Duet Partners
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Weekly Briefing Note for Founders

6th January 2022

This week on the startup to scaleup journey:

  • Founders taking equity release at Series A
  • VCs doing due diligence before the initial pitch
  • The forces a founder can't control - but must deeply understand

1. Insights of the week

Founders taking equity release at Series A

As round sizes and valuations continue to grow, competition amongst investors for the best deals is intensifying. In a bid to muscle in on the cap table, some of the more progressive VC funds are sweetening deals with secondaries, i.e. buying shares from current shareholders. This means that founders, employees and early investors are seeing some early liquidity, well ahead of a potential exit. At the sky-high prices we are seeing at the moment, finding such sellers is becoming easier. It also lowers the overall round dilution, a bonus for existing shareholders. For those willing to cash in a percentage of their holding, these incoming investors are happy for founders to potentially pocket a few £ million to compensate for the continued risk they will take in building the company. Provided the new investors believe the company is well capitalised, they don't really care if their money is used to buy primaries or secondaries - they just want ownership.

Secondaries have been more a feature of later stage rounds in the past, but now they are creeping into early stage - at Series A and even at Seed stage on the hottest deals. Frontline VC partner, Finn Murphy, says in his recent blog"Up until just 3-4 years ago taking secondary pre-product market fit was considered insane. Now it’s not uncommon. At Series A, it was reserved for certain life circumstances where it helped the founders stay motivated. Now, it’s used more and more as a standard offering to sweeten a deal." Historically, investors (and Boards) have been very wary about secondaries before the business was fully established. The risk being that founders taking large chunks of cash off the table would simply lose motivation. But there is another side to that coin; by removing personal money worries, others say that founders can truly take on the risks necessary to really "shoot for the moon". The recent case of Hopin founder, Johnny Boufarhat, is being cited by many - selling over $150M of shares starting at the Series B - with a 7x valuation increase since!

For a number of progressive funds, especially those that operate internationally, secondaries have become an important part of the investment strategy. For VCs like Frontline, this has enabled them to build positions in companies that are increasingly dilution sensitive in the primary. "With the power balance in founders hands at the moment, aggressive lead investors are often squeezing down existing pro-rata allocations and it’s hard to get all the ownership you want in the main round. But often, especially with where prices are at right now, you can find someone willing to sell." For founders, this is a rare moment where the success v failure equation isn't so binary at a personal level. It's no longer all or nothing - there are some financial relief points along the way. If you have built something that people really want a piece of then good for you. And in the end this could present an even bigger win-win outcome: If there is less temptation to entertain early exit opportunities, you can build something really huge instead.

VCs doing due diligence before the initial pitch

The emergence of 'crossover investors' - a growing cohort of big global hedge funds and PE funds - was a major factor in making 2021 a record year for VC. These big international players swooped down into the venture space, utterly disrupting the VC model. Foremost was Tiger Global, the New York based hedge fund, making an astonishing 335 investments through the year. They simply threw out the VC rule book and bulldozed the competition. Startups that chose to accept investments from Tiger Global said they were attracted by the relatively hands-off approach and founder-friendly terms. Unlike other VCs, Tiger rarely takes board seats. Late-stage startup founders in particular said they preferred the capital instead of advice. But it is the speed of dealmaking that has truly shocked more traditional VCs competing for the same deals: Term sheets have routinely been issued in a matter of days, and sometimes just hours, often after just one phone call with the investee's CEO.

At first sight, it appears as though Tiger has jettisoned the crucial due diligence (DD) step that VCs have traditionally undertaken after the initial meetings. But Tiger's model is to undertake DD before even having the first contact with the company. Just 7 months after German logistics startup Hive closed its Seed round, Tiger Global approached the company to discuss Series A plans. The founders were hugely impressed with the extensive research Tiger had already undertaken. This early preparation, which often includes discrete customer calls, has become the hallmark of the investment firm's approach to winning deals. Other big VC firms are following suit with this so-called 'pre-diligence' approach, especially those that are 'thesis-driven'. Market and company research is being front-loaded, so by the time they have the first real discussion with the founders they are all but ready to invest. In a similar vein, Accel has catalogued the top talent of 200 leading European startups across their target sectors. As soon as those individuals emerge with their own startups, Accel is ready to back them instantly.

This repositioning of DD reshapes the way in which founders must prepare for funding from thesis-driven investors. The pitch deck presentation is no longer the official starting point of the campaign but the 'concluding remarks' that wrap up the investment case. Whilst generalist VCs may view the pitch as a waypoint in building conviction, the thesis-based players see it merely as a final validation of their prior research. Founders must therefore carefully plan the funding strategy for the next round as soon as the current round is done - even before. In our recent insight, How VCs search for hot startups, we highlighted some of the methods that VCs are using to identify potential investments at a very early stage. For example, data-driven sourcing and intelligent ML-based screening is now being used widely to identify and engage with hot startups even before a deal is on the table. To tick the right boxes in this early assessment phase, founders must pay increasing attention to their public profile. Laying the 'paper trail' that makes the startup discoverable and desirable is becoming a competitive necessity to lure in the top investors with their juicy preemptive offers.

The forces a founder can't control - but must deeply understand

On the startup to scaleup journey, the timing of market entry has a major bearing on the fate of the business. No matter how compelling the product or team, entering a market too early could mean months or even years of waiting for the wave. Enter too late and the wave may have passed. You'll then be fighting constant battles with competitors who have moved faster. Spotting the tipping point for a nascent market, when external factors conspire to create the first surge in demand, is a crucial part of the founder's insight. Understanding these external factors is as important as understanding the internal factors such as the product, the team, the go to market plan, and the business model. This may feel counterintuitive as we are often encouraged just to focus on the things we can control, not the things that we can't. But in the startup, timing is everything. Successful founders know how to leverage market conditions to unleash powerful, sustaining change.

Early stage VC, NfX, describes these market factors in their Critical Mass Theory of Startups, as the tipping point when a product or market goes under rapid transformation, seemingly overnight. This moment arrives when there’s a minimum threshold of three preconditions: Enabling Technology, Economic Impetus, and Cultural Acceptance. Tech founders, who are constantly on the lookout for a better way to do things, are likely to be most in tune with the first of these. Their insights should provide a clear understanding of the trajectory of emerging technologies, and when these technologies are on the cusp of a transition that will enable transformational product experiences. Macro economic forces can have a huge bearing on costs, a classic case being economies of scale. For example, Moore's Law, which foretold lower costs for the same amount of processing power, created an opportunity for the consumer electronics revolution. And finally, Cultural Acceptance, often the most underestimated of all preconditions. As behaviours change, the viability of a market category can change as well. Rapidly evolving social media trends are one of the most obvious examples.

In the post-pandemic world, investor sensitivity around external market factors has become significantly heightened. Founders must give greater consideration to these when preparing their investment propositions. VCs believe that the company that can achieve scale at the critical mass point will win; this is what Apple did with the iPhone. Amazon did this with eCommerce, Google did this with search, and virtually every other category-defining company in history has also done. Nfx partner, Pete Flint, perfectly captures this sentiment: "This is where the first-mover (or last-mover) advantage paradigm gets it wrong. What’s important isn’t whether you’re earlier or later than your competitors on an absolute basis – rather, it’s all about who enters the market closest to the critical mass point. It’s at this point when technology, economic and cultural forces can combine to enable explosive growth for founders."

2. Other pieces really worth reading this week: 

The 30 Best Pieces of Advice for Entrepreneurs in 2021
In the First Round Review a highly digestible roundup of the 30 best pieces of advice from articles published in 2021, with links to all for further valuable reading. "Here’s to all the micro-actions and tactics that will transform companies and careers in 2022 — and to the startup leaders who will generously share them."

The Great Bifurcation
An end of year essay from one of the most widely-read and respected technology analysts of our time, Ben Thompson. "In the end, the most important connection between the Metaverse and the physical world will be you: right now you are in the Metaverse, reading this Article; perhaps you will linger on Twitter or get started with your remote work. And then you’ll stand up from your computer, or take off your headset, eat dinner and tuck in your kids, aware that their bifurcated future will be fundamentally different from your unitary past."

How to Deal with Loneliness as A Startup Founder
Founder and investor, Alexander Lim, sets out some practical advice on one of the perennial founder challenges - loneliness. "... most of the time we will feel alone. Most of the time, we will think about what we’re working on and how it relates to other people and their businesses. We will wonder what others are doing and what they’re thinking about. We will wonder if our ideas are going to work out. We will feel alone in a crowd of other people."

Happy reading!

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