This week on the startup to scaleup journey:

• Founders must think 'market-first' to attract VCs
• Valuation trend analysis offer - 3 slots left

Founders must think 'market-first' to attract VCs

VCs seek to invest in 'category winners'. This drives their need to understand where a startup 'fits' in the market and how it will create this new category. This market-centric perspective pervades their thinking. It provides their entire frame of reference from the very first conversation with a startup. But the same is not true for founders. They are heavily driven by operational priorities. Yes, market positioning will form part of the overall problem/solution thesis, but a founder's thinking is heavily focused on the technology, the product, the team, customers, and so on. When it comes to fundraising however, this perspective has to change - at least for a period. Investors expect a 'market-first' approach as founders present their investment proposition. Entrepreneurs that miss this cue will find it much harder to secure investor attention.

Why are VCs driven by markets? Most VCs consider themselves to be market experts, especially those that employ a thematic approach to investing. They will follow certain markets closely and design their investment team structure around these areas of expertise. They will monitor the key trends and know who the key players are. Thesis-based investors even develop an understanding of where market gaps may exist and will proactively seek out startups with the ability to fill them. This market knowledge enables both thematic and thesis-based investors to quickly assess the overall validity and potential of an investment proposition: For example, it helps them to scale the market opportunity ($TAM), understand the pathway to product/market fit, and assess competitive positioning. All are vital considerations in the early evaluation. In due diligence, it enables them to gain a deeper appreciation of the go-to-market strategy, customer types, and how the business model will likely evolve.

What do we mean by market? Unfortunately, the word 'market' means different things to different people, so we need to be alert when preparing the pitch narrative. It's useful to adopt a simple framework, even if it's just to have a consistent taxonomy when describing the proposition. If you claim to be creating a brand new market or a new category within an existing market, these may sound similar but are very different objectives and carry very different risks. You need to be precise with your claim so an investor can appreciate the magnitude of the ambition. Loose and unsubstantiated claims will undermine the entire investment story and damage credibility. A good place to start is your 'Industry classification' and then determine your relevant 'Vertical market' to highlight the point of intersection. For example, your startup's industry might be Financial Services and your vertical might be Crypto Currency/Blockchain. Or your industry might be Automotive and your vertical may be Ride-Sharing. It's often the vertical that gives the most clues about positioning.

Precise positioning. But the 'Industry + Vertical' description alone is not sufficient to provide investors with a precise picture of the market opportunity. It certainly doesn't yet identify your category-defining position. Take AI & ML. This is a highly innovative and rapidly growing vertical market. It spans a multitude of industries. When you break down the AI & ML vertical into a market map, it comprises many different segments: The two big ones in Pitchbook's AI & ML market map are Horizontal Platforms and Vertical Applications. Each segment comprises a range of specific sub-segments. It would be almost meaningless for a founder to position their company as simply an 'AI & ML' business to a tech investor. But by saying you are a "Horizontal Platform" company (segment) that operates, for example, in the  "Foundational Model" or "Natural Language technology" sub-segments, you will demonstrate the required precision. You now have solid positioning to develop your story.

Creating a new category. Startups have some latitude in defining the category they wish to belong to. In the AI example above, a category could be an existing sub-segment. If the company was pioneering a completely new platform approach it might claim to be creating a new sub-segment or 'category'. If we take a different example, say within the Energy industry, Clean Fuels would be a segment and Hydrogen would be a sub-segment. If a company was pioneering a completely new clean fuel from some other raw material it would be creating a new category. Within the SaaS vertical, Infrastructure SaaS is major growth area, within which DevOps is a significant new segment. There are already at least 4 sub-segments within DevOps, which are essentially market categories. It's very likely that new sub-segments will soon emerge in this market and will also be claimed as 'new' categories.

Category due diligence. When startups state their category, they are guiding the investor in the assessment of their business. One of the immediate questions is market size or $TAM. This is the scene of many due diligence 'car crashes'. Remember that institutional investors will have access to extensive datasets that allow them to scope industries and verticals, plus all the associated segments and subsegments. With a little work they will nearly always alight on their own approximate $TAM figure. If this is way out of alignment with (i.e. smaller than) your figure, this could spell trouble. The second due diligence crash zone is valuation. As our recent exercise into peer group valuation trend analysis has demonstrated, comparators within an industry or vertical can be very misleading if assumed to be representative of the market as a whole. It's often not until you look at the specific segments and sub-segments do you realise that valuation trends can look markedly different (up to 50% variance between some AI segments, for example).

Customer Segmentation. In any given category there will also be customer segmentation, but this is very different to the market segmentation we highlight above. Customer segmentation, for example by geography, channel, size, or pricing, is closely associated with the stage of the business. Startups must align their precious resources with only a small number of customers to begin with and this gradually increases over time as the startup grows. In the classic technology adoption curve, this is seen in the transition from the 'innovators' to the 'early adopters', then the 'early majority', and so on. This customer segmentation acts as a limiter on the $TAM in the early stages but this should not be a big concern for venture investors. The 5-10 year view on $TAM is what matters as this will be used as a proxy for valuation at exit.

Finding hot market categories. In 2021/22 nearly all tech markets rose to their peak after years of growth. But all that has now changed. The latest VC Tech Survey from Pitchbook assesses areas of technology that investors expect to see growing/receding over the coming year. The big winners here are AI, ClimateTech and Health/Biotech, amongst others. Areas where investors believe they are already over-invested include Crypto, Fintech and (interestingly) some aspects of AI. As we highlight above, the AI space is vast and diverse but some emerging segments are still seen as being huge disruptors, despite all the over-hyping. The big takeaway again is that industries and verticals alone rarely reveal where growth opportunities lie. Only by digging into the associated segments and sub-segments will the hot categories be found (or created).

Founders that seek to convince investors that they are creating a category winner must be prepared. They will need evidence to support their plan: They will need to describe the current market structure, how it is evolving, and its scale. They will need deep insights to substantiate hidden trends and how they will be exploited. They will need clear competitive positioning. Then by guiding investors to the growing $TAM using industry and vertical segmentation they will create a compelling sense of opportunity as prospective leaders in this exciting new category.

Valuation trend analysis offer - 3 slots remain

2 weeks ago we announced that we were making available our extensive investment research capability to provide a free, no obligation, peer group valuation trend analysis for companies looking to raise capital at Seed or Series A in 2024.

Our aim with this initiative is to provide founders with the very latest market data, customised for their specific sector and funding stage. This is the hard evidence that boards seek but is often so difficult to obtain.

The feedback from founders so far has been universally positive; "Hugely helpful and appreciated." "Incredible insights. Just didn't realise that this kind of analysis was even possible." "This has given us what we need to move our campaign forward."

We made 25 slots available for this exercise, which closes 31/12/23. Only 3 slots now remain.

Founders interested in receiving this customised market trend data should contact John Hall at john.hall@duetpartners.com.

Happy reading!