The Seas of Non-Differentiation & Meh Are Treacherous

January 24, 2019

PUBLISHED BY Bruce Cleveland

SOURCE Wildcat Venture Partners

The road to startup nirvana is littered with companies that didn’t make it. Industry statistics show that at least 80% fail outright; it’s even higher for consumer-oriented products and applications. Each year we must reflect on the past and predict the future as we review investment opportunities presented by determined entrepreneurs. So, it’s that time again when we ask, “Will this year be a year of strong tailwinds or calamitous headwinds for startups?”

One of the many great things about our Wildcat partnership is that we are all successful entrepreneurs at heart who bring a lot of experience to the table. We have personally been founders, or members of a founding team, or very early-stage investors in startups that have gone on to become large and successful market-leading companies. We’ve also been through our share of up and down-market cycles.

So, moving into the new year, I’m laying out some of the trends my partners and I expect to see as 2019 heads out to open waters.

More capital, fewer companies.

One of the most impactful trends I expect will continue into 2019 is that venture capital firms putting more capital to work in fewer investments.

According to data compiled by the NVCA (National Venture Capitalist Association), total U.S. “venture” funding increased by 21 percent from 2014–2017. However, the total number of rounds decreased 22 percent. This trend, which continued unabated in 2018, is tangible evidence that private investors are doubling down on more certain, later-stage, lower-multiple investments.

Over the same period of time, venture firms that have been able to raise a fund have raised more capital per fund, and that capital must be put to work. This has led to an uptick in investors abandoning true early-stage investing in favor of putting more capital to work per investment.

As a result, it has become increasingly difficult for early-stage entrepreneurs to raise capital before they have achieved demonstrable “traction” — evidence of product/market fit, customer/consumer adoption, revenue, and a solidified business model. For those startups lucky enough to secure seed and Series A backing, those rounds tend to be significantly larger than they were five or more years ago and at much loftier valuations. And, while at first blush this may appear to be good news for startups in this cohort, if those entrepreneurs don’t quickly generate significant market adoption, they will find themselves highly overvalued when it comes time to raise the next round and it will be difficult, if not impossible, to raise additional rounds of capital without a significant restructuring of the cap table. This will be highly dilutive to the management team and write downs for their venture investors, and large potential losses for Limited Partners.

We don’t see this trend changing in 2019, and for startups that have yet to raise a round of venture capital, it may become even more challenging to find financial backers. You may have to rely upon alternative financing support from angel investors, family and friends, or crowdfunding for a long time.

Market-engineering is a must. 

Raising capital isn’t the only challenge ahead. As an entrepreneur challenged to build a sustainable, high-growth business, it is your job to create a well-positioned, highly differentiated offering that provides a compelling consumer or business benefit. This is even more crucial if the market shifts. Ask yourself, “Have we done the upfront “market-engineering” work to define or redefine a category and successfully position our company and our executive teams as thought leaders in our space?” If not, then you better do it now as it will be crucial to your fundraising efforts.

This is also not the year to build “me-too” products for fad markets that are unproven and quickly become crowded. A case in point is the crypto market. The brutal statistics show that at least 90 percent of these startups will fail outright or sell out to another company for pennies on the dollar along with years off the lives of the startup team. If your business is built on a copycat model, then stop now. Challenge yourself and your team to ask the tough questions and whether you are really offering a differentiated product.

The talent shortfall will continue even if unemployment numbers increase. 

That’s right, attracting talent is going to be a challenge this year — even if a downturn sets in. This may seem counter-intuitive; after all, if there’s a downturn, won’t more people be looking for jobs? The answer is not necessarily…in the world of startups. If we see even a hint of a downturn, I believe it may be harder for startups to acquire talent. Here’s why.

Younger workers remember the Great Recession and how it affected them and their families. Older workers remember this period as one of the most difficult in their careers.

During downturns, people seek the stability associated with incumbent companies that can offer steady employment, paychecks and benefits that pay for basics like housing, student loans and food. By contrast, startups face the real and constant threat of running out of capital and dissolution. Potential employees know that the larger tech companies may not be hiring during recessionary periods, and if the startup fails, they may not have as many employment options — possibly none at all. As a result, a downturn may make it easier for large, stable incumbents and harder for startups to attract talent.

Hiring aside, a downturn could be good for startups that demonstrate benefit. 

Again, it’s counter-intuitive, but downturns can be a positive for young companies. Those that hunker down and survive can emerge in an upturn bereft of competitors and able to scale quickly into a market leadership position. But what separates the survivors from those who fail?

Products and services tend to be recession-resistant and in high demand if they offer demonstrable benefit to consumers (saving time or money or improving quality of life) and businesses (generating more revenue, more cost effectively). Startups that have developed consumer or business technologies that are merely “nice to have” tend to suffer during economic downturns. Those whose offerings are considered a necessity will likely survive to see another cycle, though they may experience slower growth.

If we see a downturn, early-stage startups will need to be able to successfully demonstrate to their investors — through product usage rates, ongoing downloads and low churn rates — that their products are part of a “must have” cohort.

The digital transformation impacts everyone. 

A final expectation for the new year — and even beyond — is the continued impact of the global digital economy and digital transformation on the 21st century economy. Over the next few years, this will compel all companies to retool their infrastructure and processes to secure and increase the top and bottom lines. In the 21st century, the top and bottom lines begin with the product line. This year, my partners and I expect to see:

  • Product obsolescence happen faster
  • Competitive advantages disappear more rapidly
  • Cash cows gored in months, not years
  • Internal product innovation and delivery skills become imperative, not just “nice to have”

Products must be designed and delivered faster than ever before. This creates enormous opportunities for startups developing breakthrough consumer products that leverage digital transformation, such as autonomous vehicles and online education. The same is true for startups that enable digital transformation for existing companies via new technologies such as artificial intelligence (AI), machine learning, robotics and augmented/virtual reality (AR/VR). Startups that take advantage of this opportunity are likely to experience rapid growth and some of them will likely replace incumbents on the current Fortune 500 list — 50% of the companies that were on the list in 2000 are now gone largely due to digital transformation forces. For these startups leveraging digital transformation, this process is a significant tailwind. We expect to see an acceleration of investments in startups in these areas, particularly where unique applications have been developed. But if your startup doesn’t enable or leverage digital transformation, this should serve as a warning.