Duet Partners
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Weekly Briefing Note for Founders

9th May 2022

This week on the startup to scaleup journey:

  • VCs changing investment strategy
  • B2B enterprise startups require a 'sales culture'
  • The power of non-recurring revenues

1. Insights of the week

VCs changing investment strategy

Even though dealmaking remained buoyant across Europe through Q1, VCs are operating with greater caution. Headwinds from a major public market correction are pushing back valuations - at late stage in particular. This is forcing an industry-wide rethink in VC funding strategy that founders are trying to comprehend. Let's look at one of the strategic questions venture firms are now debating, using an example, courtesy of Tomasz Tunguz at Redpoint. A VC finds a great company and invests $8M for 16% at a $50m post-money valuation. Six months later, the company raises $100m at $500m. Things have gone very well."Your $8m has 10xed. So do you invest your full pro-rata of $16m [in this new round]?" Pro-rata is the right to invest more to maintain your percentage ownership.

"If you invest an additional $16m to maintain your ownership, the investment multiple falls to 3.3x: $80m / ($8m + $16m). Two-thirds of your dollars are now invested at a much higher price. Which path do you pursue? Stay pat to maximize the investment multiple? Or double down to $16m and juice the holding value - the total value of the position?"  In the heady markets of recent years the decision has been easy - double down to optimise the holding value. With the inexorable rise in exit valuations, greed has been the dominant motivation. But with unstable prices, fear enters the equation. What if the third round is a down round? The investment multiple will compress and a VC may be forced to invest more to maintain their ownership ("pay-to-play"). The VC's great return might degrade to a mediocre outcome as a consequence. Investing say $24m to get a 3x return isn’t bad in absolute terms, but it's a long way off the heady 10x on $8M.

A major correction in public markets now casts doubt over the holding value strategy. Rather than doubling down, a VC could allocate those $16m of reserves to a new investment in an earlier stage company at a lower valuation. Maybe this will generate a better return? This is the very question that many VCs are currently debating. Some of the most well-known late-stage investors have already shifted down to look at earlier-stage opportunities. Some of the biggest, for example Tiger Global, are raising new early stage funds for this very purpose. Many though are taking a wait and see approach, with an uptick in the use of convertible notes to defer valuation discussions to a later date when the market will have hopefully stabilised. As Tunguz says: "The greater your confidence in stable prices in the fundraising market, the more likely you are to double down. The less confident, the greater your reservations about reserves." 

B2B enterprise startups require a 'sales culture'

Pursuing big ticket enterprise sales is a strategic necessity for some startups. But selling to the enterprise can be tedious. Sales cycles are often complex, time-consuming and a common source of founder anxiety. As we have highlighted before, the key to enterprise sales is understanding the enterprise: Figuring out who to target, how to qualify, how to design and execute an engagement, and then finally get paid, can be a daunting challenge. Multi-level selling is essential, right from the executive-level budget holder 'approvers', to the operational 'recommenders' and finally the users or 'supporters'. Nothing happens quickly and every victory is hard-won. But  VCs who are proficient at backing such startups understand the value of the enterprise market as it can be so lucrative and sticky. "The tantalizing lure of the enterprise is that once you are in, you are *in*. Do your job right, and you’ll earn an annuity for decades."

Founders that focus on big enterprise sales from the beginning have two particular challenges. First, the choice of investors - right from Seed stage - is crucial. Revenues are unlikely to start taking off until years 5-7. For Deeptech startups this could be even longer. This requires truly patient capital. But just as crucial is the development of a 'sales culture' from the very formative stages of company development. That's because over 50% of enterprise success comes from 'distribution' - the sales function. This can seem counterintuitive to some tech founders, who place almost all their faith in the product. VC David Frankel sums this up perfectly: "Product is important, and product-led growth is a viable strategy, but everyone on the team needs to think about “sales” as a core part of their job description. “Build it, and they will come” is a doomed strategy in this arena. Strategy divorced from front-line product or sales experience is useless. More than any other area of the startup ecosystem, commerce and code need to be fully integrated."

This integration starts earlier than most think, even before a startup has a product to sell. The sales culture, driven by the founder, guides the early go to market strategy. If the founder doesn't have direct enterprise sales experience, this doesn't mean they need to hire their VP Sales quite yet, but it does mean that someone with this specific experience and skill set should be contributing to the discussion. This could be a member of the board or the advisory board if they have the relevant operational background. This is key because unlike the B2C world where customer acquisition is in essence a marketing-driven game plan, the go to market strategy for a B2B enterprise model is sales-driven.Tapping into and ultimately recruiting such sales expertise is becoming harder. Frankel: "Serving enterprise customers requires a vanishingly rare combination of skills and personality traits. Relentless execution paired with a zen-like approach to the passage of time. Technical proficiency married with diplomatic poise."

The power of non-recurring revenues

In the SaaS world, recurring revenue (ARR) is the hot growth metric. ARR provides visibility into future financial performance and is much prized by investors. So much so that nearly every startup, irrespective of sector, will strain every sinew to figure out how they can build a recurring revenue stream into their business model. It's no surprise that all new software companies and 80% of historical vendors are offering subscription-based business models. But it's no longer just Software as a Service that is driving the change but Product as a Service, even if it includes hardware. For example, subscription services and membership models are now a major theme in consumer electronics. Not only does this provide a more predictable revenue stream but it increases the frequency of communicating with customers, reduces financial blockers as appliances no longer have to be paid for in advance, and increases convenience. 

But this is not the whole story. Some of the best SaaS businesses in the world generate a lot of one-time or non-recurring revenues. Research shows that from 73 SaaS companies to go public (going back to 2019) on median generated 11% of their revenue from non-SaaS sources and 24% on average. This is not just material from a financial standpoint, is has a strategic significance as most of these revenues come from services. The concept that customers are not just buying a product but are buying a solution still holds, especially in the enterprise. And "companies that touch their clients often with support, consulting, services, repeat onboarding, customer success initiatives, ideas on new use cases, etc tend to have way less churn." This solution-based approach makes the offering sticky, especially when services support the embedding of the product into the customer's core business - think Stripe for payments of Salesforce for CRM.

For many early-stage businesses, the road to recurring revenue can be fraught. It can take time to find product-market fit and see demand start to climb. That's where non-recurring revenue can play a big role in essentially 'financing' the initial development of the business. It's a source of cash - and cheaper than almost all other alternatives. In some cases the scale can be significant. For example, NRE charges to build a 'proof of concept' solution with a major early adopter can generate £100k's or even £M's if this has the potential to unlock significant strategic value. For many Deeptech startups, NREs are often the primary source of early income - as well as being a sign of market confidence in the company's potential. Whilst recurring revenues have now become the key measure of commercial success in many sectors, founders shouldn't forsake one-time revenues. Especially in the early stages, it can be the easiest form of 'funding' to secure.

2. Other pieces really worth reading this week: 

Funding To EU Startups Slows Sharply After Brisk Start In 2022
Funding to Europe, which includes both EU and non-EU countries, bucked the trend in Q1, with total funding up slightly quarter-over-quarter. However, data for the past two months shows funding to the region is now trending down. This latest article from Crunchbase looks at what's happening and sends an early warning signal.

COVID-19 Drove More Corporations to Explore Venture Capital
Despite the overall hesitancy to commit venture funds in the first half of 2020, first-time CVC investments more than doubled over the same period in 2019. In a recent article, Nicolas Sauvage, President of TDK Ventures, assessed how the new influx of CVC investors is changing the Venture industry.

China's Leadership Is Prisoner of Its Own Narrative
Startups dependent on Chinese manufacturing are having to deal with continued production stoppages, clogged ports and strained supply chains. This interview with Joerg Wuttke, President of the EU Chamber of Commerce in China, provides some useful insight into what's going on there.

Happy reading!

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