Seed Funds Need Fertile Soil: Sourcing High Quality Venture Opportunities – August 2018

As analysts in the venture capital space, our team at MJ Hudson Allenbridge have conversations every week about different venture funds’ investment criteria, as managers and investors look to identify promising entrepreneurs and profitable ideas. So too, when outside the office, our team is often greeted with a startup idea, or is told about a new venture that someone has just embarked upon, often with the expectation of some words of wisdom or titbit of advice.

Probably the most shared piece of advice for young entrepreneurs looking to start their own business, which also could serve as a basic filter for investors taking a first look at an idea, might well have been given by Paul Graham, the famous American entrepreneur who started the renowned Silicon Valley startup accelerator “Y Combinator”. In his essay “How to Start a Startup”, Graham argues that, deep down, a start-up only really needs three ingredients: “to start with good people, to make something customers actually want, and to spend as little money as possible”.

This disarmingly simple formula is undoubtedly wise advice for a budding entrepreneur, but when turned and looked at from another angle, could probably serve as a neat starting point for a new fund, looking for the next British Facebook or Tesla. The question for managers (rather than the entrepreneur) becomes how should one most efficiently look for those startups with the best combination of leading talent, innovative ideas, and lowest cost base to really thrive?

Some managers tout their links into the startup scene in London. London, of course, boasts the cosmopolitan outlook and cultural buzz to constitute what the urban sociologist Richard Florida called “a creative class” which he argued would drive the prospects of cities in the post-industrial economy. For the budding company founder it is close to pools of potential investment, has access to an ecosystem of tech-sponsored accelerators and incubators, and team members are likely to want to live and work in the nation’s capital. However, London has a real estate market and business taxes that can be punishing for early-stage businesses which need to be conscious of costs, and which often prefer short-term profits to longer-term thinking. Meanwhile young people are increasingly put off by London’s eye-wateringly high rents.

While new ventures can often bootstrap from coffee shops, and the rise of co-working spaces like WeWork might help provide more affordable rents for young companies, the prevalence of so many investors and funds also makes London more capital-saturated than less-heralded areas of the country. There may be more university graduates moving to London from the regions every week, changing the economy and politics of both, but there are also more venture capital firms and investors competing for the best startups, often pushing up company valuations. Presence outside of London and a brand name that is known in Britain’s regions, therefore, has become a regular selling point for venture managers headquartered outside of London and the Southeast, keen to make the argument that they have dealflow that desk-bound Londonistas can’t even know that they are missing out on.

However, with the proviso that one cannot open an office in every city in the UK, how should one choose where to plant the flag for a venture fund, maximising dealflow and beating the competition?

The first distinction to make is that whether a fund is a seed or very early-stage investor or, instead, a growth or scale-up vehicle makes a telling difference to how a manager should seek to burnish their company’s brand. The American Venture investor Ali Hamed put it memorably that “seed investing is a B2C [business-to-consumer] business, while growth-stage investing is business-to-business”.

Hamed’s argument is that a seed investor should aim to be one of the top 3-5 funds that a young entrepreneur might be able to name off the top of their head when looking for that first funding, whereas growth or scale-up investors are likely to rely more on a network of intermediaries: local accountants, businesspeople, earlier-stage investors, or other local contacts. If a seed investor is bragging of regional offices, alarm bells should ring. Instead of bricks and mortar, the earliest-stage investors should be investing their time and reach through more efficient B2C channels like blogs, Youtube webinars, giving talks, and getting in the media.

However, if a growth manager does have a regional office that in itself does not signal proof of a wider network of those contacts and intermediaries that could help secure future potential dealflow: an office with three admin staff is not the same as having investment professionals who are plugged into local networks of business professionals and entrepreneurs. The quantity of connections which radiates out of that office matters more than simply having an address to help make for a better talking point about “regional presence”.

Equally the quality of that network, as well as how thick it is, is a clear indicator of how many opportunities are likely to flow to a manager; and, just as London has both a large number of startups and a large number of investors, a quality of a network has to be seen both in terms of how many startups are likely to be part of that network’s ecosystem but also how much competition there is likely to be for those opportunities. A growing body of research has started to look at innovation in rural settings (particularly for manufacturing), which might be both costlier to locate but also potentially more profitable if there is a mismatch of high demand for investment and a much smaller number of funders willing to engage regularly with management once a cheque is written, or even engage with the opportunity in the first place.

In a recent study looking at whether there were new hubs of innovation emerging outside of the usual hunting grounds of American venture capital, researchers found that “established tech hubs continue to lead, but startup hubs are emerging in new, smaller places”, mainly college towns where there are also “place-based assets” such as a rich cultural scene and affordable housing. So too have smaller hubs of innovation emerged in the U.K. outside of London but close to universities and a vibrant student-led cultural scene: fintech, for example, has started clustering in Leeds, and software is increasingly associated with Bristol, for example. However predicting which hub might emerge next requires a keen nose for trends in affordable housing, the cultural underground, and universities’ growth potential in areas ripe for commercialisation; a hard challenge for anyone. Getting it wrong and installing investment professionals in an office which yields little in the way of meaningful dealflow can prove to be a costly mistake.

Complicating matters still further, finding a network of introducers who refer great entrepreneurs to a manager is only half the challenge: any entrepreneur who does not also reach out to other VCs in order to find value and drive a hard bargain is also probably not an entrepreneur worth investing in. A truly great CEO of a small company is also likely to be able to find a way to not just contact other venture firms, but also find a way to get a “warm introduction” to them, making sure that they get the most possible consideration and nurturing more funding options. A great network does not guarantee deals, it guarantees consideration. Once on a shortlist or in a beauty parade, a manager still needs to win the deal by either competing on valuation or value-add.

Finally, venture investing is a competitive sport: if someone has an advantage, it should be expected that a rival will likely try and copy it. An old story has it that, after spending months and millions on trying to beat McDonalds to prime locations and failing, the management at Burger King did the next best thing: wherever they saw a McDonalds opening, they opened a Burger King across the street. So too dealflow from a particular city or source that seems to yield great returns to one manager is likely to see other managers try and encroach on their turf and get a piece of the action. Advantages rarely last.

So how should researchers like those of us at MJ Hudson evaluate claims to “regional footprints”, the opening of new offices, or geographically diverse angel investor networks? The only way is to look behind the claims and evaluate the quantity and quality of dealflow itself and look for real barriers to entry for other managers accessing the same. The hunt for the British Apple or Uber is unceasing, and managers will and should always be looking to find pockets of value unavailable to their peers, but the proof that claims hold up should only ever be evaluated in cold numbers.