Duet Partners
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Weekly Briefing Note for Founders

30th May 2022

This week on the startup to scaleup journey:

  • Venture funding outlook for Q2 weakens
  • Why are customers buying your product?
  • The tell-tale sign of the emotional buying decision

Venture funding outlook for Q2 weakens

Last week we highlighted how the funding outlook is changing for startups. Founders looking to raise capital this year are eagerly trying to read market conditions. Decisions on the amount to raise and the associated valuation target are under review right across the startup community. The latest global forecast for 2Q22 from CBInsights shows a continuing decline in both deal activity and investment levels. "Funding is at just $57.7B midway through Q2'22 as investors scale back investments. At this pace, global funding is projected to decrease by 19% QoQ (a similar drop to the one seen in Q1’22). Similarly, deals are on track to total 6,904 by the end of Q2, which would be a 22% drop from Q1’22."  US and Asia startups are already braced for further change following the dramatic reduction in investment witnessed in Q1. But for European founders, who enjoyed a strong uptick in overall investment in 1Q22 over 4Q21, the first shocks are about to hit.

Based on funding levels quarter to date, projected funding across Europe for Q2 looks like $22B, down 16% from $26.2B in the first quarter. This would also be well short of where we were a year ago when funding for 2Q21 reached a record $30.7B. Deal count is also under pressure and is projected to drop from 1,838 in 1Q22 to 1,506 this quarter, a decline of 18%. As we previously highlighted, valuations remained resilient across Europe through the first quarter of this year. But as the market cools, valuations at all stages are expected to erode. Whilst analysts won't yet be drawn on valuation projections for 2Q21, we know that exit valuations declined sharply in the first quarter and this reduced appetite is expected to filter into investment valuations as the year progresses. The biggest impact will be felt at late-stage, which is closely aligned to public market changes where there has been nothing short of a meltdown in recent months.

Median valuations for public software companies have dropped from 12x forward revenue to 5x or less since their peak around 9 months ago, representing a nearly 60% decline, estimated by Andreessen Horowitz's publication FutureFred Wilson's blog this week, ominously titled "How This Ends", says we should assume a down-cycle of at least eighteen months. As a result, IPO and SPAC numbers are expected to continue their dramatic global decline through Q2. In Q1, IPO count collapsed to 139 from 254 in 4Q21. The outlook for 2Q22 is a further big drop to 92. M&A meanwhile remained healthy through the first quarter with 2,965 transactions, which was flat compared to 4Q21. But even here deal count is expected to take a real hit and potentially fall to nearer 2,300 acquisitions as corporations try to navigate market uncertainty. In terms of market sectors, there seem to be no safe havens. At the global level, funding for retail tech is on pace to drop by 50% in Q2’22, with fintech and digital health showing a QoQ decline of 28% and 25%, respectively. Whatever stage your business is at, buckle up for a bumpy period ahead. If you are raising capital, prepare with greater diligence than ever before.

Why are customers buying your product?

One of the traits of successful founders is the ability to question convention. They know that startups can be so weird that even trusting your own instincts can get you into trouble. In Paul Graham's landmark essay, Before the Startup, he says "Startups are counterintuitive...starting a startup is a task where you can't always trust your instincts." He compares it to skiing: "When you first try skiing and you want to slow down, your instinct is to lean back. But if you lean back on skis you fly down the hill out of control. So part of learning to ski is learning to suppress that impulse."  In the startup to scaleup journey, there are many impulses that must be fought off. This takes conscious effort, so the starting point is awareness. Graham reminds us that the most basic question an investor will ask is "Are you making something that people want".  Some founders will walk straight into this trap (impulse) by talking about the product. This is what corporates do. They have the resources, market insights and financial resilience to drive a 'product first' strategy - often the primary accelerant of growth.

But venture investors don't care about the product - at least not to start with. And the idea of a 'product launch' will almost certainly frighten them away. They care about the customer and the problem you are solving for that customer. They care that there are potentially huge numbers of such customers willing to spend money to solve their problem and fuel early scaling. They know the journey there is an iterative process, not an 'event'. The belief that revenues automatically demonstrate progress is an associated trap. They may, but in the very early stages, rarely on their own. Again, this seems counterintuitive. But it is understanding why customers buy your product that investors see as true progress. For many, this question trumps all others. Through the excesses of the VC market in 2020/21, early stage investors bent these rules. In some highly competitive Series A rounds, their priorities became muddled and large deals were consummated pre-product market fit. As the market comes crashing back to reality, many of these companies have major ground to make up. There'll be no further funding until product/market fit has been nailed - and then some.

This understanding of why customers buy your product is particularly challenging for startups selling through third-party channels, where end-customer relationships and insights are much harder to develop. The acceleration of the direct to consumer (DTC) business model through Covid boosted customer insight in both B2C and B2B settings. The data gleaned is enabling customer cohort analysis at unprecedented levels. For some, this is providing the hard evidence needed to demonstrate sustainable growth - and thus fundability. In worsening market conditions, these insights are gold-dust as the evidence bar is now being raised and fewer deals are being done. This is not immediately obvious to founders as VCs seem to be taking the same number of meetings. But looks deceive. In downturns, when transaction rates slide, investors must still look busy. And when they do lock onto an opportunity, the deeper they will dig on diligence. Early-stage founders skiing on instinct, relying on the headline story of revenues alone, may suddenly find their investment propositions come crashing down.

The tell-tale sign of the emotional buying decision

In creating the investor pitch, founders naturally strive to create a 'stand-out' proposition. Because the pitch presentation is often a 'pass/fail' moment, the temptation is be expansive - to tell the entire story in all its glory, to leave nothing of any material value out. As a result, weeks are often spent developing and reworking the content, adding more with each revision. Worried that more slides are bloating the deck, further information is also woven into existing slides. Before long an extended and busy deck results. Instead of a pitch designed to 'excite', you now have a pitch designed to 'educate'. Instead of preparing to give a sales pitch you have prepared for a seminar - the kiss of death for an initial investor meeting. There will be plenty of time to educate later on in the process, but for now the real goal is to build anticipation, to draw the investor in, and to trigger the emotional buying decision.

How do you know if this is happening? The biggest tell-tale sign is the number of questions the investor asks. Albert Wenger is a partner at Union Square Ventures (USV), a New York-based early-stage VC. In his recent blog he says "..your goal is to get from push mode into pull mode as quickly as possibly. What do I mean by that? You want to stop talking and let the investors ask questions. A bad pitch is one where you do all the talking. A good one is where the investors are tripping over themselves to ask questions. So what does this imply? Keep your pitch geared towards being intriguing rather than trying to answer every question upfront." If the technique is to elicit questions, then being prepared for the hardest questions is obviously crucial. Creating a FAQ list during the pitch preparation stage will ensure you are prepared. Answers with numbers in them are the most memorable and credible. They also enable you to be succinct and keep to the point.

Wenger says, "The crucial art of giving an answer is to deliver it firmly and then shut up. Nine times out of ten that’s it and the conversation will move on to a different question." But if the investor wants to go deep, you have to go deep too. Don't try and skirt the question, as this is a test. In your backup slides you will have solid reference material on the potentially contentious points. You may never use it but having it there will give you extra confidence. That confidence will radiate. And in the debates that will (hopefully) ensue, engage fully, but don't forget to tie this into to your headline messages, your big takeaways: the key customer benefits; why you will succeed; and what's in it for investors. Make these bold, simple statements that you and the rest of your team are comfortable repeating. The initial pitch can focus on what you will do and why you will do it. The how can be the reason for the next meeting.

Happy reading!

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