Archive for the ‘fundraising’ Category

The Unfamiliar State of Funding a Startup

March 8, 2012

I work with a lot of startup companies, and am currently involved with three that share the same characteristics: pre-product, pre-revenue, and at the very beginning of fundraising. And I’m having the same conversation with all three. It goes like this:

  1. The cost of getting a company to scale and even to profitability has dropped dramatically in the past ten years.
  2. The nature of venture capital has shifted from an early stage focus to late stage or even growth equity investing.
  3. Angels and experienced high net worth folks have stepped in to fill the role VCs served for early stage investing.
  4. A viable fundraising strategy can default to a path that doesn’t assume VCs participate at all, or perhaps only towards the end.

Let me expand on each of these points.

COST OF GETTING TO SCALE – THE RISE OF THE MACHINES

There are a lot of factors at work here, to the benefit of entrepreneurs. The rise in cloud computing means that fixed infrastructure expense has largely been eliminated from the business plan, and this will only get better (Amazon just announced it’s 19th price decrease in six years). Virtual teams + Google Docs drive OPEX down even further unburdening you from lease costs.

The shift to “inbound marketing” – social media, blogs, SEO, viral – can drive large volumes of traffic at significantly lower costs (60% less or more) than traditional “outbound methods – and at higher conversion and retention rates. It takes a lot less of your marketing budget to reach and acquire users. With the shift to freemium and subscription business models you can also let your most active users decide for themselves to pay for your services through in-app messaging and offers – significantly reducing the cost of sales.

I call this the “Rise of the Machines” because metrics and machine-driven resources/methods do much of the heavy lifting at a fraction of the cost of human-intensive alternatives. Josh Kopleman surveyed his portfolio and found “…that companies today are 3 times more likely to get to $250K in revenue during an eighteen month period than they were six years ago. ”

VENTURE CAPITAL IS DEAD – LONG LIVE VENTURE CAPITAL

The money that VCs invest comes from “institutional investors” – pension funds, endowments, insurance companies – and these institutions allocate their investments across a wide range of “asset classes” to manage and diversify risk. They tend to make these allocations based on ten year return performance averages, and beginning in 2009 (as my partners and I found out with unfortunate timing) the ten year return for the VC asset class went negative.

That’s for tough the VC industry overall, but if you look at the top 20-25 firms, the ten year return is quite good. So what institutions did was stop putting money in general into the VC asset class, and only put money into the big, established firms. This caused fund sizes to swell (Accel’s most recent fund was $1.35B+ comprised of $475M “early stage” + $875M “growth equity” funds), which incents those firms to put larger and larger investments to work in each deal (to justify their partners’ time).

So at a macro level, investment into VC funds dried up for all but the top firms (reducing the total number of VC funds) and poured into the top firms, shifting their focus to larger investments in later stage firms.

ANGELS BECOME ANGELS ALMOST LITERALLY

At the same time early stage VCs moved out of the market, a wave of experienced tech executives who had made fortunes building internet companies became very active investors. They brought more than deep pockets, they brought valuable insight and experience and even better – intensive, engaged roles with the companies they funded.

And along the way, incubators emerged as mini-factories where angels could become involved with lots of companies and let the law of large numbers help them there. Overall, angels are investing 40% more than they were even a year ago – now over $700K per round, and there are concerns there’s a bubble happening with incubators. But the headlines are, angels have stepped into early stage investing at a scale and role traditionally reserved for VCs.

STARTUP FUNDRAISING HAS NEVER BEEN BETTER, AND WORSE

What this means for startups is you can get your business to scale with ten times less money that you needed 10-15 years ago. $3M – $5M. If you plan well and are well connected you can do this with individual investors who add a ton of value and will roll up their sleeves to help out. The real benefit is you can also find individuals who share the same expectations you have for the outcome of the business. A 5X return on $3M may be the right outcome for the business and for investors who define success as a financial return coupled with a durable business that solves a problem they care about.

It also means you can liberate yourself from having to map your business and outcome to the trajectory that many of the larger VC firms need their investments to align with – they need billion dollar exits to generate the billion dollar returns they committed to their institutional investors.

Don’t get me wrong here. VCs are an important and valuable catalyst to the technology sector and the economy – and many are out there doing what they’ve always done to identify the next great disruptive business. And for your business, a VC can be the exact right fit either at the beginning or once you’ve gotten to scale.

It’s just that now VCs are playing a different role than they have in the past, and for startups this means it’s a brand new, unfamiliar, day out there.

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Posted in Business planning, fundraising, machine-driven methods, Networking, Strategy, Success, Uncategorized, Venture capital | Leave a Comment »

Back online

February 29, 2012

Well, that was a long hiatus. But for a lot of good reasons I needed the time away from this and feel ready and enthusiastic about resuming the exploration of technology and startups and how failure critically enables their success.

Next post to follow, and will be on the theme of how user acquisition costs and leverage have dramatically reduced the financing required to get a company to break-even (and to a seven figure user base), and how that’s reshaping not just early stage businesses, but mature enterprises.

Stay tuned, and thanks for your patience these past months.

Pete

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Posted in Business planning, fundraising, machine-driven methods, meaningful failure, Strategy, Venture capital | 1 Comment »

Societal costs and pure economics

July 2, 2009

I wrote earlier in the year about the challenges companies face raising Series B financings, and in particular how vulnerable companies are who have demonstrated potential but not yet converted that into a reliable, profitable revenue stream.

The issue is keeping an eye on your cash while continuing to develop the business, anticipating the next infusion of capital.

But what if you look at the business today and soberly assess that it’s just not going to get to where you expect or believe it needs to be: either to raise more money from an outside investor or to deliver meaningful value?

When do you make the decision to stop fundraising and use the remaining cash to wind the company down?  It’s somehow easier to get to that decision point as an investor.  You’re almost structurally set up to make that dispassionate call, not involved in the daily business, but fluent in the operations and the potential.

But that’s structure and theory.  In practice you are very close to the business and to the management team.  You’re spending tons of time with them.  You invested in their vision.  So unless the company has missed its milestones by a country mile there’s enormous room for debate, and ambiguity.

However a looming cash-out date sharpens everyone’s focus; there’s only a few short months until you’re out of money.  Time pares down the alternatives until there’s just one.

What about companies who have enough money to keep going for a year or more, but whose business is just not performing?  And what if you don’t expect it to?  What if the shape and trajectory of the business is just not mapping cleanly onto a business that will deliver the potential you expect, or more importantly, that the market will value?

That’s a much more difficult call.

Are you better off acknowledging the futility, the wasted resources (money, time, career opportunity cost), and be deliberate about making a difficult decision sooner rather than later?  The big issue is that in this market, unless the business is profitable, the likelihood of selling it is close to zero, and if you are lucky to sell, the price will be predatory at best.  A few million dollars, maybe.

So, let’s say you have $5 million in cash now, and you’re burning $1 million a quarter.  Do you spend $3 million and three quarters to see if you can get the company to perform to expectations knowing you might be able to sell it for $5 million a year from now if you’re wrong?  Or do you just shut down the company at a cost of $1 million, and redistribute the remaining $4 million to investors?

That math is harsh, but what’s harsher is the economic climate that supports it.  This isn’t a “present value of tomorrow’s cash” kind of problem, it’s more nuanced.

Are you better off giving the company the runway and time to try?  And the employees another year of security and jobs?  It’s that second part that in the past I think would have been easier to look beyond, but today, for me, it really becomes a significant variable in the calculus.

We’re in the business of making risky bets, and generally view time as an asset to develop options and deliver unexpected upturns; taking it off the “balance sheet” seems at odds with the whole ethos of our business.

But is that also a way of dodging the responsibility of making a tough decision?  Avoiding the inevitable is different from preserving options.

How much more do you weigh these societal costs against a purely “economic” decision?  In a growing economy, it’s so much easier to focus purely on the economics.  In a growing economy people will get new jobs, some more quickly than others, but they’ll move on.

But in today’s economy it’s just not that clear.

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Posted in Business planning, Empathy, fundraising, Values | 2 Comments »

The vulnerability of a big idea

June 15, 2009

As Twitter approaches mainstream relevance, it’s also entering a period of strategic and operational vulnerability that startup companies with big ideas run into. 

By going mainstream it’s exposing the structural opportunity its founders saw years ago, but back then, only the founders and the investors were in on the secret.  There had to be a slide in the Series A deck that said  “Here’s the opportunity” and it wasn’t about building a small, derivative business.  It was about building a disruptive, billion dollar kind of company.

In Twitter’s case it’s the opportunity to redefine how people communicate, and shaping how the economics flow in and around this new communication.  It involves getting to scale, developing a third party “ecosystem” of other companies integrating with and depending on Twitter for their own success, and then monetizing all this in a compelling, huge way.  This is really hard, and the folks at Twitter are still struggling a bit with the exact business model that will do all this.

Eighteen months ago, only people in the echo chamber were exposed to the nature of the opportunity.  But today, with Twitter’s explosive growth and visibility, everyone can begin to comprehend the potential.  When Ashton Kutcher gets petulant about his million followers, when Dell trumpets that they’ve sold $3 million of products to their Twitter followers, the incumbent titans in the internet and advertising sectors, well they notice too, and they notice “threat” ahead of “opportunity.”

You saw this first with the Facebook redesign that provided a real-time status update feed a la Twitter.  A classic “fast follower” approach to someone else’s innovation. Facebook already owns a lot of people’s mindshare and time online, so the fact that they’re tracking Twitter tells you how significant the threat appears to them.  By the way, Facebook is also struggling with business model and opportunity vulnerability too, they just are further along the scale path.

How does Twitter keep eyeballs and session times growing if Facebook is just going to “fast follow” them, treating them like outsourced R&D?  This will be really hard, but let’s assume Twitter wins this round of the battle, gets to scale with a loyal and large audience for their new medium of tweets.  Do they jump out of the frying pan and into the fire?

What’s differentiated about tweets is that they flow in real-time, and finding out what’s interesting and relevant instantly has got to be worth something, and it’s so different from the problem Google solves.  Google crawls the web at a frequency measured at best in minutes, more frequently hours or days, so you could envision Twitter creating a new category Google can’t participate in. 

But what if “instant” isn’t in the end all that important.  The NY Times dug into this a bit, looking into  why Google isn’t Twitter.  And they observed that real-time search is hard and neither Twitter nor Google are currently architected to do this efficiently, or well. 

What became clear is that if you need anything other than instant, real-time search, Google can give you “close enough” search, and get closer and closer over time due to their scale.  We can all figure out who will reap the revenue rewards if all Twitter’s creates is another type of page Google can place ads on.

This kind of battle doesn’t result from incremental thinking, from safe bets.  Twitter’s vulnerabilities are proof of the significance of the idea, and what Twitter’s investors funded.  But it doesn’t mean it will have a happy ending. 

And there’s food for thought here for anyone running a startup.  Expect that you will become vulnerable to the incumbents just when you’re hitting your stride, just when people acknowledge your value and relevance.  The presence of that vulnerability is your ticket to the next round of the fight, validation that you’re headed in a worthy direction.

I dearly hope Twitter pulls this off.  I love to see the status quo up-ended, I love the mental image of apples spilling all through the marketplace as someone with a bold and compelling idea runs through, knocking the carts over along the way.

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Posted in Business planning, fundraising, meaningful failure, Strategy, Venture capital | Leave a Comment »

Failing in Style – Guest post by Jenny Hall, former CEO of Trendi.com

March 16, 2009

Jenny Hall has graciously agreed to a guest post.   Jenny was the CEO of Trendi.com, a social networking destination focused on young women’s fashion that was shut down in October of 2008, and discusses what she learned as a first-time CEO through the startup and eventual failure of Trendi.

This blog focuses on this juncture of success, failure, and finding the meaning from each.  I think you’ll enjoy what Jenny tells us through her first-hand experiences at Trendi.  Thank you, Jenny, for being OpenAmbition’s first guest writer.

——————-

I really don’t like failure, but I know it’s one of the best sources of learning. I learned a lot the past few years working at a startup, and I learned even more as a result of it failing.

I joined Trendi.com in March of 2007 as the head of marketing and I ended at Trendi in October of 2008 as the last employee and CEO. We had investors, a smart team, a fabulous domain name, a popular blog and so much more going for us- so many reasons to succeed– yet we failed. 

When people ask me “what happened?” I usually say we ran out of money. That’s the cop-out answer- running out of money is a symptom of the underlying issues. I think our underlying issues were communication related (unclear communication with each other, of expectations, and with our customers) and experience related (being young, excited, wanting to do it all and getting nothing done.)

I learned lessons from the mistakes we made as a company and my personal mistakes. Of the many lessons learned, these are the ones that stand out the most to me.

Your target audience should be so excited about your product that they’re pushing you to launch, even if it’s crappy when it launches.

I joined Trendi after the founder received funding for his idea. (I know- that never happens! We were lucky.) I talked to my target market occasionally, but didn’t seek their regular input for 2 reasons- 1) I trusted the investors and founder were right in their beliefs that the idea was a winner and 2) I was afraid of the reaction if I discovered we were wrong and proposed changing the concept.

I should have let my market share what they value, even if it differed from what we wanted to create. Sometimes we get caught up in what we’re building, fall in love with it, and fail to realize other people don’t see it the same way. It’s like parents with ugly babies (hey, there ARE ugly babies) that filter out all negative comments because they’re so in love with what they created. Trendi was, in some ways, my ugly baby.

Launching a product your market is begging to use, even with a few rough edges, will have more success than a fully developed site that doesn’t add any value. Plus, you’ll tie your market emotionally to the product. They feel invested and valued and voila- you have your first product evangelists. Furthermore, their input is the ammunition needed when confronting a team, investors, or a board about why a major change needs to take place.

Keep the focus simple and narrow.

Once you know what your audience values, keep your focus only on the features you need. Trendi started out (on paper) as a simple 8-page design. We quickly escalated the site to include a robust back end, picture management system, full social network, etc.

Extra features added time to our launch, increased the burn rate and made the user experience…fragmented. We assumed the users would like what we built only to find out they didn’t like or use all the features and it was difficult for them to figure out the ‘point’ of the site when they arrived.

We over-built Trendi for one main reason: We didn’t have a plan.

Sure, we had some general milestones, but we didn’t have an actionable, communicated business plan. When there is no plan, startup employees turn into hormonal 13 year olds with severe ADD. Anything catches their attention and can change the intended course of action. What are the competitors doing? Why don’t we have this cool feature? Let’s make it pink! No grey! We need a YouTube video STAT! (Get the idea?)

People often ask where our board was during this process and I’m embarrassed to say we didn’t have a formal board. We had our investors who would give us time when they could and we had some friends we would call on informally…but no board to help us keep focus.

Don’t do it just because all the cool kids are doing it.

There were an onslaught of “social shopping” sites in 2006 and early 2007. We jumped onto that trend and while it’s important to know the trends and competitors, it’s more important to figure out what your substantive differentiation is, how that difference adds value and how to make money because of it.

This is a mistake businesses and people make all the time- doing something because everyone else is doing it. Why do we feel more comfortable when we’re doing what everyone else is doing?

I now know questioning the trends and value proposition needs to be done regularly- at least monthly- to ensure the choices made are in the best interest of the company.

Hire only when it’s absolutely needed.

Everyone should be fully utilized before anyone else is hired and increasing the number of employees doesn’t always speed up the launch. For a company like Trendi, we probably only needed a CEO, two developers, and a designer. Ideally the CEO would have been someone who deeply understood the target market, could raise money, inspire the team, and was a stellar marketer, writer or able to contribute another key skill.

Instead, we were almost a year into the project and 15 employees deep before our Angel (who owned the majority of Trendi at that point) stepped in and made a drastic change that involved laying off most of the employees.

Yowza. Hard lesson learned. The team stayed lean and more productive after that.

If it won’t matter in 3 months, don’t spend too much time on it.

We could spend a whole day talking about how our rating system would look or a week bantering back and forth about a press release. I should have asked myself – will this matter in 3 months? If it won’t matter then, why spend too much time on it now? Time is a precious commodity in a startup and should be spent on what matters the most- quickly building a product your customers love.

——-

Funny how our resumes show our successes and we take full credit, yet we leave off the failures and if they come up, we blame others. I wish I could blame Trendi’s failure on other people and circumstances, but I can’t. No startup has it perfect- we all deal with difficult employees, investors and economic strains. I have to accept that as a company we made mistakes, but I also have to look back and accept my personal contribution to those mistakes.

Accepting the personal mistakes hurt my ego. I screwed up and it made me question my ability to lead others, my knowledge as a marketer and my future ability to start another business. But somewhere in facing my failure and accepting these mistakes, I was able to learn how I can be a better leader, new things I can try as a marketer, and that I do have the strength to try again.

I always hope for success and aim high, but I now face failure with a humility and thankfulness I didn’t have before. Ignoring failure only hurts you later- you can stuff it away and try to pretend it didn’t happen, but it’ll bite you in the butt at some point. I know that if I face failure as a teacher (a harsh one, but still a teacher) I’ll become stronger and smarter.

I like tea, Thai food and good happy hours. If you want to join me in Seattle for any of these, email me at jennymhall@gmail.com.

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Posted in Business planning, chicken killer, Failure, fear of not succeeding, fundraising, meaningful failure, Self-knowledge, Success | 4 Comments »

Guest post coming Monday

March 13, 2009

I wanted to let you know that OpenAmbition will be showcasing its first guest post, from Jenny Hall, former CEO of Trendi.com, which was a social networking destination focused on young women’s fashion that was shut down in October of 2008.  Jenny will be sharing what she learned as a first-time CEO through the success and eventual failure of Trendi.

I met Jenny the first time a little over a year ago, when she was trying to raise a Series A financing for Trendi, and for  reasons I explained to her, my partners and I were not able to fund her company.  Jenny touches on a few of the reasons in her post on Monday, but in many respects, what she describes are what many entrepreneurs wrestle with in an emerging but crowded market, where so much is learned in real-time. 

Like with many of the entrepreneurs I am fortunate enough to encounter, she and I have kept in touch, and when she stopped by my office a few weeks ago to tell me about her next startup idea, the subject of Trendi of course came up.  Jenny talked me through some of what she had learned, and how valuable the failure of Trendi had been for her personally (but not painless for her, for her employees, or for her investors). 

When we moved on to discussing her next startup idea, it was inspiring to see how much was informed by what she had learned through Trendi’s failure, how she had embraced what many would have tried to forget or move on from.  And so it seemed like she had a story to tell that the followers of this blog could relate to, find interesting, and hopefully find some meaning in too.

I hope you all enjoy it, look for her on Monday.

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Posted in Business planning, chicken killer, Failure, fear of not succeeding, fundraising, meaningful failure, Self-knowledge, Success, Values, Venture capital | Leave a Comment »

More Series B musings

March 8, 2009

In talking to a few folks since my post Thursday on the nuances of Series B financings another analogy for Series A, B, and C financings came to mind.

You can look at investing in startups like selecting who among a classroom of kids will get into Harvard; if you don’t take this (completely dangerous) analogy too seriously, there are some interesting relevant analogies.  So just for a moment, enter a playful state of mind and let’s look at the landscape.

Series A investments are like evaluating a kindergarten class and trying to select the child you think would make it into Harvard.  You could look at a whole lot of characteristics about their classroom participation and capabilities and then try and figure out who would be likely to get be accepted twelve years down the road.  But it’s very much about taking a bunch of early, early data and trying to make a long range prediction. 

[If any of you have had kids in kindergarten, the sad thing is in real life there seem to be parents doing this math for their own children.]

But to play this out, with whoever you picked you’d have enough time and resources so that if circumstances develop along the way that take the kid you’ve “funded” off-track, you’d be able to help address these. 

Series C investments are like evaluating a high school junior or senior class and trying to select the child destined for Harvard.  Now you’ve got substantive and relevant historical data about performance, capabilities, and aspirations.  You have a much richer data set, and a much shorter time horizon – one to two years. 

With Series A, anything seems to be possible when you make the investment, and you have plenty of time to deal with surprises along the way.  With Series C, you can see and evaluate a lot of the substantive date, and have a reasonably clear sense of the prospects and risks.

Series B are like evaluating a middle school seventh grader’s class, and trying to pick who’s going to be Harvard-bound.  There is a trajectory that’s been established, but you don’t have the SAT scores, the high school GPA, or the extra-curricular activities that are going to factor so heavily in the outcome.  And, it’s hard to know who will blossom in high school and who won’t.  That the sullen introspective kid in the corner may deceive you as he or she may develop the confidence and leadership to become the head of the class in two to three years.  That popular kid  vying for attention may end up having more social skills than discipline, and could flame out academically in 10th grade.

This is an entertaining thought exercise precisely because it is so ridiculous. 

By the way, I have nothing against middle schoolers (I have two myself, and think the world of them, and their friends), but it’s an awkward stage.  Taking this back to our investment stage analogy, Series B is hard because you are between the “anything is possible” world and the “we have some relevant historical data and a shorter horizon”.

I’m not saying Series B investments are bad, it’s just that they’re their own unique animal that are particularly vulnerable in the current economic climate.  Fortunately, middle schoolers, regardless of the economic climate, will be just fine.

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Posted in Business planning, fundraising, Venture capital | 1 Comment »

The nuance of Series B financings

March 5, 2009

Given the economic climate, and the implications for startups, Series B financings are going to be tough to get done;  here are some substantive and “beauty” reasons. 

Substantive reasons. 

Series B financings happen at a vulnerable stage of a startup.  The company has generally proven its core value proposition, has demonstrated it knows where to find customers, acquire them, and has begun to monetize them.  The operative term here is “begun” – they haven’t generated enough revenue to cover their burn, and likely will need another 12-24 months to do so.

What the company or the investors don’t know yet is how scalable and predictable the revenue is.  How broadly into the target market the problem really exists (and whether or not they just got lucky with those first customers in the A round), and if/where the source of explosive leverage in the business is.

But the confidence of that revenue forecast, that can matter a lot.  Startups can run out of cash more quickly than they expect because the revenue forecast shows net cash needs going down over time…which is true only if the revenue comes in as planned.  So it’s easy to get a nasty surprise here if you miss your revenue forecast; all of a sudden you’re not managing to a break-even date, but a cash-out date that’s coming at you like a locomotive.

Series B financings may have less engineering or product risk, but they can have loads of revenue and market execution risk that can be hard to get your arms around.

Beauty reasons

There are also some beauty reasons why Series B financings are nuanced.  It’s precisely because they’re not Series A financings and they’re not Series C financings.  Let me explain.

Series A financings are attractive for VCs because they’re a product of your relationships and your deal flow – a result of personal, proprietary value.  The best deals involve shiny and bold unblemished ideas, are looked at by a small number of firms, and can be highly competitive. 

Series C financings are attractive for VCs because a lot of times they involve companies who have figured out how to scale revenue and have some clarity on the leverage in their model.  The engineering/product risk is generally behind them as is the revenue unpredictability; they need capital to expand and get to break-even.  These deals can also be highly competitive, and are shiny and old, old in a good way – they’re much closer to being sold (exiting).

What about Series B?  Well, a lot of times they’re just not as pretty.  They’ve been out in the market enough to success and have some warts and have already been seen by a lot of VC firms.  There’s still all that revenue and sales/marketing execution risk.  Series B deals are tweeners – neither a shiny Series A deal with a promising unblemished future, nor a “we’re just a few years away from an exit” Series C deal.  Picking a good one is tough.

What if you’re raising a B round?

You’ve got to embrace the reality of where you’re at.  You should expect to have a fair amount of “longitudinal” metrics supporting your revenue forecast.  Metrics you’ve been tracking for quite some time that communicate fact-based clarity in generating reliable revenue.

A closely related area is to have data that examines where in your business model the leverage comes from, and how that affects the economics of your business.  This too is best done longitudinally with data collected over time (like showing a strong network effect).

Finally, you need an operating plan that spends behind revenue; increasing expenses only after revenue has increased, reliably.  This means having some clarity around the context of expense increases, tying them to product or customer initiatives; “tear-off” plans that overlay onto your base revenue/expense plan.

B rounds are nuanced, and thoughtful planning and analysis can help you navigate the nuance.

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Posted in Business planning, fundraising, Venture capital | 3 Comments »

Series-shifting, terms, and fallout

March 4, 2009

The good news in the startup landscape is that companies are getting funded, and the pace and quality of startup activity remains strong, especially here in Seattle.  This seems to be the case in the valley too. 

But the deals that are getting financed are generally “obvious” ones; series A deals where the founders have solid track records or later stage deals that have proven they can acquire customers and most importantly, monetize them.  The deals everyone would like to do. 

What about all the others? 

Well, they’re ruled by the bleak exit landscape for venture-backed companies.  Any investor looking at a good company now is doing a returns analysis using much lower exit valuations than they’d used six months ago.  The economics have to adjust downward to make the numbers (and the risk) workable.  Make no mistake, the obvious deals feel this “compression” effect too, perhaps the fundraising process moves more quickly for them.

The first “compression” effect I call “Series-shifting” – when a company that’s out raising its B round gets valued as if it were on its A.  Or a C round company gets valued as if it were raising a B round. 

Colley Godward reports median Series C valuations dropped almost 40% in 4Q08 compared with the prior 1Q08-3Q08 timeframe.  40% isn’t a bad approximation of the step-up in value you might expect from the Series B post-money valuation to the pre-money Series C valuation, based on the company’s progress in developing the business.  In today’s fundraising environment this means the market is assigning little to no economic value to that progress.  Ouch.

As an aside, this introduces some nuance into your fundraising.  The post on your last round is likely high relative to today’s market.  At an appropriate time, you need to signal that you know this and will be flexible on valuation without prematurely putting a “fire sale” sign up.  If you wait too long to signal, you’ll scare off investors who think you’re out of touch with today’s market.  There’s no rulebook for how to handle this, just experience and good judgment; the goal for both parties is to be fair and realistic, not to take advantage of either party.

There’s a second “compression” effect: terms are getting much more aggressive, reflecting today’s more conservative assumptions on returns and capital recovery.  While not painless to the entrepreneurs and early investors, liquidation preferences can be a way to let the valuation retain some “loft” while enabling the new investor to limit the downside if the outcome isn’t what everyone hoped for.  If everything goes as planned, everyone’s happy, if not, it’s the new investor who gets protected. Ouch again.

Don’t take it personally, it’s just math, not a case of predatory investors.  It’s the messy reconciliation of the business model of the startup and the business model of the investor.  If you choose your investors (or your investment) well, this is a juncture that can be navigated honestly and transparently, but perhaps not painlessly.

So now what?  How many businesses are going to be able to pass through filters that have such conservative assumptions or where new investors need such aggressive forms of protection?  The answer is, not a lot. 

As Andrew Chen also highlights, there are just too many Web2.0 businesses out there, and as with the Web1.0 bubble, a lot of these in hindsight are features of someone else’s platform, or have thin value propositions to begin with.  We’ve seen this before, and lots of companies just won’t get funded, or won’t raise their follow-on rounds.  In the medium term, a good thing for the industry, in the short term a lot of carnage will result.

Paul Holland of Foundation Capital says it well in a BusinessWeek interview “The most healthy thing for this industry would be a clearing out of people who don’t have the stomach for it.”  That applies to both sides of the table, companies and investors.

Healthy, yes.  Pretty?  No.

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Five ways you can tell if the VC you’re talking to is being straight with you

November 28, 2008

One dose of humility I try and keep at the front of my mind is that before I went into venture capital, I was in startup companies, and I had to raise money myself. This means I also had to develop and hone the pitch deck, and meet with venture capitalists.

It’s a good place to put your mind when you’re hearing a pitch from someone. To remember what it felt like to try so hard, and be so eager to hear the good or the bad, to get some feedback, some guidance, some hope.

But something I think we’ve all learned as VCs is how hard it can be to say “no” to someone, and to do it in a way that respects the entrepreneur’s role in the transaction. We look at 400+ deals a year, and fund fewer than four. Saying “no” happens a lot, and happen for a range of reasons, generally not because the company is bad or the idea is bad, but because to fit through our filter, a whole lot needs to line up really well.

So, if you walk into your meeting with a VC cognizant of the fact it’s 100 times more likely you will be turned down than not, well, you better get something back for your time, don’t you think?

So here are the five ways you can tell of the VC you’re dealing with is NOT being as fair with you as you’re being with them:

  1. They took more than they gave in the first meeting. VCs see tons of deals and have relevant experience. Meeting with you should be an opportunity for them to help you. If they view the meeting as a way to feed them, time to move on.
  2. They’ve met with you more than two times without setting expectations. Remember, your time is valuable, and you can’t waste it with folks who can’t articulate a process and put you on a timeline. The process can be “Let me track you for the next year”, which tells you no funding in the meantime. But if you’re trying to raise money now, then you need to know within two meetings if you’re on a path to that, and where that path leads.
  3. They want you to extract all the risk. It’s totally chicken for a Series A VC to tell you they’ll be ready to invest once you’ve proven the business works at scale. Go to a bank instead (assuming you can find one that is lending).  It’s fair of them to ask you to show you’ve validated the value proposition and core assumptions, but that’s different.
  4. They want someone else to lead. What does this mean? “I will give you money if someone else says they will invest first?” This is kind of helpful, but in the end moves you not a whole lot further down the road.  You need someone to lead the round, and firms that wait for another to lead are making essentially a non-commitment, and are leaving a great deal of work for someone else to do.
  5. They didn’t tell you why they said no. This is really important. VCs pass for specific reasons that they discuss in their Monday meetings. Reasons might be “the team has never done this before” or “I think this is a feature of someone else’s platform”. Don’t you think this is important information to know if you’re the CEO? Yeppers, it sure is. You’ll know when you’re dealing with a quality VC when they tell you why they passed, because they know this is information that will help you.

So, a quality VC understands your time is valuable, that they’re in the business of making risky investments, and most importantly, that “no” is an opportunity to impart advice/feedback to help the entrepreneur raise money from someone else where the fit is better.  Whether you raise money from a particular VC or not, it’s the process of the interaction that’s valuable and important.  Success or failure has meaning here, and the high quality VC firms not only acknowledge this, they focus on it.

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