VC funding – not a silver bullet
Tech Nation’s ‘The future UK tech built’ 2021 report, published earlier this year, revealed that the UK currently sits third in the world for venture capital (VC) investment in tech companies, behind only China and the US, with $15bn pledged last year. Great news for the UK’s emerging businesses, right? Well, Simon Philips, CEO of ScaleUp Capital, tells a different story.
Fundamentally, the issue is that VC funding is not right for most early-stage tech companies which are not hyper-growth. Only a tiny percentage of VC-backed startups make it – four percent are sold for more than $50m, one percent make it to ‘unicorn’ status, but seven in ten fail.
There are lots of great businesses out there with revenues of up to £20m and good (if not explosive) growth. Yet in many cases they are simply not given the time of day by investors because they don’t fit the VC or private equity (PE) model.
ScaleUp Capital have spent the last 10-15 years as a specialist scaleup investor in the digital sector, funding and supporting companies with revenues between £1-10m. “These companies are post the initial startup phase,” Simon commented. “They have a foot hold, clients, revenue, a product-market fit, etc, but they have a long way to go before they scaleup to critical mass and achieve what I call ‘escape velocity’. That scaleup phase is important, but hugely difficult, and it’s where a lot of companies come unstuck.”
The UK is third in the world for the number of startups, but 13th for scaleups, meaning the UK has a very poor conversion rate of taking startups to the next level. While there are myriad worthwhile businesses in the scaleup phase, many are stuck in a funding gap (where there are very few suitable investors around), and also a skills gap (where they struggle with handling the complexity of scaling their business).
Mind the gaps
Life for a scaleup CEO means working hard to grow the business quickly and winning customers as part of day-to-day business operations, while at the same time, the business is going through more change than at any other time in its life so far. “These are the adolescent years of a business,” Simon added. “Founders shift from pulling all the strings to a full management team that are running the business in a professional way. As a founder you’re trying to grow up and grow at the same time, so it’s a really difficult phase. Most of these businesses are not yet profitable so they need funding to give them the muscle to get through this phase.”
As well as funds, most businesses going through the scaleup phase are also hit with a skills crisis, as it’s a phase that is unfamiliar to most founders. According to Crunchbase, it’s uncharted territory, and 80% of founders are debutants trying to build a business for the first time.
Simon continued: “A lot of founders are subject matter experts (an ex-teacher for an edtech startup, an ex-doctor for a healthcare startup etc). So, it’s people that know their product, customer and market, but they have not yet been anywhere near the challenges of scaling a business. And doing that is a science, a method, and a process – there’s lots of things you can get wrong, so there is a huge skills gap within an awful lot of these scaleups.”
This double-pronged gap of funding and skills is the reason why many scaleups stumble and plateau, don’t make it through the scaleup phase, stay as a lifestyle business, or worse, fizzle out altogether. This is of course a tremendous waste, not only from the point of view of the businesses themselves, but for the investment community, as many of these scaleups are really worthwhile entities, and with help and money, they could get to be worth £50m to £100m, and some could even kick on well beyond that towards unicorn status. “It’s a missed opportunity for the country as a whole, because we’re missing out on so much job creation, prosperity and innovation by not helping these companies,” Simon added. “And if we could go from 13th to third in the table in terms of the number of scaleups, the resultant impact on the economy would be huge.”
The problem with VC and PE
The funding gap exists primarily because PE investors are on the hunt for profitable, mature businesses (even at the lower end of the PE model), with complete and established management teams. Scaleups are at a stage where they simply don’t have that in place, and as such, are not even looked at by PE investors.
When it comes to VCs, while there are more in the scaleup arena, they all operate on the same, ‘hits’ model. With each fund VCs will invest in 20-30 companies, each a genuine ‘moonshot’ candidate - hyper growth companies (around 100% per annum, and often a lot more), that are inherently disruptive and have potential at the point of investment, to get to the moon, i.e. unicorn status. “It’s a great model which works for the VCs, and it’s great to produce unicorns. However, it’s based on finding companies that meet their criteria, and that means hyper-growth, highly disruptive, change the world type models, that are extremely ambitious with visionary type CEOs,” Simon said.
If a scaleup ticks those boxes, then they will generate a lot of VC interest. However, in reality that only applies to around one in 100 companies. Most scaleups are sensible businesses growing at anything from 10-70% per annum – the vast majority are not moonshots, and the few that are will be looking at a timeframe of around 20 years to get there (not the five to ten that a VC will be aiming for). Therefore, most scaleups won’t even get through the door of almost all VCs, and the wall of money that exists within VC and PE investment, which is getting bigger all the time, is simply not accessible to scaleups.
For ScaleUp Capital it presents a huge opportunity and when speaking about the benefits available to scaleup companies Simon added: “You can see a scaleup investor because they provide more than money, they will have an accelerator or scaleup programme, and it’s that programme that provides the skills and the money to plug the funding and skills gap.
“If you offer both as a package then you give a scaleup everything it needs, and you will get a great outcome. And we’ve proven that. We have a 6x return on all the money we’ve ever invested, and the average growth rate of businesses we invest in is 35% per annum (during the time that we are invested), which is an acceleration on their prior growth and more than the average for scaleups.”
Simon explained that the way ScaleUp Capital has developed its methodology enables them to see it working on the ground. They deploy a very structured programme with five work streams, in multiple stages, which are rich in process, best practice, benchmarks and training materials in areas such as how to build an inside sales team, how to optimise a lead generation engine, and how to upgrade a product platform. “We provide a team of consultants and experts who will engage with the business, help them roll-out the programme and give them everything they need to successfully go through scaleup transition.”
How it works
ScaleUp Capital’s programme is a step-by-step process broken down into five different work streams, one of which is product market fit. One of the common issues with scaleups is that they try to do too many different things, instead of lasering in on a sweet spot where they’ve got the most compelling offer, product or platform with the biggest market opportunity and focus.
Another stream deals with customer acquisition - addressing lead generation and conversion, different routes to market (self-service, e-commerce, inside sales, field sales, partnerships channels etc). It also looks at putting in place the right processes and governance and hiring the right people.
The customer lifetime value stream is all about retention rates, average order value, upselling etc. There is a general stream around talent and people - filling out the C-suite and understanding the management team, the gaps that exist within that team, and then how to fill them.
A typical suite C-suite might have six or seven key people. At the stage where Scaleup Capital would invest, a company would typically only have one or two of those roles filled. “Our talent team are made up of ex-head-hunters, and they will work with the business to map out what is required, design the job specs, and then run the actual recruitment process,” Simon added.
“We are very careful to make sure that the management team are always accountable for everything and are the ones driving things – our role is as a very good support act. We are providing the framework, the tools, and the people to help scaleups get things done quicker and easier. We provide a project manager, strategist, talent expert, finance expert, and that team engages with the business, creating a joint team to roll-out the programme, and they will address all these key points about what the business needs to do.”
A key feature of the programme is the Knowledge Centre which is full of checklists, templates, training materials and processes which relate to scaling a business. “We don’t force it on them but it’s there to be used,” Simon continued. “For example, if they need to build an inside sales teams, we know that process inside out.”
“Most founders have never done it, so they wouldn’t know where to start, and they may fail as a result. However, we can provide exactly the right structure of how it should work, the job specs for every single role in that team, the types of data, how you go about hiring, how you incentivise and pay them, how you manage them – it’s all there in our knowledge centre.”
“There’s a tonne of science behind it, and it’s a good example of where we can bring all that expertise to bear for a business that probably has never done that before. And these things make all the difference between a business failing or scaling up and succeeding.”
Paying the price
The processes involved in scaling a business are absolutely vital and if there are any missed steps or missed hires for key roles, then a business can lose two years, and that could be enough to take all the wind out of the sails of a scaleup – and once momentum and growth stops, a scaleup may well throw in the towel. “Those hires are really important,” added Simon. “Making sure the people you hire have the right skills, are hungry, aligned with you, and are trustworthy, is tough, but we will help to make sure they do that right. Because if you get that wrong, it’s problematic, and the number of times we’ve seen it happen is telling.”
Another problem is that most scaleups are completely unaware of what VCs are really looking for. They see this wall of money and assume that it is going to be available to them if they need it. However, if a business has £5m revenue, growing 30% per annum, but is not yet profitable, it won’t be able to raise money from VCs - and that’s the bulk of companies.
“I’m actually a big fan of the VC model, and it does work for them,” said Simon. “The best VCs can deliver exceptional returns, and they provide a lot of money for hyper-growth businesses. And as we can see, there’s an increasing number of moon landings (unicorns) – we’ve seen extraordinary stories of companies getting a lot of momentum quickly, and that is partly because they’ve been able to raise lots of money from the VC community.
“However, the downside is that there’s quite a lot of collateral damage. To make that ‘hits’ model work, you’ve got to land a couple of companies on the moon. Therefore, the VCs will be very closely monitoring the performance of all the 30 or so companies they’ve invested in. If they stay on that moon trajectory, they’ll continue to support them with money, time and effort, but as soon as they veer off course, they get put into an unloved category, where no more money or time is available.”
While some of those companies that fall short of the moon will be high risk, and ultimately flawed experiments, there will be another batch that will be really worthwhile that, while unlikely to become unicorns, could still grow to be worth £50 to £100m. However, these companies will fail to get much love, attention or money from VCs because they will be concentrating on the one or two that they can land on the moon.
Simon added that entrepreneurs who do raise VC funds on a big valuation are, understandably, incredibly excited at the prospect. However, two years later when the dream hasn’t quite become a reality and the VC has lost interest, the entrepreneur can be left completely burnt out. They will have been pushed as hard as possible by the VC (as that is the only way in reality that a company will reach the moon), but the ones that don’t make it will have spent all their money, worked incredibly hard without making it, and will have lost all affection for their VC.
“They’re damaged goods,” added Simon. “It’s the collateral damage to this VC model. A lot of those businesses would have been better off targeting a lower orbit from day one (rather than shooting for the moon), and doing it sensibly, patiently, and with a different sort of investor.
“And you can see why they get caught up - they are sold a dream by the VC, that they’re going to be a unicorn in four years. They get trapped by that, and they’ve got to deliver on it. You can’t turn around the next day, thank them for their £20m, and decide not to shoot for the moon, but instead try to build a nice sensible business.”
So, there are some issues with the VC model that cause this loss of opportunity, lack of alignment, potential burnout and collateral damage as a by-product. There is plenty of support for startup companies in the UK, which has a buoyant Angel community, Government and bank schemes, and as an enterprising nation, there were still a plethora of companies starting up, even during the COVID-19 crisis.
However, it’s the next phase of a business’ development where issues currently arise. The UK is only 13th in the world when it comes to scaleups, so there is something going wrong. While the Government have recognised the issue and are beginning to implement solutions, Simon added that there could be more help to grow schemes, financial support to individuals, and employer training programmes to help close the skills gap and subsidise the training of founders and management teams - all the things you need to scale a business.
On the funding gap, the investment industry needs to respond. Simon added: “The Government will do their bit through their Future Funds, but that’s always going to be limited. So I think it’s the investment industry that needs to step up and really help create more entities like us, who operate in that space, and are prepared to put in the heavy lifting - because there’s a lot more work that needs to be done at the stage we operate in.
“As an example, if we had a £300m fund, we’d probably have 50 people who would engage with the portfolio companies within the scaleup programme. A normal VC or PE with a £300m fund would have around ten people. So it’s a much more people intensive model, so it’s harder work than traditional PEs or VCs, which is probably why there aren’t that many in the space.
“I’d like there to be more companies like us. We can only do a certain number of investments and we see so many companies that we’d like to invest in, but we turn away because we’ve run out of capacity. And that’s a shame. Our business model is more like running a platform business, and less like coming in as a traditional investor. So I’m not sure many of the traditional funds would come into this space, so I suspect it’s going to be more companies like us that set up as specialists from day one.
“I’m hoping the investment industry will respond and there’ll be more companies who recognise that they could turn out some really good returns, and hopefully we can lead the way.”