Category Archives: VC

The attractiveness of different investment stages

When I first started investing, I thought that the best investment opportunities were at the seed stage. In other words, I thought that the best opportunities were in being the first investor in companies. My reasoning was that, if you know what you’re doing, this is the stage when there is the greatest return potential.

However, in addition to the greater return potential, seed stage investments also feature the greatest risk, and the greatest competition. If you know what you’re doing, you can minimize the risk. However, you can’t change the competition.

The number of people who can lead a $500K seed round, or contribute $50K towards it, are numerous. And this number will only grow as technology in general, and software in particular, changes the way that things are done in more and more sectors. The result is that seed valuations are often pushed higher than what can be justified by seed companies’ underlying business prospects.

As the round size and the resulting check size increase, in other words in Series A and B rounds, the number of people who are competing for a deal declines. And my intuition suggests that the reward to risk ratio does not decline as much. In other words, series A and B investors occupy a more attractive part of the value chain than seed investors.

I’ve participated in a few later stage rounds, beyond the series B. However, I haven’t done so a sufficient number of times to have a feel for whether later stage rounds are even more attractive than series A and B investments. With time, perhaps I’ll find out.

What’s missing from this reasoning is your personal fit for different stages. For example, earlier stage investment decisions are more qualitative in nature whereas later stage decisions are more quantitative in nature. As a result, even if series A and B investments represent a more attractive part of the value chain, they might not be the right fit for a highly qualitative investor.

When to raise money from a strategic investor

As a startup, there are two benefits of raising money from a strategic investor.

First, the strategic support provided by the investor can provide value beyond what a financial investor can provide. For example, this may come in the form of new customers, new suppliers, a distribution channel, technology, or a reduced cost base.

Second, a strategic investor can turn into a strategic buyer at the time of exit.

There are also two downsides to raising money from a strategic investor.

The first is that the strategic investor can, either through their investment rights or through persuasion, pull your startup in a direction that makes sense for the interests of the strategic but not necessarily for your startup. This goes beyond the different perspectives that founders and all investors, including financial investors, can have about the best direction for the company to achieve its goal of maximizing long-term shareholder value.

The second is that the presence of the strategic investor and the fact that it is often a likely buyer of the company has the potential to limit other exit options for the company. As a result of the restricted exit options, financial investors are often less willing to invest in the company.

When you’re an early stage company, you have yet to exhaust the many ways in which you can create value. You’re also far removed from an exit. As a result, the costs of raising money from a strategic investor outweigh the benefits. If you have other options, you should avoid raising money from a strategic investor.

When you’re a late stage company, a strategic investor can provide new value in an environment where you’ve exhausted many of the easy ways to create value. You also start to think about an eventual exit. The benefits of raising money from a strategic investor might begin to outweigh the costs, so you will want to think about doing so.

Startup investments as call options

Although an investment in a startup gives the investor equity ownership in the company, the return of the investment is actually better thought of in terms of having bought a call option on the company. Here’s why.

The main drivers of the value of a call option are its underlying stock price, strike price, time to expiration, and volatility.

At the time of purchase, a call option has an underlying stock price that is below the strike price. If the underlying price rises above the strike price, you exercise the option at the strike price and make the money between the higher stock price and the lower strike price at which you exercised. This means that, at the time of purchase, a call option is out of the money. Similarly, at the time of the investment, a startup is valued at a higher figure than its fundamentals suggest. You invest with the hope that the company’s fundamentals grow, and pay a premium for this optionality. If they don’t, you very often lose money on the investment.

The longer a call option’s time to expiration, the greater its value. Similarly, an investment in a startup is a long journey that, excluding an acquihire which might take place earlier, takes upwards of 7 years and often much longer to produce a return.

Finally, the greater the volatility of a call option, the greater its value. Similarly, startups are highly volatile investments, both at the startup level as the company tries to build a product, achieve product market fit, and scale, and at the portfolio level, with many more startups failing than succeeding.

As a result of these reasons, if you view startup investments as traditional equity investments, you’re less likely to make the types of investments that succeed than if you view them as call options.

Startup: A Silicon Valley Adventure

I recently read the book Startup: A Silicon Valley Adventure by Jerry Kaplan. Jerry was the founder of hand-held pen computing pioneer GO Corporation in 1987, and the book tells the story of the challenges, pains, and joys on the road to building and eventually achieving a modest exit with GO.

It’s a story which highlights the importance of product market fit (it turns out that a hand-held pen computer’s close cousin, a touch-based hand-held or in other words a smartphone, is the right solution), timing (GO was a few years too early), and competition (large markets attract the attention of large tech companies with greater resources than startups, and the startups that succeed achieve distribution before incumbents achieve innovation).

I strongly recommend reading the book, which you can check out here.

The drivers of revenue multiples

The revenue multiple, or in other words the ratio of a company’s valuation to its revenue, is a commonly used metric to value startups. The reason is that most startups have negative EBITDA and net income, so it isn’t possible to value them based on these metrics.

However, it isn’t possible to simply take one company’s revenue multiple and directly apply it to value another company.

Specifically, different companies demand valuations which reflect different revenue multiples. The reason for this is that a company’s revenue multiple is driven by numerous factors. The most important of these are:

  1. The company’s growth rate: Companies that are growing faster command higher revenue multiples.  Since it’s easier to grow fast off of a small base, earlier stage companies tend to command higher revenue multiples than later stage ones.
  2. The size of the company’s addressable market: Companies targeting larger addressable markets have more room to grow their revenue by capturing more of their addessable market. As a result, they command higher revenue multiples than companies targeting smaller addressable markets.
  3. The company’s margin structure: Companies with superior margin structures (higher gross margins, contribution margins, EBITDA margins, net income margins, …) will have more money left over from each dollar of revenue that they make. They will therefore command higher revenue multiples. Although most startups have negative EBITDA and net income margins, many have positive gross and contribution margins. It’s therefore possible to value them based on gross margin and contribution margin multiples, which are better reflections of the fundamentals of the business than the revenue multiple.
  4. The company’s long-term defensibility: Companies with business models that are difficult for competitors to challenge will be able to retain their revenues and profits for longer periods of time in the future, and will therefore command higher revenue multiples.

Fundraising for the existing average business and the new and promising idea

After a startup raises money, three things can happen.

The first is that it performs well, either with its initial business idea or following a pivot, and goes on to raise more funding based on this performance.

The second is that its business does not grow, attempts to pivot do not either, and the business therefore fails.

The third case lies in the middle. Specifically, the startup ahieves some growth in its initial business idea. However, this growth is not high enough to raise more funding based on the company’s performance, and it’s not low enough to declare the business a clear failure.

Startups that experience this third scenario often come up with a new business idea that is adjacent to the initial business, and try to raise money for the new idea. When this happens, they need to decide whether to stop working on the initial business to focus on the new idea, or to continue working on both in parallel. Many decide to work on both at once, and therefore pitch new investors the combination of an existing average business and a new and promising idea.

When this happens, interested investors want to invest in the new and promising idea. However, they don’t want to pay for the existing average business, and they don’t want the team to spend any time on the existing average business.

As long as the existing average business continues, this makes it challenging for the startup to raise money.

If you don’t want to raise money, you can keep working on both businesses in parallel.

However, if you want to attract investors, you’ll very likely need to close the existing average business and raise solely for the new and promising one.

Meeting a founder’s team

Most investors state that, together with the market, founders are one of the two key determinants of a startup’s success. While this is true, a founder is only as good as the team they’ve built. As a result, meeting a founder’s team, consisting of the founder’s direct reports and any other key team members, is a great way to evaluate the founder and their startup.

The first benefit of meeting a founder’s key team members is that they reveal how good the founder is at identifying and attracting talent. The more impressed you are with a founder’s key team members, the more impressive the founder who built the team.

The second benefit is in observing the interactions between the founder and their key team members. Who speaks more often on issues pertaining to the team member’s responsibility? How does the founder address their team and vice versa? Do the founder and team members seem perfectly aligned, which is usually a sign that they are not expressing their differences in viewpoint, or do they point out where their perspectives are different and how they’ve decided to move forward to either test out the different hypotheses they hold, or despite their different perspectives?

Meeting a founder’s team in a series of one on one’s, together with holding a group session in which each key team member participates, is a half to one day exercise that greatly improves the quality of an investor’s investment decision.

What the founder will do

One of my first learnings as an investor was to focus not on what you can or would do with the company, but what the founder will do.

It’s a continual work in progress to take this viewpoint because, when you’re excited about the promise of an idea, your natural reaction is to think of all that you could and would want to do with it.

However, if you decide to invest, you often soon discover that the founder takes the company in a different direction than what you imagined.

If you formed your view of the company’s future without carefully listening to the founder before investing, this direction can be radically different.

If you listened well, although there will still be surprises due to the experimental nature of startups, hopefully these changes will be for the better and the general direction of the company will remain as you envisioned.

Plan B

Plan A doesn’t always work out. That’s why it’s useful to have a plan B.

However, you can’t have a plan B for everything, all the time. There will be unexpected twists and turns for which you haven’t had the time to prepare a plan B.

When these occur, your best bet is to, to the extent possible, take your time. Although it doesn’t seem like it in the heat of the moment, a plan B often emerges, either in the form of a new way of approaching the existing opportunity for which you had designed plan A, or in the form of a new opportunity altogether.