Weekly Briefing Note for Founders

13th June 2022

This week on the startup to scaleup journey:

  • Protectionist deal terms will increase startup risk
  • A good business model is just as important as the product
  • Things you should never say to an investor

Protectionist deal terms will increase startup risk

The phenomenon of low interest rates was a key contributor to the massive expansion of capital flowing into VC over the past 5 years. In the US, annual investment soared from $88.4B to $342.2B in that short period, according to Pitchbook. Globally, the rate was almost as impressive: from $214B to $620B, according to CB Insights. This unprecedented investor demand combined with a relatively steady level of companies seeking to raise capital "fostered the consistent growth in VC valuations from 2017-2021."  Now the funding outlook is changing for startups and we are in a period of valuation reset. Late-stage deals are already being impacted and it's only a question of time before the pressure rises in early-stage rounds. To some extent, startups are able to control downward valuation pressure via the deal terms included in their capital raises, specifically by adding greater investor protection. Pitchbook comments that more of these protectionist deal terms will emerge in the coming quarters, especially if the downturn extends or deepens over the next six months.

VC's will undoubtedly see the downturn as an opportunity to gain back some control over deal terms that were ceded to companies during the easy money times of the last few years. But the increase in 'protectionist' term sheets and associated concessionary behaviour from founders, which serve a short-term function to save face and avoid down rounds, could quickly turn into a slippery slope for startups. For example, giving non-diluting shares and/or share buy-back provisions to new investors could be the kiss of death for longer-term funding prospects."These terms can muddy the cap table, causing knock-on effects such as increasing the difficulty to attract new investors to join in on future fundraises or in the worst cases, forcing liquidity decisions that aren’t ideal for all insiders, including LPs, GPs, and especially equity-holding founders and employees."  In the current environment, Term Sheets must now be read with ever greater caution. Fully understanding the downstream implications of even the most innocuous terms is essential.

For startups that are nearing an exit, the realities of the valuation environment are even more top of mind. New IPO issuance slowed to a trickle with just 14 IPOs closing in Q1—only one of which was over $1 billion in value at the time of listing. This drastic decrease in purchaser demand for new listings is particularly concerning for VC relative to other private market strategies given that "around 90% of all dollars exiting VC since 2019 have come from the IPO market." 12 months or longer without a material amount of liquidity for the swelling number of unicorns sitting in VC portfolios will likely result in some fairly serious valuation haircuts. Exit markets provide a third-party validation of private company valuations, and if that function pauses for more than a year, Pitchbook says we should anticipate an uptick in down exits and rounds, as delays or repricing of comparable transactions could force some private companies’ hands.

A good business model is just as important as the product

After a 30-year journey building the robot industry, Colin Angle's discoveries make powerful reading for any entrepreneur. iRobot's 14 failed business models is a classic founder's tale - of the extreme variety. But the lessons and insights could apply to any technology platform company today. "For a long time the robot industry was unfundable. Why? Because no robot company had a business model worth funding. It turns out that a business model is as important as the tech, but much more rarely found in a robot company."  Angle describes how his company changed the world by eliminating the need for people to vacuum the house themselves. But this is a long way from where they started. Each successive business model 'experiment' delivered fresh insights until eventually they landed on the business model that would unlock a huge market.

But funding the almost endless experimentation required a particular approach to partnerships. "The kind of partnership we looked for were ones in which there was a big company–one that had a lot of money, a channel to the marketplace, and knowledge of that marketplace, but for whatever reason lacked belief that they themselves were innovative. We were a small company with no money, but believed ourselves to have cool technology, and be highly capable of innovation."  The corporate partnership model needs very careful navigation as it creates risk in some areas as well as reducing it in others. The reduction element is about managing your own financial risk by having a partner underwrite the big costs. The risk creation element is related to who owns the results. But the most valuable results for iRobot were in fact the disasters. The things that failed. They provided the true insights that could be carried forward.

The accumulation of lessons learned from trying different monetisation strategies (e.g. joint development fees, licensing fees, royalties), different markets and different manufacturing approaches, finally provided the ingredients for the bold vision. In Angle's view, iRobot has now succeeded in changing the world by making robots a daily reality for it. The company, listed on NASDAQ, has made the robotic vacuum a mainstream consumer product. To date they have sold over 30 million consumer robots. The corporate partnership approach remains a powerful experimentation model today when there is a longer road to travel. Provided the partner pays for the initial engagement - usually via some form of non-recurring engineering (NRE) fee to secure the focus of the startup's precious resources  - and the IP rights are carefully managed, a low-cost journey to product/market fit can eventually be found.

Things you should never say to an investor

One of the most onerous exercises in preparing a company for an IPO is the creation of the 'verification notes'. This is the documentary evidence supporting claims made in the prospectus. Every claim, no matter how small, must be traceable - and the lawyers must be happy that this is so. In early-stage funding, the process isn't quite as daunting, but applying the same mindset is a great discipline. Any material matter in your pitch presentation will eventually get checked during due diligence, so you want to be sure that what you claim to be true is true. In new or emerging markets there is often a lack of good, reliable data. So what is the truth when so much is unknown? Founders that use this ambiguity as an excuse to 'oversell' the proposition run the real risk of damaging investor trust. Those that maintain a more humble narrative can still be awesome at the same time.

There are certain things you really never want to say to an investor, no matter how bullish you feel about your business. Even if they are true, you run the risk of simply appearing arrogant. For example, "We have the best technology" or "We don't have any competition" are both going to be a red rag to a bull. By all means state your claim, but better to be specific and, if possible, use the words of a customer to substantiate each point. Let the evidence do the talking - customer testimonials are hard to beat. Claims about what might happen in the future are impossible to substantiate but some rational justification is still necessary. Exit potential is a particularly tricky subject, as belabouring it in the first meeting can give the wrong impression. Institutional investors are unlikely to invest in a founder who just wants to get rich quick - and that includes VCs.

Predictions of future revenues and high valuation expectations are also places to easily come unstuck. Hockey stick revenue growth forecasts with little or no historic revenue need to be presented with care. That means clearly setting out your assumptions and probably being a little more modest with the growth rates - unless you are on the cusp of a transformational deal. In which case, better to close the deal first. Valuation, as we have said before, is for the investor to offer - certainly when you are dealing with VCs. If you start slinging numbers around in the first meeting you are going to appear naive at best. As the funding market cools, investors are digging harder into the substance. A deft, self-assured and substantiated presentation will do more to convey belief than a string of outlandish claims.

Happy reading!

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