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Raising a Seed Round in 2020 in the UK (despite COVID-19)

According to Pitchbook, investment in European startups in 2020 kept the high pace shown in 2019.

In particular, it appears that corporations are driving the VC industry up, with an increase interest in backing and accessing “deep tech” companies in fields such as cybersecturity, IoT, AI and health-tech.

Is this the case, though?

To find out, I decided to pick the brain and first hand experience of our friend Hussein Kanji from Hoxton Ventures, who’s been hitting the VC headlines since out of the UK companies he invested in recently, three have already hit the coveted “unicorn” status.

On July 29th, in occasion of our “COVID-Proof Deep Tech Startup” virtual meetup, I hosted a guest chat with Hussein to talk about the Venture Capital scene in the UK and Europe. Not just in terms of overall money invested overall, but specifically when it comes to high-tech seed-stage teams raising capital during covid as well as now and in the near future.

Hussein begun by sharing his view on the market dynamics in the tech stages he focuses on (seed and series A), before moving to a more Q&A style session. At that point, startup entrepreneurs attending the webinar got a chance to join the chat by enquiring about what makes a startup investible for a VC and what he currently sees going on in the ecosystem.

VC When Covid Hit

Hussein: Most of the venture community in the early days of this covid situation, in early March or maybe even late March, was largely taking stock of what was going on in their in their own portfolio and spending quite a bit of resources to figure out how much triage they might need to do inside of their own portfolio companies. I think by the time April rolled around, everyone was loosely done with that. Which was a good thing, as it allowed new investments to restart. We’re now continuing to see people actively invest.

I think there’s a bit of a flight to quality in the industry, but if you’re a really interesting company [the opportunity to get funding] actually hasn’t really come down in any kind of way. It’s it’s actually quite competitive on the venture side to get into those companies. Prices are a bit up and this is partially because if you look at the public markets, their performance has also been quite strong. They have been much more resilient than they were in previous crises – that is, both the financial crisis as well as the dot com bubble crisis.

This time around the public have kind of held their value, which means that the venture community, which has raised quite a bit of money over the last few years, really had to “get to work” and show returns. So the the most interesting companies are continuing to to raise money and we haven’t seen any difference in those interest levels or in the interesting company bucket at seed stage as well as the later stages. So, across the board you’re starting to see deals get done [after the “pause” seen in March and some of April].

American VCs: maybe less US capital coming in… Or maybe not.

Hussein: One thing that we might be seeing a little bit more of in Europe is that the American funds, which were typically coming over and doing the Series B type rounds are going to be doing less of those going forwards.

This is because it’s much harder for them to travel in and and do their due diligence, but that said we still know of US people doing deals on this side [of the Atlantic].

Sequoia has announced that they’re setting up shop in London and that’s going ahead. They’ve just hired their second person on that team, which isn’t as well known. There’s a handful of venture funds out in the Bay Area that are planning on opening up offices in London and some of them are
relocating already as of September.

So, after the initial “panic”, nothing has really changed?

Hussein: I would say that, overall, I don’t think things have actually changed all that much between the “before the pandemic”, then the “into the pandemic”, and now kind of “slightly post pandemic”. At least as long as the r-rate of covid comes down, investors are open for business. With the caveat that everything is now taking place virtually: I don’t hear about meetings being done in a person-to-person setting.

Startup assessment: during and post covid

Francesco: When you’re assessing company – and this is really a double question – do you see any difference between now and the before-covid? In particular, when it comes to deciding to do an investment, have you done anything differently now, because of the covid situation? And, going forward, do you see a lasting impact in the long and medium term about the factors you keep into account before you decide to invest in a company?  

Hussein: Yeah, I mean, I think that the biggest change that we’ve made is that we want to make sure that all of our companies (despite what i just said about how good the fundraising market might be for the best in class companies) had enough cash in the balance sheet to get through all of 2020 and as much if not all of 2021.

I think, historically, there was a time when people were okay with fundraising cycles kind of being like 8 to 12 months. A lot of us VC investors are now focused on a 18 to 24 months cycle and none of us really knows what the what the scope of the pandemic is going to be. Is there going to be a wave 2? If so, how severe is the wave 2 going to be? So you really want to be able to get through all of this period as much as possible without
draining your cash reserves.

All of us are asking those questions. Can this startup really make it for 18-24 months without new cash injections?

What about the Startup pitching and DD?

Hussein: Other than that, there was of course a change in the process. In our case, at Hoxton Ventures, we’ve done seven deals from the beginning of the year. Three of those were initiated pre-covered, so we had quite a bit of quality time with the team, even as we did the deals into lockdown; but then four of them we’ve done entirely in a virtual setting.

I think in a virtual setting you just have to figure out how to be able to do them. You spend a lot of time on Whatsapp. We’re doing more referencing than we were used to before and the cadence is a little bit different because it’s all Zoom or Google Meet meetings. But in terms of the actual job, I don’t think that much has actually changed, apart from the fact that we want companies to have more runway.

Grants can help extending the runway but a VC would not factor that in

Francesco: One of the startup founders watching us is asking: Does your appetite for making an investment change, in case of the startup showing to be on track towards claiming an R&D tax relief or grant?

Hussein: Does that make an impact if you can claim Government cash? I mean, not really, although it can’t hurt. For example, a couple of the businesses that we’ve invested in have done very well in terms of getting R&D tax credits and then not just tax credits but also Innovate UK grants, which is great because they extended out their runway.

When we invest, though, we do so with the expectation that companies are not going to get the grants. Then, of course, if the grants do come in, they have even more months of time on their side, so it’s certainly helpful. One of our portfolio companies in Germany, for example, is really good at writing these research grant proposals and they’ve gotten something over a million in research grants alongside their equity. So, they’ve extended their life almost by a year because they’re still a very early stage company. That’s a huge plus, but I would say that it largely doesn’t factor in when we make a decision to invest. It’s a benefit, so it’s nice to have, but not necessarily a must-have, because we’re writing the cheques anyway: we’re assuming that the Governments aren’t really going to write the cheques, but if the Governments do write the cheques, that that’s just extra upside.

The case for Hardware Startups 

Francesco: Another one from our founders: Can you talk about Hoxton’s current attitude towards early stage hardware? How does this ‘being cautious’ about runway and cash come into play with hardware or hard-tech solutions? Because normally hardware companies struggle especially with monetisation at the very beginning and then maybe they have a bigger explosion later on. What is your opinion on this?

Hussein: We’ve done a couple of hardware companies. I wouldn’t say we’re the hardware go-to-investor, since there are other funds like the Hardware Club that are very focused on hardware as an investment strategy. For us it’s a question of this: Can you can you build a big enough “defensive mode” around the hardware, as the hardware gets commoditised over time?

Our view is that, if you want to build hard-tech, you want to be able to build a “defensive mode” around it.

The second thing is: how much money does it take to to be able to build a piece of hardware and how much time does it take? The longer it takes, the more money it takes, the less suited it is for an early stage venture fund that can’t write a huge cheque. Because you will need a bigger cheque to be able to get into market. Also, how long and how difficult is it to sell the hardware onto onto people? Again, if it’s a very long sales cycle then it’s it’s much tougher.

We’ve actually done a hardware robotics company for food. The startup is building a robot that makes food and they went off to raise a £7m round, so it was very well capitalized from day one. We’ve done another hardware one in real estate, which is a company making a camera, which by itself is a very cheap piece of hardware, that we sell as a software subscription or as a subscription package to real estate agents who use it to build their floor plans and do their photos. They’re accelerating growth and they’re doing really well. Then, we’ve done a hardware company in the construction industry that’s also doing really well. They are building a safety helmet and using augmented reality on a construction site and they raised a £4m round. See, in both the hardware intensive cases, the construction company as well as the food robotics one, the startups raised a very large seed rounds by normal standards for that reason.

“Exotic” Hard-Tech startups: which VCs to go to?

Francesco: How do you think founders find the best VC that’s fit for their sectors? Especially if they’re very specific and, say, non-traditional SaaS B2B that, as you know, pretty much everyone invests in.

Hussein: You’re right, if it’s in the traditional SaaS business you kind of know who the really good firms are. Reputation kind of carries a little bit longer.

If it’s in a more exotic field then it’s a little bit tougher.

I think you want to find other companies that are similar enough to you, which may not be competitors and which may not be doing exactly the same thing, but which they’re loosely in the same field. There’s some amount of camaraderie in this industry, so if you find out whom they raise money from and you reference the venture firms the same way a venture fund does references on founders, you should figure out who it is that you want to talk to.

Don’t build a “better mousetrap”: Create your own market category.

Francesco: Great, then another question from our startups: what are you specifically looking for when you’re investing in companies? And, did that change in some ways, in terms of market or business model, because of coivd?

Hussein: It really is kind of the same for all of us in VC. We’re looking for businesses that we think can scale and our world is largely looking for new market categories, where the company is going to win their market category. And it has to be a category that will carry over internationally, to the US market, for example, versus just the European market. I like startups that can win in the US too.

The one thing that we at Hoxton in particular don’t tend to do, putting aside sector, stage, etcetera, is investing in “better mousetrap businesses”. What I mean by that is that we don’t tend to invest in companies that are doing something that’s just a better version of what might actually exist today. We we really do look for brand new types of businesses that couldn’t have been created before. So, you know, the challenge with covid is how do you sell? I mean, it’s fairly easy to know how to build a product during covid, because people will go virtual and still be pretty productive. Developers are actually very good at being removed from the office, as long as they have a good setup at home. Hardware starts out a little bit tougher in that sense, but the real question is: How do you get your sales engine working in an entirely virtual world?

That’s the one thing that we focus on when we’re talking to companies these days.

The VC Referencing Process

Francesco: Another founder is asking: how do VCs go about doing referencing?

Hussein: They call they call people around the founder. They call former employees, they call former bosses, they call people whom the founders are suggesting they talk to, other investors who might have invested in the founder, so they do kind of the on-the-list and off-the-list reference. It’s no different than if you’re hiring someone. You’d probably call their former boss, but you might also call some colleagues whom that person has worked with. Ultimately you are trying and get some some intel as to how good or strong the person is.

It’s the same exact thing and on our side.

Europe and its VC scene is definitely becoming attractive: even by US standards

Francesco: Another question, this one focuses on what you mentioned before. So, you mentioned before that US investors’ behaviour might have
changed a little due to covid. This entrepreneur is now asking: why do you think there is increased interest from Bay Area investors in the UK market? What changed in the last few years to justify setting off their new offices in London?

Hussein: The simple answer is that there’s a lot more stuff happening on this side of the pond that’s interesting and that can generate venture returns. I think that if you talked to a lot of people about 10-15 years ago, they would have said Europe really doesn’t produce anything in the way of scalable tech companies. I think people now understand that that’s not true anymore. The fact that Spotify is valued at over $50 billion, the fact that Adyen is kind of the market leader in payment processing type businesses, the fact that Spotify is a leader in music streaming, it all proves that there’s a bunch of companies that have come out of Europe, like Tranferwise, Revolut, etcetera. People in the Bay Area pay attention to that.

Also prices here are still lower than they are in the US and, even more importantly than prices, employee retention is much higher. Because one of the struggles in the Bay is that, if you build a good team, then Google comes and knocks on your employees’ door and tries to take them away from you. Facebook does the same thing. It’s just so competitive to retain talent out in the Bay Area and that’s not true in London. Also salaries are lower than they are in the Bay Area, so it it makes your dollars go much further and is much more likely that you can actually get to the next stage. So, the people in the Bay Area have noticed it and they spend cycles now coming out here and taking a look at these companies.

Francesco: Just to be mindful of time here, I’ll put you another couple of questions I see here, before I’m gonna close off the the Q&A’s. First, though, let me ask you a bit of a tricky one. As you know, we raising a VC fund ourselves here at Silicon Roundabout and because of that we’re doing a lot of deep diving into the data around the VC market. We’ve noticed something peculiar and I wanted to hear your opinion on that: US and European VCs, if you look at the mid-range and the low-end of the returns distribution, have pretty much the same average returns. Their profiles “match”, so to speak. US VCs in the top quartile, though, tend to go much higher on returns. Do you think there is any reason around that? And, if so, what is the outlook looking like for Europe now that new funds are coming to the market? With Hoxton for example, I know you guys have just raised your second fund and many more brands are also emerging, just like our new fund. So, do you think now things will change?

Hussein: Yeah, I mean, venture is one of these things where you don’t want to look at average returns. You really want to look at the top quartile returns because the returns curve is not like a bell curve and it’s not a normal distribution: it’s a power law distribution. So, the nature of a power law is that it clusters over to the left-hand side of the graph and then everything else looks a lot smaller, and if you look at what drives those returns, you’ll find that it’s a small handful of companies that turn out to be the really, really large outliers in the tech industry. These generate most of the wealth in the industry and if you’re a shareholder in one of those companies, your fund tends to do really well and it ends up in that top quartile bucket. Whilst, if you’re not a shareholder in one of those companies, you tend to follow into the other three quartiles, which are not as interesting to look at because of the nature of the power law.

If you look at the outcomes in in the US, you’ll see that the US is capable of producing hundred billion dollar type companies. It doesn’t happen very often but it happens. If you look at Europe, Europe largely produces billion dollar companies, not even 10 billion dollar companies, and so if you’re a shareholder of a really great European company, up until very very very recently, your your exit or the size of your return would just be that much smaller than the size of the really good venture fund in the US.

One of the things that was kind of conventional wisdom in the US, and it was true about again 15 years ago, was that if you invested with the top 10 venture funds in the US there was no point in really having venture fund number 11 or venture fund number 20. That top 10 guys or girls captured all the returns in the industry by being inside of all the interesting companies. And you really didn’t need any more of an asset allocation strategy than those top 10 names.

What’s happened now is that a lot of the younger people in those top 10 firms have gotten frustrated and left and formed their own funds. So now, all of a sudden, they perform at the same level as their old funds and the dispersion it’s gotten much wider. Then there are a bunch of angel investors, who are very good investors and who professionalised and became venture investors: they also got access to the top of those leading companies that drive returns, so now it’s not a given that the top 10 return the top 10 firms captures all the returns in the industry. There’s a much wider base of people who are capturing the returns.

The same thing is slowly happening in Europe as well.

There’s still a conventional thinking in the LP (“Limited Partner”, aka someone who invests in VC firms) community in Europe, though, that if you’re in Index and you’re in Accel, then you get all the returns from Europe. The thinking goes that there’s no point in being in any other fund, because those two get all the good names. Maybe they missed the occasional name but the vast majority of names would end up in their portfolios. Now, there is evidence to believe that: for example, Deliveroo is an Index and Accel portfolio company. UiPath is an Accel company. Index has been in a lot of great companies, so is Accel and unicorn ownership is not as well distributed in Europe outside of those funds. Even if they come in a little bit later stage, they still capture a lot of the upside in in that return if it turns out to be a mega type outcome.

So you don’t necessarily need the incremental seed fund, unless that seed fund is investing in a bunch of stuff that nobody else is investing in and generating that kind of wealth.

Francesco: I think you’re spot on there: if you are a VC and you want to capture value outside of the big names, you need to focus on outsmarting them at Seed stage.

Do investors ever turn away from a market completely?

Francesco: Now, let’s try to put the last two questions from the audience I had promised: one minute per question.

How ugly can a market be before you lose interest? I guess that one came when we’re talking about covid, so I would assume that it is about sectors and verticals: how ugly does it have to be for you to lose interest with the market in general?

Hussein: I would say that, in general, if a bunch of people have historically been losing money in a given space, most venture investors will kind of avoid it. They’ll internalise the old lesson and and project out that the old lesson is applicable for the new scenario and then just walk away.

There’s always exceptions to the rule but sometimes there are structural reasons why an industry isn’t really going to take off. For example, if you look at virtual reality, virtual reality has been talked about since like the mid 90s and nobody’s really built an interesting business-wise.

Some of the things like Oculus and Magic Leap are trying to be the exceptions to the rule, but it’s kind of always reverting back to the mean, which is that consumers just don’t care and these these products are still very very raw when it comes to the consumer behaviour perspective.

Adapting to Covid: does it mean cutting costs?

Francesco: Could not agree more. Now, last question: would you say that a seed-stage company could take advantage of the current pandemic in terms of lowering costs of operation? Should a company respond to the pandemic in terms of lowering their costs, for example by hiring remotely and cut office costs?

Hussein: I think a lot of people did try to figure out how to stretch cash. They were trying to figure out how to rationalise costs. I mean the easiest cost to get rid of was the travel and entertainment cost. That’s in the budget because you’re not going to travel and there’s not that much entertainment to do now.

I would argue that focusing on the cost side of the equation is probably less interesting than focusing on the revenue side. Right you you really want to be able to scale the business up. If you’re not scaling the business up, then you have to go figure out how to rationalize the costs; and if are scaling up but revenue is going to lag because of covid, then you definitely want to rationalise costs. Because you don’t want to run out of cash and go back to the investor community prematurely.

But for most of businesses that are scaling, you really want to focus on revenue and then figure out what investments you need to make in order to drive that revenue. There are a bunch of our businesses that are actually scaling exponentially despite covid. So it it’s not like, just because of covid, all of the business is kind of shut down in the world. There is still quite a bit of business to do.

Francesco: Thank you so much Hussein for your time today and see you again on on a Silicon Roundabout event soon.

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