Early Stage Marketplace Investing

user-pic

One of our Launch Capital staff, Ed Coady, pinged me the other day regarding marketplaces and asked me how does one find the next big marketplace startup at the seed stage. We both remarked that there are a ton of posts on marketplaces and what makes them successful - BUT they are all written as if the marketplace actually has traction. In stark contrast, there are practically no posts written on how to evaluate and pick the next big marketplace at early stage when there is no traction.

For example, some funds will invest in a marketplace when they get to $500K-1M monthly gross market volume (GMV) . But, as a startup, how do you get to $500K-$1M monthly GMV without a series A? And how do investors pick the next one that will get there BEFORE series A?

Those who know Launch Capital know that we invest in early stage where startups are often missing traction, revenue, product, or any combination of the three. In fact, although we call ourselves seed stage investors, we have really moved to what people now call pre-seed, where it is more typical that all three elements are missing and we are only betting on the idea and the strength of the founders. If those are the only knowns, then how does one pick a marketplace play that will be successful?

Ever since I joined Launch Capital, I've been looking at marketplaces in a variety of industries. Here is what I look for in a marketplace for investment which will give it the best chance for success, either reaching breakeven or metrics good enough for the next round:

The marketplace must have no competitors.

I am OK with old traditional, offline competition. However, I don't want to see another startup or three or ten working in the same space. Competition for customers is fierce and with too many things competing for our attention, sometimes everyone becomes your competitor. Thus, it is much better to be the only one in the market trumpeting a service and solution to your problem. Customer acquisition becomes so much easier when there is only one solution available. When there are many, customers need time to decide and this slows down the adoption process. Lack of speed is death to the early stage startup! They need revenue as soon as possible or else their bank account will empty before they reach breakeven or metrics good enough for the next round. Thus, I have found that lack of competition is potentially the most important criteria for early stage startups to have in order to be successful. With today's crowded startup world, most projects we meet have many competitors - all the obvious stuff is being worked on ten times over. When we find startups that lack competition, this often leads to untapped, unsexy markets where I need to spend a lot of time researching the industry and learning about it. In effect, I need to work to fall in love with something that is unsexy!

The market itself must be believably big, in the tens of billions of dollars at least.

This provides not only the biggest opportunity, but also it provides something attractive to other investors who are also looking for big market sizes. When you step into untapped, unsexy markets, it's amazing how big they are and how many are still out there that are untouched by today's entrepreneurs.

Generally for today's early stage marketplaces, I like to see margins be 25% or greater.

Margins that are small require tremendous traffic to get to any meaningful monetization. It's just too hard for startups to reach scale without significant amounts of capital now so I like to see some survivability built into their model by enabling a larger take for each transaction. Note that high margins are tough in marketplaces; more than likely there will need to be some specialness to the marketplace that will enable it to justify higher margins to its users.

However, if the transaction size is large (like in the thousands of dollars or more), then I'm ok with a lower margin. Certainly I like to see larger margins whenever possible, but I am more forgiving on lower margins realized on large dollar transactions. This is more often seen in B2B marketplaces.

The marketplace must have figured out a believable lock-in strategy.

Often entrepreneurs will enable the first transaction, but there is the possibility that subsequent transactions will not happen on their platform. I think this is extremely risky and could leave a lot of future dollars off the table. It is much better if the marketplace has figured out a believable way to incentivize both buyers and sellers to keep using the platform so that they can continue to monetize hard-won users.

I like to see that the founders have depth in the industry their marketplace operates.

Too many founders think there is a problem in an industry but have no real world experience to validate it. Or they lack business contacts in that industry which could give them an advantage in gaining business usage of their platform.

If they have traction when I meet them, even better.

Using the above decision process, I've invested in 8 early stage marketplaces over the years. 4 are doing amazingly well; 2 are too early to tell if they will be successful, and 2 are questionable. With 4 out of the 8 doing extremely well, it seems that something is going right!

Spotting the next successful marketplace is not an easy task. It's always easy to write about how marketplaces get big AFTER they get there, but it's not easy to find them before they are anywhere. There is still opportunity to build big successful marketplaces but they will most likely be in places where few tread but yet are still big markets.

A few weeks back, I wrote a post entitled The Tweetstorm that Spawned the 10,000X Startup where Dave McClure of 500startups lamented about the state of early stage, that valuations were way too high, and that early stage investors will lose money.

But, really, how risky is seed investing in today's world? Are we paying too much for early stage startups?

Over the years that I’ve invested in early stage companies, I’ve heard numerous claims that valuations should be this or that, and if they are not, we will lose money. But I have never been presented with a model or math to show that this or that was true or what would happen if you were to invest at certain valuations.

So with one of our research team members, Tom, we set out to build a model using today’s data sources and see what would come out of it.

First, we took the famous CBinsights Venture Capital Funnel, which is a great way to show the path of startups through their lifespan to future funding rounds, M&A exits, or a death or self-sustaining state.

Then we melded that with data from PitchbookVC’s latest 1H 2015 Venture Capital Valuations & Trends Report. There is some really great information on current valuations, rounds, and exit values there, and we used the median values to model where most of the activity would be. Thus, the following analysis looks at what returns would look like if your portfolio performed at that median level.

Dilution via option pools is also in the model, although we estimated the numbers based on our own experience.

The model itself is available for download here.

You can set the investment amount, portfolio size, and pre-money for the seed round.

On a relative basis, the investment amount doesn't matter as the resulting return percentages and multiples will be the same for any amount you enter. For the purposes of this post, we entered our usual $150K investment per startup.

Entering the portfolio size does matter as it shows the quantity of startups you'd have to invest in, at a minimum, to yield startups out the other end of the funnel. For example, to exit the funnel with at least one remaining startup who has gone through 6 full rounds of financing, you'd need a minimum portfolio size of 25.

The pre-money inserted in the model is $6M, which is the typical market rate seed round valuation you'd find out here on the West Coast.

If you invest into rounds at the typical market rate valuation of $6M, you are essentially short by 22.6% after your cohort goes through 5 years of life and 6 rounds of financing.

If your portfolio is large enough, the model calculates that you still need to make a multiple of 5.65x on your last remaining startup in order to make back that 22.6% shortfall and break even: a tough goal under any circumstances. (Note that the bigger your portfolio is, the more startups you will have out the end of the funnel. However, to breakeven, you will need to make back 5.65x per startup that is remaining. For example, if you have a portfolio of 100, then you’ll be left with 4 startups remaining, and you need to make back 5.65x on each your startups, or 5.65 x 4 = 22.6x on only one of those startups.) For most angel investors, having enough cash to create a large enough portfolio to have a chance at breakeven or even do better is very difficult.

If we take this model as-is, investing at today's market rates as an angel investor sure looks like a losing proposition. Of course, any investor worth anything would be arrogant enough to think they had what it takes to beat the market and this model. Let’s dive further into the model.

The CBinsights database is made mostly up of companies who have done equity rounds. Given that the world of seed seems dominated by convertible note financings which don’t show up in the CBinsights database, what does this dataset mean? Equity financings typically include a seed fund or something similar like an angel group. So you can be sure that most of the companies all have an entity behind them to help them with their progress. They have an advantage with this help over those who do party rounds of only angels. Still, despite the help of these funds, the funnel ends up negative for those who invest in these companies at seed.

Note that the majority of financings out there aren’t even taken into account here, which are note financings. I'm not sure one could make the argument that note financings are better than equity financings when viewed across the entire set of startup financings. So you'd have to be at the very least able to invest only in rounds that are also supported by a strong seed or angel fund to be on par with the results of this model. But as the model shows, it is not enough unless you are able to move the odds of successful outcomes in your favor.

What is this model a representation of really? It's an index fund of startups who got equity financings; if there was a mutual fund that allowed you to do that in 2009, this is what would have happened, assuming the fund could invest in every startup that got an equity financing. You would have lost money for sure. So "spray and pray" is a terrible strategy if you are just investing at market rate valuations. If you could "spray and pray" at much better valuations, the model results in positive returns - think accelerators where they deploy very little money for large chunks of their companies at very low valuations.

Despite the bleak overall outlook of the model, we dove into some of the more prominent seed funds to see how they performed against this model. For example, First Round Capital was a fairly large seed fund back in 2009. According to the same methodology used to build the CBInsights funnel, they managed to have 33% of their 2009 cohort exit via M&A versus the 20% level assumed in the model; they also showed consistently higher follow on rates. Obviously they are doing something right, and better than average.

What are better seed funds doing that make them so great? Pandodaily wrote a post entitled Why Jeff Clavier Insists There's No Series A Crunch which has a good list on what Jeff Clavier does to help his portfolio companies and take them to success. So there is ample support for being able to invest in rounds which include one of the strong seed funds out there.

Bear in mind what I mentioned before - the CBinsights funnel ALREADY assumes you are investing alongside a seed or angel fund. The likelihood of that happening is pretty difficult, unless you are doing a lot of work to become friendly with the seed funds. And then, not all seed funds are alike; some are definitely beating the funnel in returns but there are many that are lagging.

Suppose you had a portfolio large enough to result in some startups surviving past a 6th round of financing. Our model says that with a portfolio of 25, you'd have one left, and you'd have to make at least a 5.65x to come out positive on your portfolio. With a larger portfolio, there would be more companies surviving after the 6th round to return money and then some; in today's world, it is likely these would be the unicorns of legend.

Ordinarily, we would all celebrate the unicorn-esque status of one or more of our portfolio, on their way to great heights and potential IPO. However, consider this recent post by Tomasz Tunguz of Redpoint Ventures, The Runaway Train of Late Stage Fundraising. These late stage financings seem to be a current fad and are proliferating while the number of IPOs languishes. However, one thing that is not talked about much are the terms in which these financings are done. A recent post by Ben Nasarin entitled Big Valuations Come with Dangerous Small Print highlights the problems that come with late stage financings. You can guarantee there are many preferences (see liquidation and participating preferences) in the distribution of exit capital. You may end up in a situation where the company seems to exit well, but the preferences result in little or no capital being returned to early investors; that includes an IPO situation (see Ben's post regarding the Box IPO). While unicorns are definitely good for bragging rights in a portfolio, they may not return as much capital as you like, or need, to breakeven or make money.

The presence of preferences which could stifle your returns requires you to really think through what your strategy might be for dealing with these situations. It may mean you would take the first opportunity to sell your shares at a secondary offering, for example, and take the early exit versus waiting for something bigger later that may never come (In stark contrast, late stage investors nearly always make their money back even in a losing situation).

This model doesn't take into account follow-on investments, which is true for most angel investors and non-fund entities who don't have the resources to follow on. So we only account for one investment at seed and no more investments afterwards. Mark Suster has done a great job showing how Founders are diluted in subsequent rounds, but this topic hasn’t really been tackled when talking about angel/seed investors and plays heavily into understanding returns. Preliminary looks at follow-ons increases the deployed capital substantially and take you further from breakeven. Following on precognitively in only the winners does help - ESP anyone?

One might ask - couldn't we calculate actual exit results from information in their database? Unfortunately not - of the 2009 dataset, there are exit values for only 9 out of the 49 total exits that year. M&A numbers are still pretty secret overall. The best we can do is insert median exit values as a proxy.

The Dead/Self-Sustaining number/% is a bit deceptive. Some of the companies in this number that are surviving could be big companies who simply didn’t need to raise another round, and digging into the companies that did not raise a large number of rounds is needed. Also, indication of death in the CBinsights data unfortunately isn't all that complete at this time- yet another place for improvement in the data. However as time passes for the 2009 cohort, we should see the final results of those surviving companies.

In examining breakeven, I asked the question, at what starting valuation could I break even according to the model? Using Excel, I calculated the break even valuation to be $4.08M pre-money. Unfortunately, with current West Coast market rate valuations for seed stage startups hanging around $5-6M, you’d have to do something very special to be investing at $4.08M pre-money. Investing at lower than $4.08M valuations means you’d be positive with the model - great job finding startups that early and negotiating awesome deals!

We then compared this model to investing in the public stock market. Using a Cambridge Associates report from last year, we used their calculated return multiple from 2009 for the Russell 2000 (they have a proprietary method for calculating a return multiple to compare your investment in venture capital and private equity against other traditional investments). In order to match the return of investing into the Russell 2000, your last startup must yield a 19.4x! So you would need a 5.65x return to merely break even, but an additional 13.75x to beat investing in the public markets, which is by far a safer investment than startup investing. Why was I angel investing again…?

Using the median values doesn't appreciate what you might individually do or what actually happened for each round and any preferences that may come with a round. We just made the assumption, right or wrong, that most things would happen at the medians of all the values.

The model is just a model. A reflection of reality, yes, but still not reality. It still communicates some interesting things about today's investing world and how you might alter your strategy in investing to beat the model.

The Tweetstorm that Spawned the 10,000X Startup

user-pic

This interesting tweetstorm by Dave McClure caught my eye. It was regarding entrepreneurs not wanting to accept a 2x return clause on notes and the high valuation caps on those notes that are running around the Silicon Valley right now. Then at the end Sam Altman of Ycombinator jumps into the fray, who replied:

When our research team and I saw the 10,000x, we thought we’d have some fun with it.

Wow - 10,000x. That’s an over-returner for sure - probably the unicorn to end all unicorns. But how would you get one and would anyone have experienced one already?

Let’s do some back of envelope calculations. Assume you’re a seed investor like Dave. You could take companies in the unicorn club and divide their current post-money valuations by 10,000. This would theoretically determine what their seed valuations needed to be in order to return 10,000x for the company’s early angel investors.

But then, you’d have to take into account the dilution that occurs by the time a startup is a unicorn. Our principal, Tom, built this ownership model to show the typical ownership dilution each round experiences on its way to series E.

You could stand to lose 50% of your ownership, assuming nothing else bad happened funding wise along the way, on the way to unicorn status.

Let’s take Uber. It’s valued at $40B right now. If you take $40B and divide by 10,000, you get $4M. But then divide by 2 to account for the ownership drop and you’re left with $2M POST money. Essentially this is the valuation of a seed round you would have needed to invest into in order to achieve a 10,000x at the $40B valuation.

Back to Dave’s twitter rant about high valuations pervading in the Valley. Does any reader of this post think they can get in on a high flying, unicorn-esque startup in today’s world at $2M post money valuation?

Still, has anyone ever even achieved a 10,000x? Uber is worth $40B, but its exit story hasn’t been written yet. We poked around and came up with Peter Thiel’s reported $500K investment into Facebook at a $5M valuation. It makes sense on paper that at $5M seed valuation you’ll get a >$104B exit - that’s 20000x! Unfortunately, he must have suffered some dilution and/or sold off stakes early because he arrived at the IPO with an awesome return of 5000x! Dang - only halfway there.

OK 10,000x is a worthy goal. But what’s the odds of you getting that kind of return?

Cowboy Ventures’s Aileen Lee wrote in her infamous unicorn post, Welcome To The Unicorn Club: Learning From Billion-Dollar Startups that she found that since 2003 to the date of the post in 2013, there was a .07% probability of a startup reaching unicorn status. Remember, that’s .07 PERCENT, which means 7 out of 10000 startups have reached unicorn status. Pretty long odds assuming that you even had a shot at investing into one of those pre-unicorns.

Looking back at my investing past, I was scheduled to meet with Uber (what was then Ubercab) but was one of the last investors they talked to. The round was oversubscribed, and I was shut out. I was there at YC when Airbnb started out but sharing rooms in my home wasn’t something I personally believed in, so ultimately I didn’t pursue. I was also there at YC during Dropbox’s demo day. I was in the running for investing, but yet again was shut out as other larger and more prominent investors pushed me out. For every other unicorn, I never even had the chance to even review the deal, let alone invest.

But from what I could remember about Uber, Airbnb, and Dropbox’s funding valuations - sorry about my very fuzzy memory, but those were the days when $4M pre was still possible - I don’t think I could have achieved a 10,000x return coming in at the seed round - maybe >10x, maybe even in the 100x range but definitely not 10,000x.

By now, you may see how absurdly rare a 10,000x is, potentially even unachievable. So what are Sam Altman and Dave McClure really talking about?

It’s the golden age for entrepreneurs. Entrepreneurs have all the power. You can go raise seed at valuations higher than anytime ever in history. New investors on the scene are naive; they haven’t had the history of investing in less bubbly times. They are forced to take whatever deal is in front of them. They think these valuations are normal. And with small checks, they have no ability to affect the terms of the round. But the first naive seed investor that pulls the trigger inadvertently validates the terms.

But the risk is also higher; competition abounds and there literally is an app for anything. So investors pay more for higher risk. It’s also why those who know me, know I like to say that the seed market is bubbly and that it’s the worst time to be a seed investor with no dry powder to follow on. Angels and funds who only invest in seed rounds take all the risk yet get lower/no returns if a company goes unicorn-ballistic through severe dilution. This risks their ability to break even or make money at seed investing.

Entrepreneurs win no matter what the outcome. As many have replied on Twitter to Dave and Sam’s tweets, even a small win is notable or even life changing for the entrepreneur. It is not a bad thing to get acquihired into Google or Facebook, right?

Dave is probably the only guy out there willing to publicly say something about the current attitude of entrepreneurs. The rest of the investor crowd needs to toe much more lightly and quietly; it’s too easy to be shut out of deal flow. Who wants to be shut out from Ycombinator demo day? The entrepreneur forums are quick to denounce investors who are too this or too much that. You don’t play by entrepreneurs’ rules nicely, your reputation is shot, and you’re blackballed from deals.

High valuations at seed are all over the Valley. Market rates for the average SF Bay startup are probably around $5-6M cap on note (forget equity rounds), with jumps to $8-$12M for those coming out of Ycombinator. These are for startups with little or no traction. Market rates for startups with traction at seed can head towards $8-$10M.

If you’re moonshotting for 10,000x at a $10M valuation, you’ll never make it. That’s a >$100B exit valuation for the company, which is at the black swan category for companies like Facebook and Alibaba: outliers by a *wide* margin.

Speaking of black swans, in Sam’s post Black Swan Seed Rounds, he states:

Great companies often look like bad ideas at the beginning—at a minimum, if it looks great, the seed round is likely to be overpriced, and there are likely to be a lot of other people starting similar companies. But even when I attempt to adjust for price, the hot-round investments still have underperformed.

I asked a few other investors about their experiences, and most are roughly similar. Most of the really big hits never had TechCrunch writing about their super competitive seed round everyone was trying to get in.

Interesting that a 10,000x comment comes from someone who also wrote the above…?

Many thanks to Tom Egan, Edward Coady, and John Lanahan for reading/commenting/contributing to this post.

The Customer Adoption Problem for Health Startups

user-pic

We can all agree that for today's internet startups, customer acquisition is one of the biggest issues they face. The world is so crowded with apps, things to do, things to grab your attention and waste time - it's one of the hardest problems to solve to break through the noise and get someone to notice you AND download you or try you out. Consumer startups face this problem the most, but B2B startups also face this problem. There are enough B2B startups now hitting up the IT managers of companies big and small that they are slowing down in their decision to implement a new product or service. And as I've always said, if it takes too long to gain customers and get to sustainable traction or great metrics, you will die because your bank account won't last that long.

However, there is a similar and IMHO worse problem for today's health related startups. But it's not quite a customer acquisition problem - you can spend money to get people to download your app or get to your website - it's more related to conversion and I call it a customer adoption problem.

First, I want to clarify that when I say health startup for the purposes of this post, I am leaving out the "health" startups which don't really have definable, definite, repeatable health impact - I would put fitness trackers, GPS watches, workout apps and hardware, etc. into this category. They provide data, but you need to figure out how to use it OR, there really is no definable, definite, repeatable health benefit - by this I mean, you can't tell someone exactly how many steps you need to take to lose 10 pounds or to prevent a heart attack. It's just not possible.

I would also leave out the traditional biomedical device startup, whose path is generally not direct to consumer (some are, and more are needing to go to market first before some kind of exit happens), they create a great device, take it through FDA trials to prove efficacy, and then sell to a large biomedical device company. The biomedical device startups who are going direct to consumer, however, can be placed in my category of health startup.

So leaving out those kinds of "health" startups, what are we left with? Some pretty cool startups that are applying technology to solve some really sticky health problems. However, there is a HUGE hurdle towards success - the culture of the consumers highly tilted against adoption of these kinds of products and services.

These hurdles are:

1. People have been trained for decades that they should never pay for their healthcare. Insurance should pay for all of it. If it's not reimbursed by insurance, they won't pay for it out of pocket and avoid treatments of any sort that makes them pay.

2. We are in a "curative" culture of healthcare and not a "preventative" one. We would rather wait for something to happen (and lead crappy, self-indulgent, unhealthy lives to get there) and then do something about it.

3. Along with 2., we don't see the value of something we haven't experienced yet, or have no experience with. Why should I worry about my thyroid? What the heck is that? My heart beats so why worry ahead of time about it?

4. We hate hearing something might be wrong with us. So any product or service that would tell us that is avoided as well.

5. Inaccurate, outdated information on health hampers the ability of new information, packaged into products and services to gain traction. The illusion of knowledge exists in health; knowledge seems to be eternal but it is not. Every year new information comes out and old information is discarded, but people stubbornly hold onto information they learned years ago and they erroneously think it's permanent. Still this means that they are resistant to adopt new information or methods due to thinking they already know enough.

As you read through the above, I'm guessing that you can relate to each one of those points. To me, these are nearly unsurmountable issues that are deep rooted in the culture of our society. These are issues that are top of mind for me right now in looking at today's health startups (by my previous definition). Finding a believable, reliable solution to the customer adoption problem that circumvents these issues is critical to their success, and whether I will invest in them.

All About US Investors for International Startups

user-pic

A few weeks back I gave this presentation to a group of Kazakh entrepreneurs at the Silicon Valley Innovation Center. They wanted to know about US investors, what they look for in investments, how to find them and how to create a situation where they might invest in a startup coming from another country.

While the presentation is geared towards this group of international startups, US startups who are just starting out might find this information useful as well.

Upstream and Downstream

user-pic

In mentoring startups, I have noticed two things have come up recently:

1. Entrepreneurs keep remarking to me that investors are looking for multi-tens or hundreds of billions in market size. I believe this is one of the results of the explosion of startups we have seen over these last few years, as investors at all stages keep raising the bar for the startups they invest in.

2. Startups at early stage are, more often than not, always focused on solving some singular problem and jumping on the early customer adoption as a sign that there is a business there.

But startups who are solving some singular customer problem still can’t seem to satisfy current investors’ desire for truly huge market size. One possible solution to re-defining a startup project with larger market size, is to use the concept of Upstream and Downstream to expand on what you’re working on to something with a bigger vision, and thus larger market size.

What is Upstream and Downstream?

If you solve a particular problem, then looking upstream means to look at what you can solve that is closer to the customer and what they need to do before they can use your service. Looking downstream means providing solutions for what the customer needs after they use your service. Expanding your capabilities up and downstream means you expand your potential business and market size by that much more.

For example, suppose you are an adtech startup. You help companies serve ads across multiple ad networks.

Looking upstream from the problem you are currently solving, you see what the customer needs before they get to your service. So if you are currently helping people serve ads, then things that need to happen before the ad serving are:

1. Media planning for the ad serving.
2. Campaign creation and management.
3. Ad creation and design, visuals and copy.
4. Landing page creation.
5. Ad network selection.

Looking downstream, what does your customer need after ads are served?

1. Analytics - ad performance results, which targets worked the best/worst.
2. Insight into what ads to run next and where.
3. Landing page results, testing, and management.
4. Post campaign management of ad networks.
5. Ad modifications due to results, suggestions for the modifications.

Now, you are providing a more fuller solution to your customers instead of just one small piece. If you didn’t provide these services, your customers would be forced to use other resources or services from other companies. Some of those might be connectable to yours, some they would have to stitch together by hand or home grown technology. Customers always want to have one place to do their work; multiple solutions complicate things dramatically. Being the one place where customers can do everything is a big advantage for them.

Ultimately, expanding your business both up and downstream is a recipe for world domination. Instead of serving only one portion of a customer's needs, you instead service all the needs up and down the chain.

Today’s world encourages cooperation amongst companies: expose your data via APIs and share it; use outsourced services to do things you don’t want to do. This may be true for some things, but more and more I am finding that startups need to do more by themselves instead of depending on others. By securing more value internally to themselves, they can then expand their vision to be much bigger, capture more potential revenue, and target a larger market which investors love.

End note: Of course, there are examples of startups doing one thing that have gotten big: SurveyMonkey, Evernote. Remember, these companies started years ago in a world where there wasn't so much competition. Today is different; there are thousands of startups out there and investors are much pickier. Without a bigger vision, you may not even be able to get off the ground. Work Up and Downstream and make your world domination plan a reality!

The Billions of Dollars Opportunity

user-pic

Time was, if you had at least a hundreds of millions of dollar market, or up to a billion dollar market in your pitch, that was enough to get you funding. But today, I've heard multiple times that even a billion isn't enough, let alone hundreds of millions. Venture funds are now looking for multiple billions, into the tens and hundreds of billions of dollars market.

Some might argue that VCs were always doing this - what's different now? Why is this important today?

Early stage venture funds are using this as filter. There are too many startups out there, so why not say no to everyone except those with a believable billions of dollars of market story? The implications of this are, the startups with smaller opportunities will find it hard, if not impossible, to get funding.

Startups don't realize the danger, and seed investors are starting to wise up. There are too many chasing after too small opportunities to be able to pass this filter. If you can't raise money, it may be that what you're working on is too small, even for a hundreds of millions of dollars opportunity.

Suppose you get to some impressive scale, like $1M+ in revenue run rate. As you go for the big round, the current crop of series A funds won't even touch you despite having strong revenue growth. If your market is small, so is your potential and your ability to "unicorn" is not all that great.

So if you're raising seed, I would figure out what it is you're doing if not a billions of dollars market and change it to be one. Investors are always searching for unicorns and it's best that you shoot for being one from the very start or else you may not get very far in your fund raise....

The Pre-Emptive Bridge

user-pic

Yes folks, we are a bridge happy funding community. I expect that 90+% of my seed investments will require a bridge, and adjust my expectations and funds to prepare for the inevitable ask. It simply takes too long in general to get to either breakeven or good enough metrics/traction to land the next big round - I estimate now it takes somewhere between 24-26 months to get to either on average. That doesn’t mean there aren’t outliers who do it in less time; it just means that most of them won’t be outliers and will take that long. The problem is that nobody ever raises for 24-36 months - we do see seed rounds edging higher to $1.5-2M rounds over the $500K-$1M we say not too many years ago. Still it’s tough to even push $2M into 24-36 months. If nobody raises for that long, they will most likely come back to us and ask for more money.

Lately though, I have seen startups and investors work better together and do a bridge before they really need it. I call this the Pre-Emptive Bridge.

Usually what happens is the startup looks at when they expect to raise the next round, most likely a series A, and now do it well more than 6 months in advance of that time. They now know there is seasonality in investing, and take this into account, trying to now adjust cash and burn to run out in July instead of December. They try to plan such that they can go out early in a year, say January through March, and start their series A process then versus in the fall.

Then they look at what they will have accomplished by the time they want to start raising their A. Will they have good enough preparation, traction and metrics for the A?

If they do not have good enough preparation/traction/metrics or their cash will run out before they do or cash will run out in a poor time of the year, then here comes the Pre-Emptive Bridge.

They come back to us with the outlook and the plan, and we look to raise some more money to get us to any of:

1. Breakeven
2. Running out of cash in July instead of a poor part of the year.
3. Good enough traction and metrics for a decent chance at an A, and achieving those traction/metrics at a time to go for the A starting in the early part of the year.

In years past, I’ve felt that investors were always caught off guard by the bridge. Now it seems like even angels are expecting it, and it looks like many are prepared to put more money into those with a good plan and likelihood for success. I’m not only glad for this, but also for entrepreneurs to have the foresignt to look ahead that far and take steps to increase the probability of success well in advance versus waiting until the last moment.

[UPDATED] The State of Early Stage in March 2014

user-pic

A few weeks back I had the pleasure of presenting to the Silicon Valley Innovation Center, an organization which works with many Eastern Europeans on introducing them to and making connections in Silicon Valley. They wanted me to talk to them about the state of startup investing, and I chose to present on the state of early stage investing, the area where I do most of my work.

The events in Ukraine prevented many from coming, but two people did make it to my presentation. The presentation was not an upbeat one; I showed slides from many data sources stating that I believed there were some serious issues for seed investors to operate and profit from. After the presentation, I was surprised that they said I was only the presenter who didn't have an extremely optimistic outlook on events in Silicon Valley.

Here is the presentation - it is updated to information to late March and is missing some new data that has appeared:

Just to be clear - I have no issue with entrepreneurism. I admire people who start businesses to either make money to support themselves and their families to those who go for the gold. It's not easy to do, and it's the Golden Age of Entrepreneurism right now. Nowhere in history has it been easier to raise some money to go pursue the dream of starting a company. Nowhere in history has there been so many resources dedicated to helping companies start. Nowhere in history has there been so much fame and attention assigned to entrepreneurism. You're a superstar if you start your own company today.

Each day, more and more investors emerge. With the passing of the JOBS Act, soon the normal average US citizen will be able to invest in startups. And we are seeing the appearance of so many new funds. Where are they coming from? Some are angels in disguise, some are family funds, some have international origins, some we don't really know. Still Silicon Valley is awash with money looking for somewhere to go. We can partially thank the Fed for some of this - holding interest rates at zero, making bonds a non-investment - they've pushed everyone out on the risk curve, and investing in startups is one of those places investors have been pushed to.

Each day, more startups emerge. Most startups I meet already have 4-6 competitors - or more. By the end of 2013, we had done our own counting and thought there would be 2500+ startups out there. Unique-ness is a hard competitive advantage to achieve. Raising a ton of money when you have little traction is much easier by far.

Who to pick to invest in? I've heard many methods out there ranging from "just pull the trigger if you like them", to doing a ton of research into the market as if you were putting millions in, to "if so and so is in, I'm in too." Still, the brutal reality is that risk is way up because it's so easy to start a startup and thus competitors sprout the moment they are seen on Techcrunch.

Even as risk is up, valuations are also up. At one time, if something was more risky, you'd pay a better price for it. Today it's not like that with startups. Risk is up but so is their price. The going rate for seed stage startups is generally $5-6M cap on a note, or pre-money, with jumps up to $8-12M. When I started investing back in 2006, the norm was $2.5-3.5M pre-money - there were no notes back then.

Manu Kumar just published an excellent post called The New Venture Landscape. In the section entitled, "Re-jiggering of deal stages and sizes", he states:

Seed is not the first round of financing any more. In fact after noticing this trend last year, I have transitioned to calling most of my initial investments “pre-seed” rounds, where the company raises close to $500K, before raising a full seed round. The Seed round is larger — closer to and sometimes upwards of $2M. The Series A is now the fourth round of funding for a company — the first is usually friends and family, or an incubator (~$50K), then pre-seed (~$500K), then seed (~$2M), then Series A (~$6M-$15M).

So I can't even call myself a seed investor any more - we are sometimes part of the $2M "seed" round but more likely we are part of the "pre-seed" round. Even at pre-seed stage, we pay a higher price generally, but yet the company doesn't raise enough to survive on that alone and usually needs to raise more later (aka the bridge round) to keep going, assuming it gets somewhere at all. Thus, risk is up yet again but there is no reflection of that in the price we pay.

That is why I believe that while this is the Golden Age of Entrepreneurism, it is also grown to be the riskiest place by far for former-seed-now-pre-seed investors. Other stages are not immune to what is happening, experiencing things like Series A Crunch and even the potentially looming Series B Crunch. However, IMHO the issues manifested themselves first at early stage which is where things begin and the other stages don't feel the issues until much later as it takes years for startups to grow to those stages.

What are the issues?

1. Valuations are up, but yet risk is also up. We are either paying more for a startup at the new seed stage, or in order to get a slight consideration for price we enter the more dangerous pre-seed round.

2. Competition is way, way up. It's too easy to start a startup, so for us pre-seed investors, how do we know that it's my startup amongst a group of 4-6 similar startups who will win?

Still, we see those who seek to disrupt the current winners. After Whatsapp's $19B exit, how many messaging apps have appeared?

3. According to Berkery-Noyes, in 2013 the median of exits is hanging around $12-15M. Contrast that to 2008 when the median was around $20M. Remember also that valuations back then were lower than they are today - startups that exited in 2008 probably started in 2006-7.

When you invest in a startup and the median of exits is less than or equal to 2x that of where most startups will exit, you might be happy with a 2x return in today's world where our economy sucks and we can't make money elsewhere. The problem is that your ability to make money is not sustainable in the long run as a startup investor. Your losers will far outpace your winners and investing in startups hoping for a 2x return the median exit will ultimately lead to you going negative pretty quickly.

To give you a look into the failure rate of startups, CBinsights reports that for a given cohort of startups vintage 2009, 75% die, 21% get acquired, 4% are potential over-returners (or the elusive unicorn). That means that you have to invest in 25 startups statistically to get 1 over-returner.

Contrast that to when I started angel investing back in 2006, the venture fund folks I chatted with all told me that if you invest in 10 startups, about 5 will die outright, 4 will either return your money or 2-4x, and then there will be one that will return everything you've lost and then some. But that was also at series A stage; there were very few seed funds back then and the seed stage was mostly supported by angels and angel groups.

Let's play with some scenarios. Assume you put equal amounts of money into every startup you invest. Assume that you invested in 25 startups.

First, let's apply the current $5M pre money/cap on note metric for funding and assume a $6M post money, and use the low range of median of exits of $12M. Using the CBinsights data from 2009, 75% of your 25 startups or about 18-19 of them will just die outright. Then, 21% or about 5 will most likely return 2x, meaning that you only cover 10 startups worth of investments that failed; you have another 8-9 which still need to be covered in order for you to break-even. That means that one startup which over-returns must do so at 10x to just break-even.

Note that I've also made the important assumptions on the 21%. These are:

1. The 21% didn't raise any more money and you were not diluted.
2. I also assumed that you could actually take into account ownership at the valuation of the round. Most rounds these days are notes with caps and you can't always assume the ownership is there. In my experience, if you don't own stock, all sorts of things can happen to your detriment even at a 2x acquisition on current valuation of the company.

I think you can assume that the above case is the BEST case scenario and all other scenarios return less than here for the average person. It also assumes you can get into right deals and not bad deals. Your own investing record can vary widely from the above.

Now for another important metric. By CBinsights count, there were 472 seed funded startups in 2009. In 2013, that count jumps to 856. Again, we are back to more competition with each other and for customers, thereby increasing risk for the average startup that is out there.

How do I cope? Largely, there are three coping strategies:

1. I keep strict valuation discipline.

2. I generally invest only in startups with no competitors.

3. I am always out there searching for the unique, special stuff and looking in places where others are not. I am patient to wait for when items 1 and 2 above align.

(Pre) seed investing has gotten to be an interesting place. I still believe opportunity is out there, but it is largely shifted towards later stages where traction, survivability, and sustainability can be proven, and for investors who can continue to invest throughout the stages of a startup, versus only being able to invest once and either follow on not at all or very sparingly.

NOTE: The strategies I employ at Launch Capital are not necessarily the strategies employed by the other directors.

UPDATED/EDITS: I wrote this post quickly and under uncomfortable conditions! Reading it over I found the need for edits. Here they are:

1. The calculation with the CBinsights data is incorrect. If you return 2x on the 5 acquired startups (21% of 25), you cover 10 startups you invested in. However it forgot to cover those 5 acquired startups so there are 5 additional startups worth of return to cover the 19 dead startups. That means you still have to cover 14 startups, not the 10 I said previously. So the 1 over-returner needs to return 15x just to break even, not 10x. That is even more difficult by far!

2. I said that this was the "best" case. I think this is the wrong word. I think "average" case is a better descriptor. Then my statement about other cases being worse is not quite correct. You can of course return better than 2x in the acquisitions, and return over 15x in the one over-returner.

Biohacking as the Next Opportunity

user-pic

In early 2013, I had the pleasure of attending the Bulletproof Conference put on by Dave Asprey of Bulletproof Exec fame. It was my first real introduction to the concept of biohacking.

According to Wikipedia, biohacking is the "practice of engaging biology with the hacker ethic." That means that you use many different means to actively alter and enhance your biology. These could be technological, or they could be biochemical, or they could simply be revealing more on your current biological state so that you can effectively take action. To most people, I think it evokes images of cyborgs and wearing steampunk like hardware on their heads. At one point the hardware may have necessarily looked like that: big, clunky, expensive, wires running everywhere, lights flashing. But today, technology has reached a new level of miniaturization and availability.

I couldn't resist exploring the potential of these devices. I began training with a specialized electrostim machine called an ARPWave POV with the guys at EVOUltrafit. While the intent was physical results, the training is actually neurological. So while I get results externally, I find that there some amazing benefits internally. I bought a Somapulse which uses pulsed electromagnetic fields (PEMF) to induce healing and to re-energize cells, and was developed by some guys at NASA. I bought it out of frustration that my elbow, which got strained, was not healing fast enough on its own for months. In 3 weeks with the Somapulse, it was all better.

I've also tried the various popular fitness trackers and found them lacking. I'm also testing some sleep trackers but nothing comes close to the now defunct Zeo, which I unfortunately was too late to buy one. I also got a transcranial direct stimulation (tads) device called the Foc.us, which I haven't played with - too many toys! I am also looking into Rife technologies - cure cancer anyone?

I also tried WellnessFX and now am a big fan of more constant monitoring of your blood markers AND the ability to do it without requiring a doctor to prescribe a blood test - direct to consumer still has not seen its full potential but I have seen the value of it. While blood draws may make people cringe, companies like Theranos are changing that to drawing only a few drops of blood (and by the way, 10x cheaper)! I am also actively working with a functional medicine doctor at JustInHealth to get my blood markers back into healthier levels. With my thyroid and adrenals number back in place, every day I have more energy, resistant to disease and more resilient to the stresses that occur in my life.

Much of these technologies are on the fringe still; early adopters and hobbyists messing around with interesting devices, some getting good results, some questioning. It also requires a level of commitment, education, and initiative that most people don't have. Most people are totally passive on their health and physical condition and just wait until they get themselves into an unhealthy corner before doing something. By that time, it may be too late.

Experiencing the potential of these technologies firsthand and seeing the explosion of such devices across the internet and across crowdfunding platforms like Kickstarter and Indiegogo, I believe that we are on the edge of a new opportunity for startups to create something really new and impactful.

The challenges I see now are:

1. Most of this technology is still complex and requires a lot of effort on the part of the user. Until it is simplified further, wide adoption could be very difficult.

2. The customer base needs to educate themselves on taking control of their health and wellbeing. This will take some time.

3. It is possible that a simpler product could make a customer acquisition strategy work in the short term. One issue I have seen is that companies who have done this do not have the expertise or knowledge to advance their products beyond where they are now.

4. The hardware itself needs work. At the moment, wearing the devices can be cumbersome and uncomfortable. Power requirements limit usage times. Even something as simple as wearing a heart rate monitor belt around your chest all day is annoying. I also think that wireless technologies still need advancing. Bluetooth LE is a step forward, but I find that there are still issues.

The startup who can take a biohacker technology AND figure out the broad adoption problem will really have something. I've experienced firsthand the results of biohacking and there is way too much value to not bring to the general population. But for them, it's a user interface problem applied to super high technology; hide all the wires and blinking lights and make it one button easy.

I'm excited to see science fiction become reality in my lifetime. As a startup investor, I plan to be fully immersed in biohacking technologies in my search for the next winner.

Monthly Archives

Favorite Links

Twitter Updates



My Moblog



Tag Cloud