Category Archives: VC

Startups, growth, and valuation multiples

When you invest in a startup, you invest at a very steep valuation multiple.

It isn’t possible to justify the valuation at which you’re investing using traditional multiples like revenue, gross margin, EBITDA, or net income. The latter two are almost always negative, and depending on the stage at which you’re investing, the first two range from small to non-existent. Your reason for investing is that you believe that the startup will grow to produce revenue, gross margin, EBITDA, and net income in the future. It is this growth that you pay for.

However, even if the startup is successful in growing to produce these figures, the relevant multiple at which it is valued in the future is very often lower than that which you invested at. The reason is that even healthy businesses are eventually valued at traditional multiples that reflect a lower growth trajectory.

As a result, for an investor to make money in a startup investment, the increase in the company’s valuation which is produced by the company’s growth needs to offset the decline in the company’s valuation which will take place as a result of the lower future valuation multiple assigned to it.

This is why growth is so important for startups. If it stops or declines, even if the company is able to manage its costs so as to achieve break-even, the decline in valuation multiples makes it very difficult to achieve a return on your investment.

Curiosity

In an earlier post, I wrote about how our son’s curiosity for and resulting fascination with everything in life reminds me that each new moment is a miracle.

In that post, the reason I gave for why we often default to living as though nothing is a miracle is that we’ve experienced many things before.

However, there’s also a second reason why we often default to this approach. And that is that most of what we’re guided to do, especially as a child, is to complete tasks in predetermined subject areas. Rather than ask the questions that interest us and follow the paths that result from our attempts to answer these questions, we’re guided to complete predetermined tasks without asking questions. In other words, we’re guided to set aside our own curiosity for what society believes we should be curious about, to the extent that society believes we should be curious about it.

Fortunately, our own curiosity does not go away. It sits there, beneath layers of externally constructed interests.

Just like our son, and just like when you were a child, you just have to have the courage to let your curiosity surface.

Meaning, uncertainty, and worry

When you do things that you know the outcome of, there’s no reason to worry. You already know that you’ll achieve the outcome.

Worry sets in when you pursue something with an uncertain outcome. The greater the uncertainty of the outcome, the greater the worry.

Looking at things this way, doing things with relatively certain outcomes is an easy way to avoid worry.

However, those things with relatively certain outcomes also tend to be less meaningful. Those things that are worth doing tend to have uncertain outcomes.

So the choice is between doing meaningful things with uncertain outcomes and hence worry, and less meaningful things with relatively certain outcomes and low worry.

There’s room for both. However, most of us naturally gravitate towards the latter in order to minimize worry. Reminding ourselves that the former produce worry for a good reason helps us do more of these things.

TBH is acquired by Facebook

TBH (short for “to be honest”) is an anonymous messaging app that promotes positive communications rather than the negative communications that often plague anonymous messaging apps. We had invested in the app’s parent company at Aslanoba Capital, and TBH was recently acquired by Facebook.

At the time of our investment in February 2015, TBH’s parent company was working on an on-campus messaging app, not the anonymous messaging app that is currently TBH. The team then went through several iterations of other messaging apps before finding success with TBH. This article outlines their journey well. In other words, TBH wasn’t an overnight success, but the result of perseverance, learning, and continual growth.

I commend the TBH team and its CEO Nikita Bier for each of these three traits.

Creativity and performing predefined tasks

Work can be broken down into two different activities. The first is deciding what to do and the second is doing it.

The former requires creativity while the latter requires putting in the time to perform an activity with relatively less brain power.

Since the latter requires less brain power, it’s possible to spend extended periods of time, which I define as more than 12 hours a day, doing it.

Creativity, on the other hand, comes in short bursts. You can’t be creative for 12 hours a day. My creative periods last for 4 to 5 hours a day at best.

As a result, creative roles spend less time working than roles focused on carrying out a predefined task. However, this does not mean that creative roles produce less output as correct decision making is a higher leverage activity than task execution.

In roles that require both creativity and performing predefined tasks, it’s useful to set your daily schedule to allow enough time for your high value creative bursts to occur in the environments and the times of the day when they’re most likely to surface, while spending the remaining time on performing predefined tasks.

The due diligence questionnaire

In an earlier post, I wrote that an investment memo is “a very useful tool to help collect your thoughts in advance of an investment decision. It’s basically a document that summarizes the important factors which help inform an investment decision.”

I also wrote that, “if you’ve done your research and thought about the startup at length, 2 to 3 pages of crisp text written in half a day is all it takes.”  

In other words, the investment memo doesn’t need to be long. The reason for this is that if you’re sufficiently well informed about a company and its market, you know which factors are important for your investment decision and which aren’t.

The same is true for due diligence (DD) questionnaires. A DD questionnaire is a document that an investor sends to a company to gain a deep understanding of how the business works, its team, historical performance, and the proposed transaction, with the goal of developing an informed view on the company’s likely future trajectory. The DD questionnaire is usually sent after one or several meetings with the company.

Similar to the investment memo, a DD questionnaire can be very long. I’ve seen DD questionnaires that are over 10 pages long.

However, very long DD questionnaires usually reflect the fact that the investor hasn’t researched and thought about the business at sufficient length to parse which factors will ultimately determine the success of the company and which won’t. As a result, they look for the sense of comfort that comes from feeling like they’ve covered all the bases by asking every possible question. While this provides short-term comfort, it doesn’t contribute to producing the informed investment decision which increases the investor’s probability of making the right investment that gives them long-term comfort.

If you’ve thought about which factors will ultimately determine the success of a company and which you can ignore, a 2 to 3 page DD questionnaire is all you need.

Sleeping on important decisions

Important decisions rarely need to be made on the spot. The clear exception is if it’s a life threatening and hence potentially life saving decision.

For most other decisions, like the decisions you face as an entrepreneur or an investor, you can afford to sleep on it.

Sometimes you know that you don’t have the answer on the spot, and sometimes although you think you do there are likely to be other variables that you haven’t had the time to process in the moment.

Sleeping on the decision for as many nights as necessary to get comfortable with the likelihood and magnitude of its potential consequences is a simple behavioral habit that greatly improves the quality of your decisions and thereby produces greater peace of mind.

Sustainable success as an e-commerce company

E-commerce sites across verticals use informational content as a way to differentiate themselves from their competitors. The reasoning is that if they attract visitors by providing informational content about the third party products they’re selling, once informed, these visitors will also purchase the products they were looking for on the same site.

At the margin, this is likely true. Providing a visitor with extensive informational content prior to making a purchase helps build trust which makes the visitor more likely to transact on the same e-commerce site. However, very often this earned trust isn’t enough to overcome differences in the price of the product on different sites. If the product is cheaper elsewhere, the visitor simply learns about the product at your site before transacting at the site with the lowest price.

This is especially true for commoditized product categories and verticals with strong third party brand names. For such product categories, the marketplace approach of aggregating and showcasing the third party products available from different suppliers, thereby letting the customer compare the prices of these products to buy from the supplier offering the product at the lowest price, is more defensible in the long term than the e-commerce approach.

This leaves the creation of a new proprietary brand as the remaining approach to achieving sustainable success as an e-commerce company.

Work, experience, and output

In order to become a professional in a given field, you need to start off by working very hard. The reason is that there’s a lot to learn and you’re competing with other people who are further along the learning curve than you are.

However, the more you learn in a field, the less there is left to learn in that specific field. Although learning never ends even in a specific field, the pace of learning declines.

In addition, many people who were further along the learning curve when you started off in the field drop out, and you surpass many others as a result of your hard work.

When this happens, somewhat paradoxically, you work less hard as you gain more experience.

However, this doesn’t mean that your output declines. To the contrary, since you’ve learned which activities contribute to what you’re doing and which don’t, you don’t chase after everything as you used to when you first started off.

So you get to work less hard, but more smartly, while continuing to see increases in your output.

This continues to be the case unless you decide to enter a new field. If you do so, you get to experience the challenge but also the joy of once again learning something new.

The benefits of raising at a slight valuation discount

In an earlier post on fundraising do’s and don’ts, I wrote that startups should optimize for success rather than valuation. Specifically, I wrote that sometimes it’s worth “taking a few additional points of dilution [by accepting a lower valuation] to get the right partner in your company”.

Marc Lore, the founder of Jet.com which was acquired by Wal-Mart for about $3 billion in cash and $300 million in Wal-Mart shares, gives several other reasons why taking a slight discount on your company’s valuation is likely to increase your company’s likelihood of success.

In addition to letting you work with the right partner for your company, the benefits of taking a slight discount on your company’s valuation are that it:

1. Increases investor demand for the round, thereby creating scarcity which sometimes even results in a higher final valuation for the round.

2. Makes it more likely that the round’s investors have a nice paper return by the time of the next round, thereby making them more likely to be happy investors who refer the company to other investors.

3. Lowers the likelihood of a potentially morale hindering future down round.

4. Increases the pool of potential buyers of the company by not boxing out smaller buyers who would otherwise not put in the time to evaluate the company due to believing that they wouldn’t be able to meet its valuation expectations.