James Codling, Managing Partner of Volution
26 April 2022
It is no secret that venture capital has experienced a boom decade: deal flow, deal size and above all valuations have ballooned. Funding has been pouring into emerging companies. In 2018, there were more than three times¹ as many seed rounds in Europe as there had been in 2012, and over four times as many Series A deals.
That is an exciting trend, but one that requires a market structure capable of absorbing the higher early-stage volume: supporting fledgling companies with their capital and operational needs after Series A. At the moment, it is hard to argue that this exists at the scale required. Series A deals are booming but follow-on rounds at Series B are not keeping pace: in the year to May 2021, just 86 UK companies raised a B round² compared to 250 at A. Even taking into account a natural drop-off as start-ups climb the funding ladder, that suggests a capacity problem. It is like trying to push higher and higher water pressure through the same old garden hose: wastage rises to an unjustifiable level.
This issue compounds what is already a challenging stage of development for start-ups. As any founder will tell you, the road to Series B is the toughest stage of execution for a young company. Before that point they can go a long way off the strength of a well-honed value proposition and early signs of commercial traction. It is a very different story at Series B, where investors start to discount vision and emphasise metrics, demanding evidence of robust product-market fit and a sustainable business model.
That is as it should be, with companies needing to demonstrate commercial maturity as they rise up the funding pyramid. The problem is not that Series B investors are rigorous, but a market that is badly structured to support such a high volume of companies to meet that challenge. While there is plentiful capital at the seed, A and B stages, many funds find their hands tied on extension rounds due to their structures, with capital constraints that can limit their ability to provide additional investment and a typically 10-year fund cycle that requires very tough decisions on which companies to support on the journey from A to B. The upshot is that funding is largely siloed at these milestone points, and companies must successfully navigate through the desert before they reach the next oasis. The evidence shows that they are increasingly finding it harder to get from one side to the other: whereas 16% of European start-ups seeded in 2009 and 2010 made it to Series B³, only 8% of the 2013 cohort could say the same.
A market organised in this way assumes that every company will progress in a straight line, pacing its evolution in neat 12–18 month increments that accord with the needs and expectations of investors. This has the unfortunate effect of imposing a linear template onto companies whose journey is invariably non-linear, as they work to iterate and optimise their business model, experimenting and correcting missteps along the way. The nature of an early-stage company is that it must take customers wherever it can find them. In many cases, it will only gradually refine its target market, learning over time how to reach the right customers efficiently and at scale.
A good example from our own portfolio is Brightpearl, the operating system for retailers working across digital and bricks-and-mortar storefronts. Its status as a UK success story was confirmed last year when it completed its acquisition by Sage for a cumulative $360m. But it was not an overnight success, having raised its Series A round back in 2011 and taken seven years to move from its B to C rounds. Among other changes, it took a significant pivot in the business, re-focusing on a specific cohort of high-growth retailers, to gain meaningful traction.
Brightpearl is a shining example of how patience can be such an important part of the venture journey, giving companies the time they need to find and exploit their sweet spot. Ultimately it prospered through lasering in on the right customer segment, with the support of a strategic investor that became its acquirer. Yet the funding market is poorly structured for start-ups that need to take the scenic route. Many will be running out of money just as they reach the point where they have arrived at a go-to-market strategy with real promise. They then find themselves caught between two stools: unable to raise all the extension funding they need from their Series A investors, limited as they are by capital constraints and fund cycles, and not yet ready to meet the criteria for investment by a Series B fund. With the exception of venture debt and its associated costs of capital, there are few alternatives. The risk is that a company runs out of road just as it is ready to take off.
That is the problem we are seeking to address at Volution, where we look to make the first institutional investment in a company after its Series A, at a point where such funding can make a meaningful difference in boosting the journey to B, alongside the operational expertise and support we offer. We believe that the demand for funding at this stage is only going to grow. Last year the median Series A round for a European start-up was $9.6m, more than three times what it was in 2011. Higher valuations at this stage mean that companies must work harder, and often longer, to grow into those expectations. The journey from A to B will increasingly be completed in multiple stages rather than a single leap. Yet the venture market structure has not evolved to reflect this, a situation that serves neither the companies nor their early investors, which in the UK market of the last decade includes a significant taxpayer component. It is an unfortunate truth that the current funding market will consign many of the current generation of early-stage companies to failure through impatience and inflexibility.
Our thesis is that there is collective benefit in helping more companies to complete the journey from A to B. Funds as well as founders will reap rewards from an environment in which more companies can make it to B and beyond: a company that raises a Series B round increases its chances³ of a successful exit by 46%. We want to provide capital where it is needed and to facilitate patience where it will make a difference.
Of course many venture-backed start-ups will fail, as is the nature of the business. But they should fail on their own terms, not because they have fallen through the cracks of a flawed funding market. Start-ups with huge potential should get the benefit of the doubt and a level playing field on which to stand or fall. They deserve better than to be forced to navigate what is a siloed and hidebound investment landscape. By investing between rounds, colouring outside the lines of the traditional venture market, we hope to play our role in shaping a fairer funding market that is more in tune with the complex realities of how start-ups grow, sometimes stumble and ultimately succeed.
Footnotes:
1: Dealroom.co, The Journey to Series A in Europe, April 2021
2: Globacap, The Series B Crunch, June 2021
3: Dealroom.co, August 2020
