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Why venture capital needs to stop hunting unicorns

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Why venture capital needs to stop hunting unicorns

We’ve entered another decade – but will it gear up to be as prolific for start-up fundraising as the last?

That, certainly, is the hope of many early stage businesses looking to fundraise in the coming years. Government accelerator programmes, tax schemes including entrepreneur’s relief and SEIS/EIS led to a boom of new start-ups launching, and investors backing them.

The question is firstly, will this trend continue? And secondly, at what pace can we expect the private market to grow or contract?

>See also: VC funding for UK tech start-ups breaks new record

VC investment stalls in 2019

If you are paying close attention to the headlines you may have a dimmer view. VC investment stalled in 2019 for the first time in seven years. Small clouds appeared over a sector that knew only sunny days, with many saying that the implosion of the WeWork IPO was just the beginning of a larger malaise. For the more diligent and optimistic however, it is clear to see there is plenty of room for growth yet. Headline figures largely played on US and China investment, which indeed did have a downturn; however in Europe and the UK we had a record year. In fact, there is a growing trend to pull money out of public markets and into private companies and so you could argue timing has never been better for start-ups to raise capital.

‘Is investment in early and seed stage businesses increasingly falling away in favour of later stage deals?’

Late-stage myth

Research from KPMG Private Enterprise last year painted an interesting picture of the VC industry’s future. The numbers initially look bleak for early stage start-ups: there were 1,648 VC investments in the UK in 2019, but most of them were driven by later stage deals in the healthcare and fintech sectors. Is investment in early and seed stage businesses increasingly falling away in favour of later stage deals? If you’re to believe the data from one year – and don’t take into the account how a few very large deals can skew the picture – then perhaps you are concerned about early stage funding.

However, the hunt for unicorns – a company which is valued at $1bn or more, like WeWork once was – continued to gain pace and only appeared to intensify last year. Pitchbook’s numbers showed a record number of VC-backed unicorns in 2019, with 110 new unicorns created globally. From a local perspective, the number of new unicorns in Europe grew by a staggering 50 per cent. And you would think it makes sense – the return on an investment for a VC who spotted a unicorn early can be immense, particularly taking into consideration the model on which many funds are built.

Fundamentally however, if you’re hyper-focussed on unicorn discovery you’re likely being dragged further up the deal stage pipeline. This is where you see mega deals the likes of Softbank cutting in Series C, D and E rounds – and evidently many of these do not stack up when the companies finally go public, and break-even horizons are ever more stretched. To get the real returns, the sort that famous fund partners include in their memoirs, the action is happening much earlier in the funding journey.

‘The hunt for unicorns is not sustainable for VCs’

While Pitchbook still predicts 2020 to be a year that will mark a new annual record for mega deals in the US, the sector is becoming more nuanced. Aileen Lee, the VC who coined the term “unicorn” and has written extensively about the factors that “make” a unicorn, was one of the first to caution that the hunt for them would not be sustainable for venture capital. To make back not just their initial investment into a unicorn but also recoup their losses on other investments, VCs would now need the few unicorns they find to be “really humongous winners”.

As investors assess and analyse 2019 performance and investment strategies while tallying their IRR after the spending spree of recent years, many could be forgiven for growing more cautious in 2020.

>See also: Why venture capital investment is like rock climbing

Be clear about the right VC for you

Just as there are no shortage of start-ups seeking funding, there is a growing number of VCs and investors who have capital to deploy, and so finding the right partner is a challenge.

In the early stages of fundraising, a VC needs to be as much a partner for the founder as well as a source of capital. When it comes to the approach, businesses need to be on the lookout for VCs that offer the operational support and strategy that will accelerate their journey to building a scalable revenue model as well as the funding they need. Too often, founders are lured by a term sheet versus really getting under the bonnet of how their investor operates and what value, outside of cash, they bring to the table.

During discovery calls and meetings, businesses need to look for VCs which try to understand what value they can bring to the business. Is it their experience in the sector, their network of prospective customers, or hands-on experience of scaling a similar model or business? Founders should be asking themselves “what do I want from an investor” and be very specific. This is obviously more important at the earlier end of the spectrum, from pre-seed to seed, whereas Series A and onward it’s usually a slightly different “need” relationship.

What kind of expertise does a VC offer?

Other than the VC’s track record, another aspect to explore is their background beyond the investment industry. Have they got experience as an entrepreneur themselves? How many similar businesses have they worked with? And was it as a VC, founder, or board member? All these questions offer an indication on the type of expertise the VC can offer. The scale of the hands-on business experience a VC has will add significant value as they really have been there and done it. They will have learnt invaluable lessons along the way which they can pass on to your own company, and furthermore they understand what it feels like to be in your shoes. So don’t just focus on how many university degrees they’ve got under their belt and how well they can run a spreadsheet.

From start to seed – be realistic

If you’re just starting out on the journey, you may well be able to bootstrap or raise an angel round to support product development and a minimum viable product (MVP). Next, the ability to scale Proof Of Concept (POC) with prospective customers will be a critical component as you look to raise institutional money in a seed round.

Early business plans should break down specific milestones such as the point of customer traction and early revenues on a fully deployed product – this is where you will be able to drive up valuations when you come to raise. Too often start-ups are raising a seed round without real revenue, but at a late seed or even Series A valuation, realism is key. Investors will want to be able to validate the product and identify the fastest route to scale toward a Series A, and so refining the business model is an important element to get right early on.

As someone who has been through the process of launching a company from scratch and fighting the tiring but satisfying battle to accelerate growth year over year over year, I applaud those who have taken the decision to start a business. Leaving the comfort of a day job, salary, and benefits package and facing the unknown is a daunting feat – but one that is wholly rewarding, and far beyond the riches you may dream of as the eventual goal.

Daniel Pitchford is a venture partner at SuperSeed

Further opinion on venture capital

Why venture capital funds need to develop a social conscience

Source: https://www.growthbusiness.co.uk/why-venture-capital-needs-to-stop-hunting-unicorns-2557410/

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