Category Archives: Entrepreneurs

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.

Hard at first, easy later

Doing something consumes energy. As a result, you have less energy to do the thing again in the short term, which makes it harder to do.

However, doing something also builds that thing into a habit. This means that it takes less energy to do the thing in the long term, which makes it easier to do.

So you need to do things that are hard at first in order for them to become easy later.

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.

Doing less rather than rushing

When you’re giving a presentation in a predetermined time slot and you realize that, if you continue at your current pace, your presentation isn’t going to end on time, you have two options. You can either speed up your pace by talking faster or cover less content by focusing only on the most important remaining content.

The former approach creates stress, and that stress impacts not only your ability to communicate your thoughts but also your audience’s ability to understand your message due to simultaneously thinking about your frenetic body language.

The latter approach means that you don’t cover some content. However, by skipping the content that isn’t a priority, you can get the key elements of your message across, thereby retaining your calm and increasing the likelihood that your audience understands your message.

The reasoning outlined above regarding what to do when you’re pressed for time when presenting can be generalized to other contexts. Specifically, when you’re pressed for time, it’s better to do less by prioritizing the important things than to do the same amount by rushing through it all.

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.

One day at a time

“The best thing about the future is that it comes one day at a time”

This is a quote attributed to Abraham Lincoln, and I have two takeaways from it.

The first is that you can’t do everything at once. If you have a goal, you have to make patient and consistent progress towards it on a daily basis.

The second is that most goals that seem very far away are actually more achievable than they appear. The analogy of climbing a mountain is helpful in explaining this.

Specifically, when you’re at the bottom of a mountain, you can’t see its peak. With each step of the climb, you see parts of the mountain that were previously inaccessible to you. To get to the peak, you must traverse through these intermediate parts. You can’t climb further than your reach at any particular step allows.

Similarly, when you first start working towards a goal, it’s difficult to envision achieving it. By making steady daily progress towards the goal, you unlock new levels that take you closer to your goal, until you can eventually see yourself achieving it.

And just like when you’re climbing a mountain, there’s no short cut. You have to go through certain places before you can get to other places.

Distance = speed * time

What you achieve in life can be thought of as the distance that you progress. Distance, in turn, is speed times time.

Speed is how fast you’re progressing, and time is how much time you put in.

This is why you’ll make more progress if you’re working on something that you’re naturally good at, by working with a capable team rather than alone, and by raising external funding rather than relying on internally generated profits. These are examples of ways to increase your speed.

It’s also why you’ll make more progress if you’re spending the majority of your time on one goal rather than pursuing multiple goals at once.