invest in marathon runners not sprinters. Another test is whether the underlying business can trend quickly to profitability once early scaling begins - a view that has suddenly come back into fashion. Founders that can develop and employ a framework for execution that enables exceptionalism are in that 1% of value creators that investors will always seek, irrespective of market conditions.

Allaying investor anxiety over channel sales

Channel sales can be used to create extremely successful business models. But the notion of using channel partners in the early stages of the startup to scaleup journey often causes investor anxiety. If the move is made too early, this could be a red flag to investors and make the business unfundable. Even when the timing is right, there are ongoing risks that must be actively managed. Founders must predict where investors will probe the deepest. Few VCs publish their thoughts on this crucial topic, but experience tells us the key questions will revolve around; Rationale, Timing, Mindshare, and Resourcing. 1. Rationale:  It is essential to first explain why you believe a 3rd party route is crucial to develop your sales growth. In an era where product-led growth has become so fashionable, VCs will immediately latch on to the potential downsides. These will include loss of visibility and control of the customer, dilution of customer feedback, brand identity risks, and the cost of resourcing this indirect channel. Costs will be linked to the type of channel such as VARs, SIs, ISVs, and Distributors, which in turn will depend on industry norms and whether your product will be sold as part of a bigger solution. To allay investor fears, quickly setting out the benefits - for example, market access - is therefore vital. A useful primer on this is; How to Build a Channel Partner Program, by Vation ventures.

The next topic, 2. Timing, is often where the biggest pitfalls lie. David Skok of US VC, Matrix Partners, provides further insight on this is his excellent article, The 8 Dangers of Channel Sales. The big takeaway is that founders will need to figure out the sales model themselves before teaching channel partners how to replicate that model. In other words, you will need to make your first sales directly using your own direct sales efforts (possibly in association with a channel partner). This will help you understand if your product/market fit is right, who you need to involve in the sales process, and whether the messaging is resonating. 3. Mindshare. Channel sales usually take a long time to get off the ground. The reason for this is that a reseller will have a different set of priorities to yours. You have a great sense of startup urgency, have total focus only on your product, and are willing to work long hours. They are usually focused on other products and deals that are paying the bills, and will usually need a lot of work to convince them that they will get a return on time invested in your product. Resellers often are lazy, and don’t want to do the work to create demand for a new product. They usually prefer to sell products where the demand already exists. This means you should still expect to create demand using your own marketing efforts. Ideally you should be in a position to feed them leads, or better still, deals that are close to being done in the very early days to build enthusiasm.

Finally, the challenge that many founders underestimate; 4. Resourcing. Without dedicated sales management, early channel strategies can easily fall apart. Partner sales management is a completely different beast to direct sales, and experience is key. This starts with channel partner selection, then training, and then ongoing coordination. Resellers need education on how to sell, handle objections, differentiate your product from the competition, and crucially, provide you with customer feedback. This requires constant work by your channel sales team, together with other specialists (such as application engineers) that may be called in to help move deals along. Every step in this process will take much longer than you first anticipate as there are so many unknowns. If you decide to use a channel sales model, be prepared to commit to it entirely, and not take orders directly (unless there are some very clear rules). If the channel sees you competing against them, it will turn them off, and lessen their commitment to your products. Given the right channel, the right people, good product/market fit, and a lot of patience, the channel sales model can be one of the most profitable business models.

VC fund performance in negative territory

If you want to get a true sense why the global VC juggernaut started hitting the brakes in early 2022, Pitchbook's latest Global Fund Performance Report reveals all. Macroeconomic shifts resulting from rising inflation, rising interest rates, and public market volatility have led VCs to mark down their portfolios, severely impacting returns. Starting 1Q22, for the first time in more than a decade, quarterly returns for VC funds were negative for three consecutive quarters. Preliminary Q4 returns of -0.8% indicate that the pain continued for a fourth. Despite these bleak figures, there is some room for optimism: quarterly returns bottomed out in 2Q22 at -8.7%, and have been inching closer to positive returns since. But this does not bode well for 2019, 2020, and 2021 vintage funds that invested at the heights of that period: They will be unlikely to hit the target 2x to 3x TVPI (Total Value to Paid In) returns that this asset class demands. That casts a long shadow over their ability to raise new funds - at least for now.

The other key fund performance metric is the rolling one-year horizon IRR. This dropped to -6.7% in Q3 2022, the lowest value recorded by Pitchbook since Q3 2009. This decade-plus record low was driven largely by the poor performance of funds over $250 million, which were more exposed to the median late- and venture-growth-stage pre-money valuation declines of 22.9% and 64.4%, respectively, measured from their 2021 record highs to 1Q23. Tiger Global, poster child of the 2021 investment frenzy, marked down its VC portfolio by 33% in 2022, losing a staggering $23B in value. Most of the losses stemmed from a write-down in valuations of portfolio companies such as ByteDance and Stripe. Tiger's VC funds lost between 9% and 25% in value in Q4 2022 alone. IRR for Tiger's PIP 12, PIP 11, and PIP 10 funds dropped to 9%, 13%, and 35%, respectively, by the end of 2022. At the other end of the scale, funds smaller than $250M showed better returns in 2022 as most of their capital was deployed in earlier-stage startups, particularly at Seed, which have demonstrated greater resilience to the valuation downturn.

Future IRR predictions are used by GPs to persuade limited partners (LPs), such as endowments and pension funds, to participate in the fund. Seed-stage funds typically aim for a 30% IRR while later-stage funds target a 20% IRR. Despite the recent negative one-year IRRs, longer time periods still reflect the benefits of the global swell in venture capital activity from 2020 through early 2022. The three-year, five-year, and 10-year VC horizon IRRs boast the strongest returns among all private capital returns at 25.2%, 20.9%, and 16.6%, respectively. However, a key characteristic of VC is that these aggregate numbers often hide huge disparities between the best and worst-performing funds. Looking at vintage years 2004 to 2017 there was a gap of 20.8% between the top and bottom quartile range, highlighting the inherent risk of VC. VC returns can vary so widely because GPs expect a few investments to drive the majority of their returns. Without a 'home run' exit, funds can perform poorly. With the prospect of 2023 being a vintage year for returns, VCs are now scouting hard for new 'outliers' that will help them recover lost ground.

Happy reading!

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